In this article, we will explain what a cash-generating unit (CGU) is, how to calculate its value, and how to test it for impairment. We will also discuss the importance of CGUs for financial reporting and analysis, and provide examples and diagrams to illustrate our points. By the end of this article, you will have a clear understanding of CGUs and their role in accounting.
What is a cash-generating unit?
A cash-generating unit is a group of assets that generates cash inflows largely independent of the cash inflows from other assets or groups of assets. In other words, a CGU is a self-contained business unit that can be identified and measured for accounting purposes. A CGU may consist of one or more assets, and maybe a division, a subsidiary, a product line, or a geographic area, depending on the nature of the business.
The concept of CGUs is important in accounting because it is used to determine whether an asset is impaired, which means its carrying amount exceeds its recoverable amount. The recoverable amount is the higher of an asset's fair value fewer costs of disposal and its value in use, which is the present value of its expected future cash flows. If the carrying amount is higher than the recoverable amount, the asset must be written down to its recoverable amount, and the impairment loss is recognized in the income statement.
How to calculate the value of a cash-generating unit?
To calculate the value of a cash-generating unit, we need to estimate its future cash inflows and outflows and discount them to their present value using an appropriate discount rate. The discount rate should reflect the time value of money, the risks inherent in the CGU's business, and the availability of alternative investments with similar risk and return characteristics.
The estimated future cash inflows should be based on reasonable and supportable assumptions, such as market trends, customer demand, competition, technological changes, and regulatory requirements. The estimated future cash outflows should include all the costs necessary to generate the cash inflows, such as production, marketing, distribution, and administration costs.
The resulting present value of the estimated future cash flows is the value in use of the CGU, which is compared to its carrying amount to determine whether an impairment loss is required. If the value in use is higher than the carrying amount, no impairment loss is required. If the value in use is lower than the carrying amount, an impairment loss is required, and the carrying amount is reduced to the value in use.
Importance of cash-generating units for financial reporting and analysis
Cash-generating units are important for financial reporting and analysis because they help to provide a more accurate picture of the company's financial performance and position. By identifying and measuring CGUs, we can assess the value and profitability of each business unit, and compare them to each other and to external benchmarks.
CGUs also play a role in strategic decision-making, as they help to identify areas of strengths and weaknesses in the company's operations and guide the allocation of resources and investments. For example, if a CGU is found to be impaired, the company may need to restructure or divest it and focus on more profitable and promising CGUs.
Example of cash-generating unit calculation
To illustrate the calculation of a cash-generating unit, let's take the example of a manufacturing company that produces and sells industrial equipment. The company has three CGUs: CGU A, which produces cranes; CGU B, which produces excavators; and CGU C, which produces loaders.
To calculate the value in use of each CGU, the company needs to estimate their future cash inflows and outflows, and discount them to their present value using an appropriate discount rate. Let's assume the following data:
CGU A: expected cash inflows of $10 million per year for the next five years, and a terminal value of $20 million at the end of the fifth year; expected cash outflows of $7 million per year for the next five years, and a terminal value of $5 million at the end of the fifth year; a discount rate of 12%.
CGU B: expected cash inflows of $8 million per year for the next five years, and a terminal value of $15 million at the end of the fifth year; expected cash outflows of $6 million per year for the next five years, and a terminal value of $3 million at the end of the fifth year; a discount rate of 10%.
CGU C: expected cash inflows of $6 million per year for the next five years, and a terminal value of $10 million at the end of the fifth year; expected cash outflows of $4 million per year for the next five years, and a terminal value of $2 million at the end of the fifth year; a discount rate of 8%.
Using these data, the company can calculate the value in use of each CGU as follows:
CGU A: $38.95 million
CGU B: $34.04 million
CGU C: $25.91 million
If the carrying amount of each CGU is higher than its value in use, an impairment loss is required. If the carrying amount is lower than the value in use, no impairment loss is required. If the CGU is found to be impaired, the company needs to recognize an impairment loss in the income statement, and adjust the carrying amount of the assets accordingly.
Conclusion
In conclusion, cash-generating units are an important concept in accounting that helps to measure the value and impairment of business units. By understanding how to calculate the value in use of CGUs and how to test them for impairment, companies can provide more accurate and useful information to investors, regulators, and other stakeholders. We hope this article has provided a clear and comprehensive explanation of cash-generating units, and helped you to understand their role in accounting. If you have any questions or feedback, please let us know in the comments below.
