Below is a simplified example of an impairment test that shows the situation pre-IFRS 16 and post-IFRS 16 and the effects of adjusting the (pre-tax) discount rate. The CGU has a finite life of five years, with no residual value. The lease term and useful life of the right-of-use asset are also five years.

*Pre-IFRS 16 Impairment test before and after IFRS 16 Leases*

Assumptions underlying the example: *Impairment test before and after IFRS 16 Leases*

- Five-year operating lease of 30 per year commencing at the start of year 1; cost of operating lease is relatively significant compared to the overall free cash flow (FCF).
- The carrying amount of the CGU includes goodwill; for a finite life time period, which is rare, although it may occur in practice that a CGU has goodwill while at the testing date the CGU has a limited life. The principles of the example would be the same if this were not goodwill, but a finite life intangible or PP&E, for example.
- Calculations are made on a pre-tax basis.
- This base case assumes, for the purposes of illustration, a business which is fully equity financed. The principle of the example would be the same if this were not the case. Under IAS 36, the discount rate must not be determined based on the capital structure of the entity, but on the capital structure typical in the industry. In this scenario, it is assumed that both the entity’s and industry’s capital structures do not differ and the extent to which the entity makes use of operating leases is in line with the industry.
- For illustrative purposes, working capital movements and capital expenditures are assumed to be nil.

*Post-IFRS 16, same discount rate as pre-IFRS 16 Impairment test before and after IFRS 16 Leases*

The example below is based on the same information and the same date as the above example, but now applying the accounting principles of IFRS 16:

*Analysis: Impairment test before and after IFRS 16 Leases*

- The headroom post-IFRS 16 with an unadjusted discount rate has decreased by 19 (21 vs 2):
- The carrying amount increased by 133 (net present value of lease payments discounted at incremental borrowing rate of 5%) from 370 to 503.
- The VIU before deducting the carrying value of the lease liability increased by 114 (net present value of lease payments discounted at 12%) from 391 to 505.
- Whether or not the lease liability is deducted from both the carrying amount of the CGU and the VIU will have no impact on the headroom as both would reduce by 133.

- In this scenario, the discount rate has remained at 12.0%. Implicitly, this means that the cost of equity inherent in the discount rate derived from WACC has been adjusted to 14.5%. The discount rate in this situation has been calculated based on the debt/equity-ratio using the market values of debt and equity, under the assumption that the market value of the lease liability is equal to its book value and the market value of equity is equal to the VIU less the value of the lease liability.

*Post-IFRS 16, adjusted discount rate Impairment test before and after IFRS 16 Leases*

*Analysis: Impairment test before and after IFRS 16 Leases*

- The adjusted discount rate, derived from WACC, has been calculated based on the debt/equity-ratio using the market values of debt and equity, under the assumption that the market value of the lease liability is equal to its book value and the market value of equity is equal to the VIU ignoring lease payments, less the value of the lease liability.
- This calculation arrives at an adjusted discount rate of approximately 10.2%, which results in headroom in the impairment test equal to the headroom under IAS 17.
- The decrease in the discount rate is relatively high due to the significance of the operating lease payments compared to the free cash flow.
- All of the calculations above are on a pre-tax basis in line with the requirements of IAS 36 for VIU. In practice, many impairment tests are done on a post-tax basis, as market data for the equity returns and discount rate is generally available only on a post-tax basis. Using appropriate assumptions and modelling, the outcome on a post-tax basis should be similar.
- As mentioned earlier, under IAS 36, the discount rate must not be determined based on the capital structure of the entity, but on the capital structure typical in the industry. In this scenario, it is assumed that the entity’s and industry’s capital structures do not differ and are impacted by IFRS 16 in the same way.
- Whether or not the lease liability is deducted from both the carrying amount of the CGU and the VIU will have no impact on the headroom as both would reduce by 133.

As can be seen from the above illustrative example, there is justification for a change in the discount rate to be applied for impairment calculation purposes.