Common issues with impairment testing of mineral assets
31 March 2021
As the impact of COVID-19 continues and the June 2021 reporting season looms ever closer, the quality of financial reports will once again come into focus from investors and regulators. Asset values, assumptions and disclosures may be significantly affected by developments or ongoing conditions since the last reporting period.
In corporate reporting terms, uncertain economic conditions can result in many resource companies needing to write down the book value of exploration assets and mineral properties, and the likelihood of future impairment losses is a close reality.
The combination of uncertain economic and market conditions coupled with a renewed focus on the quality of impairment testing by regulatory bodies means that directors need to be vigilant and ensure that appropriate consideration is given when assessing potential impairment scenarios. Further, transparent and accurate disclosures are required and under constant scrutiny by regulators, stakeholders and market participants.
Exploration vs. development and production assets
AASB 6 Exploration for and Evaluation of Mineral Assets requires exploration and evaluation assets to be assessed for impairment when facts and circumstances suggest that the carrying amounts of such assets are no longer considered recoverable. Once a project has reached the development phase and is deemed to be ‘commercially viable’, AASB 6 is no longer applicable and AASB 136 Impairment of Assets will apply.
Impairment is deemed to exist where the recoverable amount of a cash generating unit (CGU) is assessed to have a lower value than the book value of the related assets (and liabilities) of that CGU’s recoverable amount. Book value being the higher of fair value less costs to sell (a market- based model) and value in use (an entity specific model).
Watch out for indicators of impairment
AASB 136 requires goodwill to be tested for impairment at least annually, irrespective of whether there is any indication of impairment. However, all other assets are required to be tested at year-end if any indicators of impairment exist.
There may be multiple triggers for an impairment test, such triggers commonly seen in today’s climate include:
A significant deterioration in forward commodity prices;
A significant adverse foreign exchange rate movement;
Higher than expected operating costs, such as from increased labour costs or the need to move to an outsourced contract model;
Higher than expected costs on a capital project in development and construction phase;
Insufficient funds to complete the exploration programme or development and construction phase, so that the commercial production phase cannot be reached;
Failure of Joint Venture parties to fulfill funding obligations;
A significant decrease in market capitalisation of the entity or others producing the same commodity;
The existing period for the right to explore has expired or will expire in the near future, and is not expected to be renewed;
Insufficient exploration expenditure incurred during the period, infringing the terms of the exploration licence and therefore threatening the loss of the licence; and
Entering into farm-in arrangements with other parties, reducing an entity’s economic interest in a project.
Common issues found with impairment testing of mineral assets
The technical requirements of AASB 136 are complex, which means several issues are commonly seen with impairment assessments of mineral assets. Here are some of the issues most frequently encountered by auditors.
Selection of a value in use (VIU) basis over fair value less cost to sell (FVLCTS)
Many businesses prepare a simple VIU test and give no consideration to the asset value as derived under a FVLCTS test. If undertaken in accordance with the standard, a VIU test is likely to derive a lower asset value because it requires the assessment to be restricted to the current condition of assets (amongst other limitations required of a VIU model). This means cash flow benefits to be derived from either uncommitted future restructuring or from future enhancements to the capability of assets cannot be factored in.
Therefore, where there is expected mineral exploitation potential beyond current mine plans, or entities envisage enhanced revenues from additions of capital or lower costs from prospective rationalisation programs, directors should consider using FVLCTS (if other market participants would include such scenarios to value the assets in question).
Valuation experts have a range of techniques for FVLCTS including discounted cash flow (DCF), comparable sales. capitalisation of future maintainable earnings and even rule of thumb. However, under AASB 136 the technique chosen must maximise the use of observable inputs and minimise the use of unobservable inputs.
Application of a discount rate inconsistent with the cash flows
Specific assets/projects and CGUs often have different risk and return profiles to their parent entity. In these circumstances, the asset or CGU may have a different required rate of return and therefore a different discount rate to the consolidated parent. Likewise, country-specific risk premiums should be considered for assets held in different jurisdictions.
In addition, matching the correct type of discount rate to the correct type of cash flow is essential to perform meaningful discounted cash flow (DCF) calculations. Cash flows and discount rates can be:
Real or nominal;
Geared or ungeared (drawdowns, repayments and interest);
Pre or post-tax; and
A combination thereof.
Many valuation practitioners prefer to perform calculations using either a post-tax weighted average cost of capital (WACC) or a post-tax cost of equity discount rate (with appropriately matching cash flows).
Cash flow forecasts and underlying assumptions should be ‘reasonable and supportable’
Forecasts should be based on the latest management approved budgets or forecasts and these are required to be based upon reasonable and supportable assumptions that represent management’s (or the market’s) best estimate of the economic circumstances that will prevail over the remaining life of the CGU.
Greater weight should be given to external evidence such as commodity prices, and foreign exchange assumptions should be compared with analysts’ forecasts, current at the date of the assessment. Importantly, care should be taken to ensure there is consistency in the selection of foreign exchange and commodity price forecasts.
Assessment should also include consideration of the potential impacts on value of variations in these key assumptions.
Working capital balances incorrectly excluded from the CGU asset base
AASB 136 requires assets and liabilities that generate cash flows independently of other assets and liabilities to be excluded from the CGU. These include inventories, receivables, payables and provisions. However, in practice, impairment testing is normally based on forecasts for the business, which includes cash flows from the settlement of working capital balances.
AASB 136 allows companies that have included cash flows from the settlement of working capital balance to leave forecasts unadjusted if the carrying value of the CGU is adjusted to include working capital assets and liabilities. This helps ensure cash flows are aligned to the associated CGU assets and liabilities.
Problems encountered when determining cash flows associated with tax payments
Accumulated tax losses at the date of valuation need to be excluded from cash flows of the CGU as they are considered to be a corporate asset.
The tax payments included in a FVLCTS assessment are based on the tax bases of assets. Therefore, the carrying amount of a CGU should be based on a post-tax basis, i.e. net of any deferred tax losses (DTL) resulting from temporary timing differences.
As a VIU assessment is performed on a notional pre-tax basis, the tax payments should be calculated using the accounting bases of assets. Therefore, the carrying amount of a CGU should be based on a pre-tax basis, i.e. no adjustment for DTLS’s resulting from temporary timing differences.
The correct treatment of foreign currency cash flows in impairment assessments
Many CGU’s have cash inflows (and outflows) in currencies other than an entity’s functional currency. For example, most commodities are commonly priced in US$ terms.
Under VIU, foreign currency cash flows are required to be estimated in the foreign currency and discounted using a discount rate appropriate to that foreign currency and then translated at the prevailing spot foreign exchange rate.
Under a FVLCTS assessment, market based foreign exchange assumptions are used.
Any hedging contracts are required to be separately assessed under AASB 9 Financial Instruments and should not be included within the impairment assessment.
Incorrect calculation and application of a pre-tax discount rate in VIU assessments
AASB 136 requires companies to perform VIU calculations using pre-tax cash flows and a pre-tax discount rate. However, the most readily observable rates for equity are on a post-tax basis. Therefore, it is acceptable to use a post-tax discount rate with post-tax cash flows, with the pre-tax rate determined for financial reporting purposes.
Determination of a pre-tax discount rate is not as simple as grossing up the post-tax discount rate by the standard rate of tax as this does not consider the timing of future cash flows, the useful life of the CGU and the expected tax cash outflows.
Impairment testing calculations
The Findex Valuations team provides valuations of businesses, shares and other securities to assist shareholders, management teams and Boards to analyse merger and acquisition transactions and to make decisions around landmark events, including the preparation of public and listed company Independent Expert’s Reports.