The weighted average cost of capital (WACC) ^* is often used as an important reference point when determining the discount rate to be used when testing the assets in a cash-generating unit (CGU) for impairment in accordance with IAS 36. The WACCs of many entities are publicly available, although it is worth noting that they are reliant on certain judgmental assumptions - in particular, the equity risk market premium. The WACC of an entity will be reliant on some publicly available inputs, such as the risk-free rate. WACCs are usually nominal (that is, they include the impact of inflation).

A WACC relies on the market’s current expectation of future long-term assumptions, for example the long-term rate of inflation and risk-free rates. These long-term assumptions in WACCs are affected by many different economic factors and both the impact and the extent will differ between countries and even industries.

In the current climate of global economic uncertainty, with many countries experiencing rising inflation and interest rates, this raises the question whether these increases represent a change in the market’s current expectations of future long-term assumptions, or whether they represent an anomaly resulting from short term volatility in the markets.

Paragraph 16 of IAS 36 states that “short-term interest rates may not have a material effect on the discount rate used for an asset that has a long remaining useful life”. It is therefore necessary to understand whether an observable rise in short-term interest rates is limited to the short-term, or whether there is a simultaneous change in the market’s current expectation of long-term interest rates (cost of debt) and also the risk-free rate.

We have observed a notable increase in the market’s current expectation of long-term risk-free rates in a number of countries. While the risk-free rate is by no means the only variable that has changed or is changing, it is arguably the variable in the WACC calculation showing the largest relative change over the last year in many instances.

Below is an extract of the yields on 20-year government bonds (often assumed to represent the long-term risk-free rate):

These figures indicate that, for these countries, there has been a change in the market’s current expectation of long-term risk-free rates. This increase in long-term risk-free rates will increase WACCs, although this increase is not necessarily on a one-for-one basis - a 1% increase in the risk-free rate will not necessarily result in a 1% change in the WACC.

Where a similar trend is observed in other countries, it is likely that this will also result in an increase in those WACCs.

There are other components of a WACC which might have been impacted by the current economic climate, such as the target level of gearing and equity risk premium. It is therefore important to consider all components of the WACC.

Given the market movements outlined in this In brief, whether preparing or reviewing an IAS 36 impairment test for December 2022 year ends, careful consideration of the inputs into WACC-reliant discount rates will be of particular importance. Current economic trends should not be readily dismissed from WACC calculations on the basis of being short term.

This In brief provides a high-level summary of observable market trends as applicable to December 2022 financial year ends. It does not negate the need to consult with experts on entity-specific fact sets where necessary.

Consistency between discount rates and cash flow forecasts is fundamental to the IAS 36 impairment calculation. This and other relevant concepts are discussed in further detail in Chapter 24 of our Manual of Accounting and the In depth on Navigating IFRS Accounting Standards in periods of rising inflation and interest rates.

For more information contact Gary Berchowitz or Iain Selfridge in Corporate Reporting Services, or your local Valuations contacts.