What balance sheet risks arise from Brexit?

Content

List of figures

List of tables

List of abbreviations

List of symbols

1 Problem description

2. Background
2.1 UK’s relevance to the German economy
2.2 Impairment of assets under IAS 36

3. Identification of impairment risk for German companies due to Brexit
3.1 Macroeconomic Brexit effects
3.2 Impact on impairment testing under IAS 36 for German companies
3.3 Illustrative example: Impairment risk for goodwill under IAS 36
3.4 Critical evaluation

4. Conclusion

Appendix

References

Legislative materials

List of figures

App. Fig. 1: Development of GBP – EUR exchange rate

App. Fig. 2: Inflation rate in the UK

App. Fig. 3: Official Bank Rate history in the UK

List of tables

Table 1: Decomposition of DCF parameters and assignment of potentially relevant risks

Table 2: Illustrative FVLCD calculation in a pre-referendum scenario

App. Table 1: After-tax WACC used in FVLCD calculation in the pre-referendum scenario

App. Table 2: Illustrative ViU calculation in a pre-referendum scenario

App. Table 3: Illustrative FVLCD calculation in a post-referendum scenario

App. Table 4: After-tax WACC used in FVLCD calculation in the post-referendum scenario

App. Table 5: Illustrative ViU calculation in a post-referendum scenario

List of abbreviations

Abbildung in dieser Leseprobe nicht enthalten

List of symbols

Abbildung in dieser Leseprobe nicht enthalten

1 Problem description

“What is happening is a disaster for the economy, looking at it from a purely economic point of view", states C. Pissarides, a Nobel Prize-winning economist, commenting on the United Kingdom’s (UK) exit from the European Union (EU).¹ The referendum in June 2016 has triggered a series of unfavourable changes in the UK’s economic climate, which in turn has affected other European countries. Numerous businesses in and outside of the UK are suffering from political uncertainties due to the fear of a disorderly Brexit and the accompanying macroeconomic effects, e.g. devaluation of the British pound and declining consumer demand in the UK.² Foreign companies that are exposed to the UK through trading relationships, especially those with cross-border supply chains and operations, are required to reassess the future of their businesses in the UK due to adverse market prospects.³

German companies with close relations to the UK can be directly and indirectly affected by economic changes due to Brexit. It is therefore necessary to examine whether and to what extent the economic changes need to be reflected in entities’ financial statements.⁴ Particular attention should be paid to the faithful presentation of companies’ assets and liabilities. This paper seeks to identify macroeconomic risks due to Brexit and how these risks influence the subsequent measurement of assets under IAS 36 Impairment of Assets.

The central research question is whether Brexit leads to an increased impairment risk for German corporations with cross-border relations. To investigate the question, chapter 2 discusses the UK’s relevance to the German economy and explains the relevant procedures under IAS 36. Chapter 3 analyses the macroeconomic changes since the referendum and derives macroeconomic risks for future economic development. Finally, the paper examines the impact of identified macroeconomic risks on key assumptions of impairment testing under IAS 36. An illustrative example of a German car manufacturer with production and distribution in the UK shall demonstrate a potential impairment risk due to Brexit. The analysis closes with a critical evaluation of impairment testing in the context of Brexit.

The scope of the paper encompasses German corporations which prepare financial statements in accordance with IFRS.

2 Background

2.1 UK’s relevance to the German economy

The UK is Germany’s fifth most important trading partner worldwide. In 2017 the two countries exchanged goods amounting to 121.505 billion EUR⁵, thereof Germany’s exports to the UK accounted for 84.365 billion EUR and imports from the UK 37.140 billion EUR.⁶ Nearly 2,500 German companies with foreign operations in the UK employ in total 400,000 British people.⁷ 28 out of 30 DAX-companies have at least one subsidiary in the UK and employ 200,000 people.⁸ German foreign direct investment (FDI) in the UK amounted to 105 billion EUR in 2017⁹, which represents 9% of German total FDI¹⁰ and indicates a significant exposure of German companies to the UK market. German sectors with the highest revenues in the UK in 2016 were automotive, energy, transport and logistics, finance and insurance and commerce.¹¹ Companies operating within those industries are naturally the most negatively affected by the legal and economic uncertainties resulting from Brexit. If the UK leaves the EU without an agreement, it would lose access to the European Single Market including its four freedoms, i.e. the free movement of goods, services, capital and persons. The UK would have the status of a third country and trade on World Trade Organisation (WTO) terms. This development includes amongst others the imposition of customs duties on imports in the UK and exports from the UK.¹²

2.2 Impairment of assets under IAS 36

The objective of general purpose financial reporting is to provide useful financial information to shareholders and other stakeholders.¹³ Investors, lenders and other creditors use information, i.e. about a company’s resources and its management, for assessments in decision making processes.¹⁴ Hence, IAS 36 aims to ensure that a company’s assets are not presented as overvalued in its balance sheet.¹⁵ IAS 36 applies to Goodwill as defined under IFRS 3, Property, Plant and Equipment under IAS 16, Intangible Assets under IAS 38, Investments in Subsidiaries as defined in IFRS 10, Investments in Associates under IAS 28 and Investments in Joint Ventures under IFRS 11.¹⁶

IAS 36.9 prescribes an assessment at the end of each reporting period to see whether there are any indicators for an asset’s impairment, so called triggering events¹⁷ . If so, the entity is required to conduct an impairment test by calculating the recoverable amount. The standard covers a number of potential internal and external indicators and specific indicators relating to investments in subsidiaries, joint arrangements or associates.¹⁸ In this paper, external indicators, e.g. significant changes in market, economic and legal environment,¹⁹ are of particular relevance. Irrespective of any indication, the entity has to conduct yearly impairment tests for intangible assets with an indefinite useful life, assets that are not yet available for use as well as goodwill acquired in a business combination under IFRS 3.²⁰ An impairment loss only occurs when the carrying amount of an asset or a cash generating unit (CGU)²¹ is higher than its recoverable amount.²² If so, the company has to recognise an impairment loss as an expense in profit and loss or as a revaluation decrease in other comprehensive income if required by another standard.²³ An impairment loss of an asset can be reversed in future periods if the underlying estimates change.²⁴ However, an impairment of goodwill cannot be reversed as it would equal the recognition of internally generated goodwill, which is prohibited under IAS 38.²⁵

The recoverable amount is determined by the higher of fair value less costs of disposal (FVLCD) or value in use (ViU).²⁶ FVLCD is determined in accordance with IFRS 13 Fair Value Measurement ²⁷ , whereby fair value equals an asset’s price received in an orderly transaction between independent market participants under current market conditions.²⁸ IFRS 13 prescribes a hierarchy of inputs in three levels used in according valuation techniques, e.g. market approach or income approach.²⁹ Level 1 inputs are quoted prices in an active market for identical assets, liabilities or groups of assets.³⁰ Level 2 comprises other observable inputs not included in Level 1,which amongst others can be prices for similar assets or quoted prices for identical items in not active markets.³¹ Level 3 inputs are unobservable inputs, such that regularly reflect a company’s own data adjusted for assumptions that other market participants would use when pricing the asset, e.g. in a discounted cash flow (DCF) calculation.³² The costs of disposal are direct incremental costs, e.g. legal costs, stamp duty, costs for removing the asset or to bring it into condition for sale.³³ If FVLCD cannot be determined, then the recoverable amount is the asset’s ViU.³⁴ ViU is the present value of an asset’s expected cash flows.³⁵

Calculations of ViU and FVLCD with unobservable Level 3 inputs are both based on DCF principles.³⁶ The main difference between the two calculations lies in the perspective from which the underlying assumptions with regard to main parameters: cash flows and discount rate, are derived. The calculation of FVLCD requires objective assumptions, i.e. those that would be used by external market participants if they would acquire the asset. In contrast, the ViU is entirely based on internal, subjective management assumptions.³⁷ Furthermore, ViU follows a pre-tax concept, i.e. the cash flow as well as the discount rate have to be in a pre-tax state.³⁸ FVLCD calculation follows an after-tax concept, i.e. the cash flow and the discount rate have to be adjusted for tax effects.³⁹ Further differences include: the exclusion of restructuring synergies in cash flow projections for determination of ViU if the company has not committed to the plans yet⁴⁰ and inclusion of such synergies for FVLCD.⁴¹ For ViU purposes the assumed long-term growth rate of cash flow can be at maximum steady, whereas for FVLCD it can be increasing if it can be justified by market expectations. Apart from the foregoing differences the systematic structure behind the DCF calculation in both cases is to a great extent identical.⁴²

IAS 36.33 requires estimated cash flows to be based on reasonable assumptions made by management, which shall take into account a range of economic conditions over the remaining useful life of the asset as well as external market factors. Hence, for ViU the standard prescribes the utilization of the most recent financial forecasts, which are approved by management.⁴³ In case an asset specific discount rate is not available, IAS 36.A17 suggests amongst others the use of an entity’s weighted average cost of capital (WACC), whereby the cost of equity can be determined by techniques such as the Capital Asset Pricing Model (CAPM).⁴⁴ If cash flows are generated in a foreign currency, the present value has to be computed using a discount rate, which is estimated with appropriate parameters for that currency, e.g. accounting for country risk.⁴⁵ Present value is translated using the spot exchange rate on the date of its calculation.⁴⁶

3 Identification of impairment risk for German companies due to Brexit

3.1 Macroeconomic Brexit effects

The following section examines evident as well as potential macroeconomic Brexit effects on the UK economy with particular regard to the implications for German corporations. Due to the high complexity and interdependencies of different effects, the scope of the risk analysis is limited to relevant aspects for recoverable amount calculations under IAS 36. Therefore, it is not claimed that this list is exhaustive. The time horizon for the identified risks extends over the short to medium term but can also be extended to long term depending on further political action, i.e. outcome of withdrawal agreement negotiations.

Foreign currency exchange risk

An immediately visible macroeconomic effect due to the referendum has been the depreciation of the Great Britain Pound (GBP). After the referendum in 2016 the GBP depreciated from 1.30 EUR to 1,10 EUR, approximately 15% (App. Fig. 1). Since 2016 the GBP remained on a depreciation level of at least 10% below pre-referendum.⁴⁷ Consequently, imports from Germany became more expensive for UK consumers and exports from the UK cheaper for German consumers.⁴⁸ Therefore, the devalued GBP poses a substantial risk for the demand for German goods and services in the UK.⁴⁹ Furthermore, investments in UK based assets translate to lower EUR amounts leading to impairments in the balance sheets of German companies due to pure currency effects.⁵⁰ The GBP mainly depreciated due to uncertainties on the financial markets, which themselves are linked to political uncertainties in the course of Brexit negotiations.⁵¹ Hence, the magnitude of the GBP’s volatility in the future will strongly depend on the course of political actions taken.

Risk of inflation and loss of purchasing power

Since the referendum the inflation rate in the UK has increased significantly as it can be observed in App. Fig. 2. In June 2016 the inflation rate in the UK was 0.8% and increased to 2.8% in October 2017, representing a 3.5-fold increase in the rate of inflation post referendum. After reaching this peak the inflation rate has steadily declined over the following two years and was 1.7% in August 2019.⁵² One of the major reasons for this development is the devaluation of GBP, which in turn made imports into the UK more expensive and contributed to an overall rise in prices. A higher inflation rate lowers the real disposable incomes, which results in a loss of purchasing power. This in turn leads to a decline in consumer demand.⁵³ As an example, German car manufacturers have recorded a considerable sales decline in UK since 2017.⁵⁴

Interest rate risk

In order to tackle a potential decline in consumer demand due to increasing inflation, the Bank of England (BoE) lowered the base interest rate from 0.5% to 0.25% after the referendum.⁵⁵ However, in light of increasing inflation the BoE increased the base interest rate back up to 0.75% (App. Fig. 3).⁵⁶ A higher borrowing rate for consumers and companies dampers the consumption behaviour and therefore reverses the originally intended stimulation of the economy. Further BoE’s actions in terms of base interest rate will depend on economic developments in post-Brexit, hence, there is also an interest rate risk to take into account.

Risk of customs duties

If the UK left the EU without an agreement it would trade on WTO terms as discussed in chapter 2. Customs duties as well as associated formalities at the borders would increase the costs for products and slow down the exchange of goods.⁵⁷ As the bargaining power of British exporters is considerably weaker than the EU’s, the British exporters would have difficulties in passing these additional costs onto consumers, resulting in lower profits. This would negatively impact the country’s gross domestic product.⁵⁸ According to Germany’s largest car exporters, the imposition of customs duties poses the biggest threat.⁵⁹

Stock market risk

The London Stock Exchange reacted negatively to the referendum result in 2016. The FTSE 100 fell by 3% and the FTSE 250 even by 8%.⁶⁰ However, both indices have recovered and increased in the last 3 years.⁶¹ The financial market mirrors various political and economic developments and therefore its volatility due to Brexit constitutes a risk for investors. Another possible setback for the stock market is the scenario of a hard Brexit.

Country Credit Rating risk

US Rating agencies Moody’s, S&P and Fitch adjusted their ratings and outlooks downwards for the UK only a few days after the referendum result. S&P and Fitch downgraded the UK to AA in 2016 and Moody’s followed by placing the UK on negative watch in 2016 and downgrading the country credit rating to Aa2 in 2017.⁶² Further downgrades are possible if the UK leaves the EU without a transition agreement.⁶³

Taxation risk

A risk that will become evident after UK leaves the EU relates to harmonized taxation aspects. After the UK’s exit the EU Directives concerning free movement of capital and its tax exemption regulations cease to be in force for German FDIs in the UK and vice versa.⁶⁴ Whilst some of the negative effects can be offset by the current double tax treaty, other effects such as changes of value-added tax (VAT) regulations will be inevitable.⁶⁵ Future changes of UK tax law can lead to adverse effects on the corporate tax rate for multinational businesses.

3.2 Impact on impairment testing under IAS 36 for German companies

As the foregoing macroeconomic analysis shows, the vote to leave the EU has caused various adverse effects on the British economy which in turn affect German companies with cross-border relations with the UK. The following section provides an analysis on how those macroeconomic effects can lead to substantial impairments of assets, that are dedicated to production of export-goods⁶⁶ for the British market, or investments in subsidiaries, joint ventures as well as associates in the UK producing goods for the British market.

The first step in identifying a potential impairment is the assessment of impairment indicators according to IAS 36.9. The presented macroeconomic effects can be perceived as triggering events as the standard considers changes in economic or legal environment as potential indicators.⁶⁷ Furthermore, the relevant interest rate for the determination of the discount rate⁶⁸ has increased, which constitutes another indicator that the recoverable amount of the asset could have decreased. Therefore, companies under consideration are required to conduct impairment tests for assets or CGUs in question in addition to the mandatory annual impairment tests. The second step is to determine the recoverable amount of the assets or CGUs which are potentially at risk. If Level 1 or Level 2 inputs are not available, companies can use the DCF method to determine either the FVLCD or the ViU. Table 1 shows a decomposition of the pre-tax free cash flow and WACC and assigns the relevant macroeconomic risks to each input factor.

Abbildung in dieser Leseprobe nicht enthalten

Table 1: Decomposition of DCF parameters and assignment of potentially relevant risks.⁶⁹

Revenues generated by an asset or a CGU can decline significantly due to currency effects, inflation, customs duties, increasing interest rate and overall loss of purchasing power. The currency effect is especially harmful to companies with dedicated production lines or sites for the British market, which are located in Germany. The depreciated GBP translates the EUR prices into higher GBP amounts which can lead to declines in sales as consumers switch to cheaper products made in the UK or in other lower cost countries. Simultaneously, the higher inflation rate and the associated loss of purchasing power endangers the revenues of German branches in the UK. Moreover, the rising interest rates increase the borrowing costs for financing of investment goods and can lead to a significant decline in sales of investment goods, e.g. machines or cars. Furthermore, the imposition of customs duties would lead to higher costs for companies due to additional export fees and processing time for formalities at the border. Delays at the border can lead to expensive interruptions in production processes if for instance components are not delivered in time.⁷⁰ Hence, there are various adverse effects on companies’ EBITDA, i.e. declining revenues and rising costs. Working Capital⁷¹ (WoC) is also subject to the foregoing effects, e.g. a German subsidiary in the UK can have higher short-term liabilities due to increased prices for components from abroad, rising receivables due to Brexit-related deterioration of creditworthiness of customers or higher inventories due to declining sales. The amount of yearly capital expenditure (CapEx) can be affected by price levels as well as interest rates for financing the replacement goods. Overall, cash flows generated by an asset or CGU, either in Germany or in the UK, can be exposed to high risks due to the changing economic environment in the UK.

If an asset or a CGU generates cash flows in GBP, the cash flows have to be discounted using an appropriate discount rate. For instance, if a German company calculates the recoverable amount of a CGU in the UK, e.g. a subsidiary, it should use inputs from the British market. The level of interest rates significantly drives investors’ return on equity expectations and the borrowing costs. Accordingly, a rising base rate in the UK can increase the cost of equity as well as the cost of debt for an entity operating in the UK. The beta factor reflects the individual stock volatility in proportion to a reference stock index. German firms with close relations to the UK can experience higher stock price movements than the underlying index which can lead to a higher beta factor and therefore a higher individual risk premium. Companies can also include a country risk premium in accounting for investments abroad.⁷² It can be determined in accordance with the country credit risk rating,⁷³ which has been recently adjusted downwards for the UK, resulting in a higher risk premium. An increased country risk premium leads to a higher cost of equity. The market risk premium (MRP) can be determined by reference to the MSCI World Index market risk premium which mirrors the development of global markets. Apart from the base rate, the cost of debt can also be influenced by potential changes in the corporate tax rate post Brexit. In summary and taking all of the above into account, the WACC as a discount rate can increase significantly and therefore lead to a lower present value.

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¹ Meredith, S., Brexit is an economic “disaster”, 2019, https://www.cnbc.com.

² Cf. Belke, A./Ptok, S., British-European Trade Relation and Brexit, 2018, p. 1 f. + 11 f.

³ Cf. Zwirner, C., Auswirkungen des Brexits, 2016, p. 2665.

⁴ Cf. ESMA, European common enforcement priorities, 2016, p. 1.

⁵ Cf. BMWi, Facts about German foreign trade, 2018, p. 15.

⁶ Cf. BMWi, Facts about German foreign trade, 2018, p. 12.

⁷ Cf. DIHK, Auswirkungen des Brexit, 2018, p. 2.

⁸ Cf. Deloitte, Deloitte Brexit Briefing 3, 2017, p. 8.

⁹ Cf. Deutsche Bundesbank, Foreign direct investment stock statistics, 2019, p. 15.

¹⁰ Cf. Deutsche Bundesbank, Foreign direct investment stock statistics, 2019, p. 12.

¹¹ Cf. Deloitte, Deloitte Brexit Briefing 3, 2017, p. 11.

¹² Cf. Dhingra, S. et al., UK trade and FDI, 2018, p. 19-20.

¹³ Cf. CF 1.2.

¹⁴ Cf. CF 1.3-1.4.

¹⁵ Cf. IAS 36.1.

¹⁶ Cf. IAS 36.4 f.; IFRS 3.B63 (a); Althoff, F., Internationale Rechnungslegung, 2012, p. 97.

¹⁷ Cf. Zwirner, C./Zimny, G., Anwendung des IAS 36, 2015, p. 420.

¹⁸ Cf. IAS 36.12-36.14.

¹⁹ Cf. IAS 36.12 (b).

²⁰ Cf. IAS 36.10.

²¹ IAS 36.6 defines a CGU as the smallest identifiable group of assets that generates cash inflows that are largely independent of the cash inflows from other assets or groups of assets.

²² Cf. IAS 36.59.

²³ Cf. IAS 36.60.

²⁴ Cf. IAS 36.114.

²⁵ Cf. IAS 36.124-125.

²⁶ Cf. IAS 36.6; IAS 36.18.

²⁷ Cf. IAS 36.6.

²⁸ Cf. IFRS 13.9; IFRS 13.15.

²⁹ Cf. IFRS 13.72; IFRS 13.62.

³⁰ Cf. IFRS 13.76-13.80.

³¹ Cf. IFRS 13.81-13.85.

³² Cf. IFRS 13.86-13.90.

³³ Cf. IAS 36.28-36.29.

³⁴ Cf. IAS 36.20.

³⁵ Cf. IAS 36.6.

³⁶ Cf. IFRS 13.B12; IAS 36.6; IFRS 13 suggests further valuation techniques, however, the DCF calculation is prevalent in practice according to IDW RS HFA 40.5.

³⁷ Cf. Zwirner, C./Zimny, G., Anwendung des IAS 36, 2015, p. 420; IAS 36.33-36.35.

³⁸ Cf. IAS 36.51.

³⁹ Cf. Zwirner, C./Zimny, G., Anwendung des IAS 36, 2015, p. 421.

⁴⁰ Cf. IAS 36.33 (b).

⁴¹ Cf. IDW RS HFA 40.5.

⁴² Cf. IDW RS HFA 40.5.

⁴³ IAS 36.33; Generally, same assumptions apply to fair value measurement as managements’ projections shall be consistent with available market data according to IDW RS HFA 40.5.

⁴⁴ The CAPM describes the relationship between the expected return and risk of investing in an asset; The WACC is fully accepted in FVLCD and ViU according to IDW RS HFA 40.44.

⁴⁵ Cf. IAS 36.54; IAS 36.A18.

⁴⁶ Cf. IAS 36.54.

⁴⁷ Cf. Finanzen.net, GBP-EUR Chart 5 Years, 2019, https://www.finanzen.net.

⁴⁸ Cf. Welfens, P.J.J. et al., Makroökonomische Brexit-Aspekte, 2017, p. 10+16.

⁴⁹ Cf. Welfens, P.J.J. et al., Makroökonomische Brexit-Aspekte, 2017, p. 10.

⁵⁰ Cf. Zwirner, C./Zimny, G., Folgen des Brexit, 2016, p. 494.

⁵¹ Cf. Welfens, P.J.J. et al., Makroökonomische Brexit-Aspekte, 2017, p. 46-48.

⁵² Cf. Office for National Statistics, Inflation rate, 2019, https://www.ons.gov.uk.

⁵³ Cf. Welfens, P.J.J. et al., Makroökonomische Brexit-Aspekte, 2017, p. 15-18.

⁵⁴ Cf. Volkswagen AG, Annual Report 2018, 2019, p. 97; BMW AG, Annual Report 2018, 2019, p. 43+46; Daimler AG, Annual Report 2018, 2019, p. 80 f.

⁵⁵ Cf. Welfens, P.J.J. et al., Makroökonomische Brexit-Aspekte, 2017, p. 49; BoE, Inflation Report, 2016, p. 2; BoE, Inflation Report, 2017, p. 18.

⁵⁶ Cf. BoE, Inflation Report, 2017, p. 34.

⁵⁷ Cf. Sampson, T., Brexit, 2017, p. 170.

⁵⁸ Cf. Welfens, P.J.J. et al., Makroökonomische Brexit-Aspekte, 2017, p. 27.

⁵⁹ Cf. Volkswagen AG, Annual Report 2018, 2019, p. 167; BMW AG, Annual Report 2018, 2019, p. 100; Daimler AG, Annual Report 2018, 2019, p. 158.

⁶⁰ Cf. Welfens, P.J.J. et al., Makroökonomische Brexit-Aspekte, 2017, p. 47 f.

⁶¹ Cf. London Stock Exchange, Indices, 2019, https://www.londonstockexchange.com.

⁶² Cf. Trading Economics, UK – Credit Rating, 2019, https://tradingeconomics.com.

⁶³ Cf. S&P Global Ratings, Countdown to Brexit, 2019, https://www.spglobal.com.

⁶⁴ Cf. Reimer, E., After Brexit, 2016, p. 19 f.

⁶⁵ Cf. Reimer, E., After Brexit, 2016, p. 21.

⁶⁶ The term goods refers to finished products, components and services in this paper.

⁶⁷ Cf. IAS 36.12 (b).

⁶⁸ Cf. IAS 36.12 (c).

⁶⁹ Source: Own analysis and representation; the decomposition of the pre-tax Free Cash Flow is based on EY, Impairment Accounting, 2010, 5; the decomposition of the after-tax WACC is based on Volkswagen AG, Annual Report 2018, 2019, p. 127.

⁷⁰ Cf. BMW AG, Annual Report 2018, 2019, p. 94.

⁷¹ Working Capital = Current Assets – Current Liabilities.

⁷² Cf. Damodaran, A., Country Risk and Company Exposure, 2003, p. 70.

⁷³ Cf. Burger, A. et al., Beteiligungscontrolling, 2010, p. 641 f.