Impairment testing cash generating unit with IFRS 16 leases

Impairment testing cash generating unit with leases (or impairment of leased assets) is about a right-of-use asset (leased asset) and  such an asset will frequently be included in a cash generating unit to be tested for impairment. At initial recognition, the right-of-use-asset equals the recognised lease liability, plus any lease payments made at or before the commencement date, less any lease incentives received, plus any initial direct costs incurred by the lessee and an estimate of costs to be incurred by the lessee in dismantling and removing the underlying asset and restoring the site on which the leased asset is located.

The most significant part of the right-of-use asset will often be the lease liability, which is the present value of the lease payments discounted at the interest rate implicit in the lease if this rate is readily determinable, or otherwise at the lessee’s incremental borrowing rate.

Therefore, the discount rate applied to determine the lease liability can have a significant effect on the carrying amount of the right-of-use asset at initial recognition. If the value in use is determined in an impairment test mechanically, ignoring the lease liability and related lease payments from both the carrying amount and the value in use of the cash generating unit, the following effects will occur when compared with the value in use with operating leases under IAS 17:

These two effects will usually have an offsetting effect. As a result, generally, there will be a limited effect on the impairment test, i.e., the amount of headroom or impairment calculated will not be substantially different.

However, if the IAS 36 discount rate (for example, a discount rate based on the weighted average cost of capital (WACC)) exceeds the IFRS 16 discount rate (for example, the lessees’ incremental borrowing rate), this will have a net negative impact on the results of the impairment test as the carrying amount of the cash generating unit will increase more than the value in use of the cash generating unit.

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Determining a leases discount rate

Determining a leases discount rate

The definition of the lessee’s incremental borrowing rate states that the rate should represent what the lessee ‘would have to pay to borrow over a similar term and with similar security, the funds necessary to obtain an asset of similar value to the right-of-use asset in a similar economic environment.’ In applying the concept of ‘similar security’, a lessee uses the right-of-use asset granted by the lease and not the fair value of the underlying asset.

This is because the rate should represent the amount that would be charged to acquire an asset of similar value for a similar period. For example, in determining the incremental borrowing rate on a 5 year lease of a property, the security for the portion of the asset being leased (i.e. the 5 year portion of its useful life) would be likely to vary significantly from the outright ownership of the property, as outright ownership would confer rights over a period of time that would typically be significantly greater than the 5-year right-of-use asset contained in the lease.

In practice, judgement may be needed to estimate an incremental borrowing rate in the context of a right-of-use asset, especially when the value of the underlying asset differs significantly from the value of the right-of-use asset.

An entity’s weighted-average cost of capital (‘WACC’) is not appropriate to use as a proxy for the incremental borrowing rate because it is not representative of the rate an entity would pay on borrowings. WACC incorporates the cost of equity-based capital, which is unsecured and ranks behind other creditors and will therefore be a higher rate than that paid on borrowings.

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IAS 36 What is a lease impairment?

IAS 36 What is a lease impairment? IAS 36 What is a lease impairment

Simple, it is a right-of-use asset and will frequently be included in a cash generating unit to be tested for impairment.

The right-of-use-asset

At initial recognition, the right-of-use-asset equals the recognised lease liability, plus any lease payments made at or before the commencement date, less any lease incentives received, plus any initial direct costs incurred by the lessee and an estimate of costs to be incurred by the lessee in dismantling and removing the underlying asset and restoring the site on which the leased asset is located.

Lease liability

The most significant part of the right-of-use asset will often be the lease liability, which is the … Read more