Basis for cash flow projections

Learning objectives

• Explain the requirements for projections: reasonable and supportable assumptions, most recent approved budgets, a maximum period of five years unless justified, extrapolation using a steady or declining growth rate.L2
• Assess the reasonableness of management's assumptions, in particular in the light of past differences and of a growth rate exceeding the long-term average.L3, L4

Normative references

• IAS 36 §33Sets the bases for projections: reasonable and supportable assumptions giving greater weight to external evidence, most recent budgets approved by management excluding uncommitted restructurings and enhancements, a maximum period of five years unless justified, then extrapolation using a steady or declining growth rate not exceeding the long-term average unless justified.
• IAS 36 §34Requires management to assess the reasonableness of its assumptions by examining the causes of past differences between cash flow projections and actual cash flows, and to ensure they are consistent with past actual outcomes, unless subsequent events or circumstances justify departing from them.
• IAS 36 §35Explains why the detailed budget period is in principle limited to five years, a longer period being permitted only if management can demonstrate its ability to forecast reliably.
• IAS 36 §36Specifies the extrapolation beyond the budget period to the end of the useful life: a steady or declining rate, which may be zero or negative, an increasing rate being permitted only if it matches objective information about the life cycle of a product or industry.
• IAS 36Notes that favourable conditions attract competitors and restrict growth, so that it is difficult to exceed, over the long term (of the order of twenty years), the average historical growth rate of the products, industries, countries or markets concerned.
• IAS 36When using its budgets and forecasts, the entity checks that they are based on reasonable and supportable assumptions and represent management's best estimate of the economic conditions that will exist over the remaining useful life of the asset.

Original summaries of the paragraphs (reference register), never a quotation of the standard.

13 questions

• To calculate the value in use of a plant, Delmare relies on its budgets and forecasts. What period may these detailed budgets and forecasts cover?L2
• Pradel is testing a production unit. Three sets of forecasts are available. Which one should serve as the basis for the cash flow projections in value in use?L2
• Which of the following statements about the cash flow projections used for value in use are correct? (several answers)L2
• Lavandor's analyst documents the value in use of an industrial laundry as follows: (A) he starts from the most recent budget approved by management; (B) he projects the cash flows year by year over nine years from detailed forecasts, with no evidence that Lavandor can forecast reliably over such a period; (C) beyond the detailed horizon, he extrapolates at a declining rate until the end of the useful life; (D) he compares his price assumptions with external market studies. Which step contains an error?L2
• To test a restaurant chain, Caldero uses: a five-year budget approved by management (A); footfall assumptions cross-checked against public industry statistics (B); beyond year five, a steady growth of 6% a year until the end of the projection period, whereas the long-term average growth of this restaurant market is 2% and no justification is documented (C); an analysis of the variances between budgets and actual results over the last three years (D). Which item is an error?L3
• Fontbrune runs an office furniture line in a mature market. After an approved five-year budget, its value in use model uses for the following years a growth rate that accelerates year after year, on the grounds that the brand is well known, without any objective information about the product or industry life cycle. The rest of the model complies. Which diagnosis is correct?L3
• For four years, the actual cash flows of one of Sorelle's units have been about 20% below the budgeted figures. For this year's test, management uses a budget built on the same assumptions, claiming that the trend will reverse, although no new event has been identified. What should Sorelle do?L3
• Two years ago Genalys launched a medical diagnostic device. Its approved budget covers five years. Studies published by the health authority and by several independent firms show that, for this type of device, adoption by hospitals accelerates for three years after year five before declining. May Genalys use an increasing growth rate for these three years of extrapolation?L3
• Argentique Plus operates photo development laboratories. External market studies show that this sector is contracting by about 4% a year. After an approved five-year budget, management proposes to extrapolate the cash flows at +2% a year until the end of the equipment's useful life. Which approach complies?L2
• You are reviewing the impairment test of a bottled water distribution subsidiary of the Hespéris group. Value in use rests on a five-year budget approved by management, then on growth of 5% a year beyond, whereas the long-term average growth of the national beverages market is 1.5%. The last three budgets overestimated actual cash flows by about 25%. Management justifies its figures by an export expansion project for which no contract has been signed and which has not yet been launched. Write a judgement memo on the reasonableness of the assumptions.L4
• Éolis operates a wind farm with a remaining useful life of fifteen years. For its value in use, management wishes to use detailed forecasts over twelve years rather than five. It argues that almost all of the output is sold under a fixed-price purchase agreement covering that period and that, over the last ten years, its output forecasts have differed by less than 3% from actual results. For the three remaining years, it expects steady growth of 4% a year, whereas the long-term average growth of the electricity market concerned is 1%; no justification is provided. Write a judgement memo on the horizon and the extrapolation used.L4
• The approved budget of Cimarel, a cement producer, forecasts a sharp rise in selling prices from next year. Forecasts published by the industry federation and by two economic institutes indicate, on the contrary, that prices will stagnate for several years. How should Cimarel approach its value in use projections?L3
• Néridia, a network operator, is testing the cash-generating unit of its regional fixed network at 31 December 20X1. The budget approved by management includes a fibre upgrade programme, not yet started, that would cost 40,000,000 and sharply increase revenue per subscriber. Without this programme, value in use would be below the carrying amount; with it, value in use exceeds it. The budget also provides for the regular replacement of the network's active equipment, whose useful life is shorter than that of the infrastructure. The finance director argues that, since the budget is approved, all its lines must be used. Write a judgement memo on how the cash flows should be built.L4