Cost of capital and impairment testing as required by global financial reporting standards, continues to be an area of great interest to executives, investors, analysts, standard setters and regulators. The beginning of the last decade saw a high growth phase across many sectors, regions and countries only to be cut short by the financial crisis, from which much of the world is still recovering. The increased cost of capital during this time saw many acquisitions and projects being deferred but eventually companies across the globe realised that despite the persistent bearish market conditions, they needed to grow and find investment opportunities for their shareholder funds. As a result, coming out of the financial crisis period in South Africa, we have noted an increase in deal volumes in recent years, but a severely declining trend in deal values. Surprisingly, despite the low deal values, many transactions are still resulting in goodwill premiums being paid.
Some of these premiums have been paid on the back of an anticipation of the end to the downturn in markets and therefore increases in demand, margins and overall profitability. In addition, premiums are also likely given that the JSE has continued to grow quite remarkably (given such a low value of deal activity), hitting record highs in 2012 and experiencing its highest growth year since 2009. Whilst this growth in the equity market is noteworthy, it also needs to be said that certain industries have not fared as well as others. For example, the mining industry has been beset by a number of critical issues which have impacted heavily on value. In addition, we have seen a number of companies in the South African market whose price to book ratios have moved below one, which raises the question of whether these assets are impaired or not.
Impairment testing forces companies to assess whether the conditions that they anticipated when they acquired the asset or made the project investment have materialised, and therefore whether any premiums paid at the time of acquisition, are still considered to be assets of the business. Whilst the average price earnings multiples on the JSE during 2012 have finally returned to pre-crisis levels, in many ways the world market as a whole, and South Africa is no exception, has not grown at anticipated levels and the impact of this is that we would expect to continue to see impairments of goodwill based on the impairment testing framework in financial reporting standards. This survey is an attempt to establish the extent to which companies are still encountering goodwill impairments, and to understand how the cost of capital is currently being calculated, with a comparison to the prior year.
Subsequent annual valuations of acquired cash generating units, or businesses, form the basis for impairment testing. Given that the area of valuations is complex and requires a considerable amount of judgement, it is important to understand how companies are interpreting the requirements of the standard and how they are practically implementing and complying with these requirements. This survey attempts to provide some insight into these processes.
I would like to thank the companies who participated in the survey for their time and interest. I would also like to extend my sincere thanks and gratitude to the team who were involved in putting the survey together.
KPMG South Africa
Transactions & Restructuring
Significance of the impairment test
More companies recognised some form of impairment during the 2011/2012 period than in the prior period. Goodwill impairments also appear to be slightly up compared to the previous period, whilst asset impairments reported by respondents were up quite significantly. Many more companies appear to have performed trigger based impairment testing compared to the previous period, perhaps linked to macroeconomic instability experienced during 2012.
Cash generating unit criteria and valuation basis
Value in use remains the most popular basis for impairment testing valuations, with few companies using fair value less costs to sell to determine their recoverable amount. Many respondents indicated that they identify the cash generating unit at the legal entity or sub group level, whilst for half of the respondents this seemed to tie in with their segment level of reporting. There was a decrease in this year's survey in the number of companies who indicated that they identified their cash generating unit at a level below the segment level.
Measurement of cash flows
Most companies use recently prepared but unadjusted group budgets for impairment testing. This appears to tie in with the choice of value in use as the basis for determination of recoverable amount as it is requires budgets from the perspective of the entity itself, as opposed to from the perspective of a hypothetical buyer.
Determination of cost of capital
The average cost of capital calculated by respondents was up slightly from the previous year at 13.5% compared to 12.3% last year, with average terminal or perpetual growth rates being forecast at around 5%. The average cost of equity reported by respondents was 14.16% compared to 13.58% last year. In line with the decrease in the prime lending rate, the average after tax cost of debt reported by respondents also decreased. A majority of companies again determined a CGU specific cost of capital and most also indicated that they apply additional premiums such as country risk and small stock premia where applicable.
Overall economic outlook
Most companies expect overall positive economic developments in 2013 and the majority of respondents expect interest rates to remain stable.
Summary of findings
- A total of 350 South African companies were contacted, of which 42 responded. This resulted in a response rate of 12% (previous year: 11%).
- The highest respondents per industry were the bank sector (12.5%) and the technology sector (12.5%).
Significance of the impairment test
- During the 2012 financial year, 63% of companies surveyed recognised some form of impairment during the year (previous year: 36%).
- 38% of companies surveyed stated that they recognised a goodwill impairment (as opposed to some other form of impairment).
- The percentage of companies that performed impairment tests based on triggering events increased significantly to 83% compared to the previous year (50%).
- 75% of these companies identified triggering events in the impairment testing of both their goodwill and assets.
Cash generating unit criteria and valuation basis
- 38% of respondents used legal entities/sub groups to identify Cash Generating Units when testing for goodwill impairment.
- Approximately 50% of companies surveyed identified Cash Generating Units at segment level (previous year: 42%). The percentage of respondents identifying Cash Generating Units at one level below the segment level decreased to 25% compared to the previous year (46%).
- 83% of companies surveyed identified a maximum of ten CGUs for the goodwill impairment test (previous year: 81%). For the asset impairment test, 17% of respondents identified more than 20 CGUs.
- 71% of companies surveyed calculated the recoverable amount using the value in use approach with 13% using the fair value less costs to sell approach. 13% of respondents calculated both. Of these companies, the 67% that calculated both approaches stated that the value in use amount was higher than the fair value less costs to sell amount.
Measurement of cash flows
- Approximately 63% of respondents utilised their unadjusted group budget for impairment testing purposes (previous year: 58%).
- The majority of companies surveyed (79%) prepared their group budget a maximum of three months before the impairment test (previous year: 80%).
- 42% of respondents derived the terminal value based on the last projected year of the forecast horizon without making any adjustments.
Determination of the cost of capital
- The significant majority of respondents use the capital asset pricing model to obtain their cost of capital.
- Overall, 54% of respondents determine a CGU specific cost of capital.
Cost of capital parameters
- A total of 88% of companies surveyed determine the risk free rate based on national government bonds with an average life of 13 years. The average risk free rate determined was 8.16% during 2012.
- The average market risk premium applied by South African companies was 6% in 2012 (previous year: 5.7%).
- Over 95% of companies surveyed utilised historic betas in determining the cost of equity. Overall, 43% of respondents derived these betas from a peer group of companies.
- The average after tax cost of debt was 6.69% compared to 8.12% in the previous year.
- In determining the debt to equity ratio to use in the weighted average cost of capital calculation (WACC), 63% of respondents based this calculation on book values while only 37% based this on market values. The average debt to equity ratio provided by respondents was 32%.
- The average WACC provided by the companies who participated in this survey was 13.5% (previous year: 12.3%).
- The average terminal growth rate applied by the respondent companies was 4.5% for the value in use approach and 4.7% for the fair value less costs to sell approach.
Overall economic outlook
- More than 70% of companies surveyed expect positive overall economic development in 2013 compared to the previous business year.
- 62% of respondents expect interest rates to remain stable, whilst 21% expected a slight decrease.
1. About this study
1.1 Basic principles and aims of the study
The cost of capital is required for value-related corporate decisions as well as for accounting purposes, such as the IAS impairment test. The impairment test in terms of IAS 36 is a complex process described in detail in the standard with little practical guidance, which therefore raises many questions as to its implementation. The central issue which our survey has sought to address, therefore, is to determine how the IFRS rules are actually being implemented by companies in their impairment testing processes given the fact that often applications of certain areas of IAS 36 are both unclear and detailed interpretation is frequently required.
In the context of the ongoing volatility of capital markets, both the impairment test and the rules of IAS 36 have gained even more significance than in the past. This study provides insight into the different alternatives resulting from the room for interpretation provided by IAS 36. Additionally, this study also provides an understanding of the difficulties in the practical implementation of impairment testing.
We have summarised our analysis in separate sections related to four main areas:
- Cash generating unit criteria and valuation basis;
- Measurement of forecast cash flows for the impairment test;
- Method of determination of the cost of capital for the impairment test; and
- Cost of capital used and the parameters applied.
The purpose of each section is described separately at the beginning of each section. Where necessary, we have outlined the essence of the applicable IFRS rules to provide a better understanding to the reader.
The vast majority of respondents (89%) to this survey report in accordance with IFRS and the survey results were therefore based on the financial statements prepared in accordance with IFRS.
This is the second survey conducted by KPMG South Africa regarding the cost of capital and impairment testing. This survey is primarily based on an equivalent study undertaken by KPMG Europe LLP conducted across Germany, Switzerland, the Netherlands, Austria and Spain for the 4 prior years (referred to forthwith as the "European survey"). We have assessed trends in our data by comparing this year's findings to the results of our previous survey. Where considered necessary, we have also drawn comparisons of our findings to the data in the latest equivalent European study.
The central issue which our survey has sought to address, therefore, is to determine how the IFRS rules are actually being implemented by companies in their impairment testing processes given the fact that often applications of certain areas of IAS 36 are both unclear and detailed interpretation is frequently required.
1.2 Data collection
This year we contacted over 350 companies and had 42 formal responses resulting in an approximate 12% response rate (previous year: 11%). The European survey had a response rate of 27.8% in 2011, 20.5% in 2010, 18.8% in 2009 and 14.9% in 2008. Of our respondents, 88% had head offices in South Africa with 12% having their head offices located abroad.
The majority of respondents (58%) were listed only on the JSE main board with 13% of respondent's being listed on the AltX. 8% of respondents were dual listed on the JSE and other international exchanges. One respondent was listed on the LSE, and four non-listed respondent companies also participated in the survey.
Information relates mainly to financial statements released in late 2011 and during the course of 2012. The majority of respondents were from the banking sector (13%) and technology sector (13%).
2. Significance of the impairment test
Against the background of macroeconomic instability and lackluster growth, the significance of impairment testing remains in the spotlight. Most companies have become more cautious about impairment since the financial crisis began in 2008/9 and the constrained growth that continues to be experienced in more recent years. These circumstances directly influence the growth prospects of acquisitions, cost of capital and the multiples used by companies in valuations, which are required to be used to determine the values of CGUs for impairment testing purposes. Companies are continually being forced to revisit their forecast assumptions.
These slow and difficult market conditions have resulted in more respondents reporting impairments this year, compared to last year. This could be attributed to higher prices having been paid for acquisitions on the back of favourable growth prospects which have not materialised due to the instability that the economy in South Africa has experienced. Approximately 38% of respondents reported goodwill impairment in 2011/2012 (previous year: 35%), with 59% of respondents reporting asset impairment (previous year: 50%). In total, 63% of respondents incurred some form of impairment in 2011/2012, being either goodwill or asset impairment, a significant increase from the previous year (36%).
Given that impairment tests are performed either due to the annual impairment or due to a triggering event, we sought to establish how much impairment testing was being performed as a result of a trigger event.
On goodwill impairment, 83% of respondents stated that the impairment test was performed due to a trigger event, whilst 75% of respondents tested assets for impairment due to triggering events. These results are significantly higher than the previous year and the international benchmark, as the European survey for 2011/12 revealed that 37% of their respondents performed an impairment test due to a triggering event, whilst 50% of respondents reported triggering events in our previous survey. The increase in triggering events could tie into the macroeconomic instability and labour unrest experienced during 2011/2012 in South Africa.
A triggering event may arise in different ways, which are specifically mentioned in IAS 36 as impairment indicators. When considering the trigger events, the majority of respondents stated that specific pre-defined events (38%) and company specific material events (37%) were considered. Approximately 17% of respondents considered events mentioned in IAS 36.
Background IFRS – When must an impairment test be performed?
- Goodwill and intangible assets with an indefinite useful life are not subjected to scheduled amortisation but only to be amortised in the event of impairment (impairment–only approach). Goodwill, intangible assets with indefinite useful lives and intangible assets not yet available for use are to be subjected to an annual impairment test and at further intervals if evidence suggests impairment (trigger events).
- The impairment test is intended to ensure that assets are not valued at more than their recoverable amount. To the extent that book value exceeds the recoverable amount it is necessary to recognise impairment. At every balance sheet date, all assets are to be tested for impairment in order to ascertain if there are indications that the value of these assets has declined beyond their recoverable amounts.
- IAS 36.12-14 contains a preliminary list of indicators which, if identified, require the performance of an impairment test. Generally a distinction is made between internal indicators (the origin of which lies in the CGU and/ or the enterprise itself), and external indicators (for example: increase in market interest rates, a significant and unexpected decline in market value, significant adverse effects in the technological market, economic, or legal environment). Ultimately, an enterprise should identify the respective relevant indicators and test for impairment at regular intervals.
In total, 63% of respondents incurred some form of impairment in 2011/2012, being either goodwill or asset impairment, a significant increase from the previous year (36%).
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