Identification and composition of cash generating units Plausibility and consistency of cash flow projections

The following article was originally published by Wiley.

  1. Are you aware of potential misapplications of IAS 36 [with respect to CGU’s] by reporting entities in your jurisdiction? If yes, are the areas of concern those flagged by the regulators or are there other areas of concern? If you are aware of potential misapplications of IAS 36 are they due to inadvertent or opportunistic application of the standard, an inability to comprehend fully the requirements of the standard, or for some other reason?
  2. Are you aware of any concerns about the effectiveness of the CGU concept in achieving the objectives of the standard?
  3. Are you aware of potential misapplications of IAS 36 [with respect to cash flow projections] by reporting entities in your jurisdiction in the manner identified by the regulators? If yes, is this due to inadvertent or opportunistic application of the standard, an inability to comprehend fully the requirements of the standard, or for some other reason?
  4. In your view, is the information relating to cash flow projections required to be disclosed by IAS 36 providing investors and other stakeholders with a suitable set of information? If not, in what respects to you believe the disclosures are deficient?


Recent misapplications of IAS 36, based on the writer’s experience and the published results of reviews performed by the Canadian regulators, include:

  • The use of overly aggressive cash flow projections when compared to the historical trend for the Cash Generating Unit (CGU). This is a theme in the Canadian jurisdiction which is continuing from the pre-changeover environment.
  • Boilerplate disclosures, for example, where an entity discloses the definition of a CGU instead of specifically describing how the definition has been applied by management.
  • The failure to identify the CGU for which impairment losses were recognized; and
  • Not providing a description and the reason for changing the aggregation of assets into CGU’s, despite being required to do so by IAS 36.130(d)(iii).

The reasons for the misapplication of the standard are difficult to decipher. It does not appear to be through opportunistic application: the reviews performed by the market regulators and audit regulator (the Canadian Public Accountability Board) do not usually result in reissuance of financial statements.

There were some significant differences between IAS 36 and the Canadian standard prior to adoption of IFRS® Standards. Furthermore, the adoption of IFRS Standards in Canada coincided with the financial crisis and resulting economic doldrums. The risk of error due to misapplication is also increased for smaller entities that often lack the breadth of experience in applying the standard and the budget to hire outside financial reporting or valuation expertise.

The CGU concept has wide acceptance in the Canadian jurisdiction: ‘CGU’ is a concept applied by the valuation community. In terms of economic reality, entity value is driven by cash generated by groups of assets. The writer is not aware of any concerns about the effectiveness of the CGU model, outside of the details of its application.

Cash flow projection disclosures are required to be made when a CGU includes goodwill or indefinite life intangible assets. The specific detail required where recoverable amount is based on VIU (Value In Use) relates to: the key assumptions, the approach taken by management (that is, past experience or external information), the period projected based on budget or forecast, the growth rate used for extrapolation and the discount rate. In the same scenario, but using FVLCS (Fair Value Less Cost to Sell), the required disclosure includes the period covered, the growth rate and the discount rate.

The cash flow projection information does provide financial statement users with a basis with which to understand the key assumptions behind the forecasts, management’s approach and the mechanics of the exercise. There are still improvements that could be made, however, such as:

  • Details related to cash flows used for measuring recoverable amount are not required (but encouraged) where intangible assets with finite lives are being tested. For many entities that carry long-term non-financial assets the estimation process and the related uncertainties around those estimates are likely to be one of the more significant for users of financial statements.
  • Given the economic uncertainty and the level of risk premiums currently demanded by markets, it seems that this level of disclosure would be useful whenever indications of impairment exist. This would avoid relying on entities applying the general standard in IAS 1.125 for estimation uncertainty.
  • It is possible to reflect the risks inherent in the cash flows through either a risk adjusted discount rate or by adjustments to the cash flows by using an expected value approach. Being informed of the discount rate is of limited use for purposes of comparison between entities. Instead, commentary of which risks are reflected and where would be useful.

The problem in applying the standard could be addressed by management and the audit committee considering the entity’s financial reporting from the perspective of the user.

Technical parameters of value determinations

Growth rates

 5.  Do some entities in your jurisdiction use seemingly high long-term growth rates? If so, do they provide sufficient justification (as required by IAS 36.134(d)(iv))?

6.  Do you observe substantial differences across industries or time due to the issue of growth rates?

7.  How do entities in your jurisdiction incorporate the impact of economic and financial crises into their cost of capital parameters with respect to long-term growth expectations and historically low risk-free rates?

8.  In your view, do entities in your jurisdiction pay enough attention when linking inflation assumptions and the time horizon against which the cash flow is forecasted?


Growth rates observed by the writer in recent years have been in the range of 0% to 3% and are based on a variety of factors, including: long-term real GDP growth, inflation rates or expectations, and estimated long-term growth of the CGU considering also historical performance. None of these entities have reflected growth in real dollar terms in their valuation models, and disclosure of the entity’s justification for high growth rates, as required by IAS 36.134(d)(iv), was therefore not necessary.

There is no correlation observed between industries or time, which is a function of the narrowness of the range of growth rates observed.

A public entity that has both traded equity and debt instruments is able to calculate a weighted average cost of capital (WACC) based on those observable markets. For such an entity, any selling of the stock and debt instruments in the secondary market during a financial crisis would increase the cost of capital.

Any entity that has thinly traded equity or debt instruments is forced to estimate the WACC. An estimate would be built-up starting with the risk free rate (such as the long-term bond yield) plus estimates of the other components. In times of crisis when the risk free rate falls market participants would require a higher risk premium, being one of those components.

Such growth rates applied to terminal cash flow values are consistent with current inflation estimates: the Bank of Canada is projecting Consumer Price Index inflation of 1.7% and 2.0% for 2014 and 2015 respectively. If growth is expected to be the same as the inflation rate (so there is no built-in growth over and above inflation to have a positive effect on VIU) then the point is moot. However, if the growth rate used in the model is lower than the expected inflation rate during the time period, there would be a built-in contraction of cash flows for the period beyond the projection. Often this is not explicitly disclosed.

Discount rates

9.  Based on your experience, are the discount rates used by entities consistent with the requirements in IAS 36.55? In particular, do the discount rates reflect the risks specific to the asset and do they reflect the market assessments of those risks and the current market assessment of the time value of money?

10.  Do you experience cases in your jurisdiction of entities not disclosing the respective discount rate that is applied in the context of a value derivation for each CGU that carries a significant portion of goodwill?

11.  How do you assess the severity of a lack of details on the specific discount rates in terms of the reconciliation of valuation results?


Entities often provide boilerplate disclosures about taking into account risks specific to the CGU and the current time value of money, without providing any indication as to what asset specific risks have been incorporated into the discount rate. In many cases, it is possible to relate the discount rates used to different business lines only in general terms, but the driver in each case and the exact risks built into the discount rate (as opposed to being reflected in expected cash flows) cannot be seen.

Disparate valuation results can be reconciled, or the differences justified or rationalized, in many ways depending on the circumstances. Take as a simple example, an entity where indicators of impairment are apparent, such as a market capitalization below the book value of assets or operating losses. It seems the disclosures related to impairment testing (and impairment losses recognized) are not driven by any perceived need of the reader to be able to understand that reconciliation process. Indeed, a very detailed disclosure of the build-up of the discount rate in that case, together with the other disclosures required, will not get the reader any closer to understanding why no impairment loss exists.

Similarly, an entity is not required to disclose the assumptions used to determine the recoverable amount when there are indications that an asset may be impaired – disclosure is encouraged but not required.

Comparison of parameters applied by different entities is not possible due to the lack of transparency around which risks are built into the cash flows and which are built into the discount rate. A comparison of discount rates would be meaningless, and potentially misleading, in terms of the relative riskiness of different cash flows.