The Discount Rate: A Note on IAS 36

Abstract

Entities reporting under IFRSs are required to determine a value in use in accordance with IAS 36: Impairment of Assets. The value in use is the present value of the expected future cash flows. Appendix A to the standard gives guidance on how to apply the DCF calculus in the context of IAS 36. In order to determine a suitable discount rate, the reporting entity is given the choice between three alternative starting points. The requirements of IAS 36 are, in this respect, quite different from the accounting requirements of US GAAP. In this paper we analyse these starting points and demonstrate the functional interrelation between them. Given that the interrelation is complex even under simple assumptions, we will provide guidance to practitioners as to which starting point should be used. We will demonstrate that the weighted average cost of capital (WACC) is the only suitable starting point. Based on this analysis, we also show that the other alternative starting points are not sufficiently clear. When used in practice, the guidance may even give rise to substantial measurement errors and make earnings management possible. Thus, our recommendation to the IASB is to shorten the guidance and delete the other two starting points.

Acknowledgements

The views expressed in this paper are those of the authors. Official positions of the German Accounting Standards Board or the Accounting Standards Committee of Germany are determined only after extensive due process.

Notes

¹Ref. the definition in IAS 39.6.

²Ref. IAS 36.50(b), IAS 36.55. See, for example, Brealey and Myers (2003, ch. 19) for a discussion of the various DCF models.

³See IAS 36.56 read in conjunction with Appendix A.15 and A.16. However, costs of capital readily observable in the capital market will exist only rarely, as the former International Accounting Standards Committee (IASC) acknowledges, see IAS 36.BCZ55.

⁴See SFAS 144.8ff.

⁵See SFAS 144.10.

⁶See SFAS 144.17.

⁷See SFAS 144.7.

⁸The proof is essentially based on assumptions 1 and 2, see Section 2.

⁹In Figure 1, this is the case when the debt–equity ratio D/E ^l is approximately 2.

¹⁰Hsia (1981) proved the consistency of the Modigliani–Miller model, the option pricing theory and the CAPM.

¹¹The only exception known to the authors is the work of Cooper and Davydenko (2001).

¹²See, for example, Cox and Rubinstein (1985, pp. 323f.).

¹³However, IAS 8.13 requires the entity to apply its accounting policies consistently.