Companies commonly use a five-year forecast period when calculating the recoverable amount. If a company has an asset (or cash-generating unit (CGU)) with a useful life that extends beyond the forecast period, then the company needs to calculate a terminal value for the asset (or CGU).
The terminal value reflects the present value of the cash flows to be generated by an asset (or CGU) from the end of the forecast period until the end of the asset’s (or CGU’s) life, or to perpetuity if it does not have a limited useful life.
For many companies, the major impacts of climate-related matters are expected in the long term – far beyond the five-year forecast period that is typically used in practice for valuations of businesses. In such cases, it is the terminal value that is expected to be most affected by climate-related matters. If climate-related matters are expected to have a significant impact on the business, then the forecast period may need to be extended to reach a steady state (see Question 2).
Your questions answered
Yes. Climate-related matters may affect the assumptions used in terminal value calculations. The following are example scenarios.
- The forecast period may need to be prolonged if it would take longer to reach a steady state in the development of the business as a result of climate-related matters (see Question 2).
- The level of cash flows in the final forecast year (CFn in the Gordon growth model formula (see below)) may need to be adjusted to reflect the cash flows in the steady state.
- The long-term growth rate(s) may need to be adjusted to reflect the impact of climate-related matters in the steady state.
Furthermore, the useful economic life of the CGU may become limited as a result of the impact of climate-related matters.
It depends on whether the company is calculating the recoverable amount based on value in use (VIU) or fair value less costs of disposal (FVLCD).
| VIU | A restriction exists – IAS 36 states that the forecast period may only be extended beyond five years if certain conditions are met. A forecast period longer than five years can be used only if management is confident that its projections are reliable and if it can demonstrate its ability, based on past experience, to forecast cash flows accurately over that longer period. [IAS 36.35] This restriction may create practical difficulties in calculating VIU – e.g. if the long-term growth rate is expected to change. In some cases, this issue can be resolved using a two-stage or other terminal value model (see Question 3). If a company uses a forecast period longer than five years when measuring VIU, then it needs to disclose why that longer period is justified. |
| FVLCD | The forecast period can be extended if this is consistent with a market participant's perspective. |
Note: In our view, the final year of the forecast period should be used to extrapolate cash flows into the future only if it represents a steady state in the development of the business. [Insights 3.10.230.50]
Several models (see below) can be used to incorporate the impact of climate-related matters on a CGU’s long-term growth rate (e.g. to reflect a future decrease in demand for the CGU’s products) when calculating its terminal value.
In the most extreme cases, threats from climate-related risks to the business model may mean that including a terminal value to perpetuity is inappropriate.
A company cannot use these models when valuing a limited-life asset (or CGU). Rather, the cash flow projection would extend until the end of the useful life of the asset (or CGU) and the terminal value would reflect the expected salvage value from selling the asset (or CGU), less costs of disposal.
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