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IFAC PAIB finalises guide to investment appraisal

  • IFAC (International Federation of Accountants) (lt gray) Image

19 Aug 2013

The Professional Accountants in Business (PAIB) Committee of the International Federation of Accountants (IFAC) has released an International Good Practice Guidance document providing guidance on project and investment appraisal for sustainable value creation. The guide promotes the need for project and investment appraisal to facilitate long-term decision making and to incorporate sustainability-related considerations, emphasising the need for explicit value-creating strategies such as discounted cash flow (DCF) analysis and downplaying short-term criteria such as payback periods and earnings-per-share (EPS) growth.

The release of the practice guide follows the publication of an exposure draft in November 2012 and considers how entities evaluate capital spending and investment decisions such as 'make or buy' and 'lease or buy' decisions, acquisitions and disposals of businesses, and development or discontinuation of products and services.

The guide identifies the following (summarised) key principles which are considered good practice:

  • The time value of money should be considered in appraising multi-period investments
  • The time value of money should represent the opportunity cost of capital
  • Discount rates used in DCF analysis should reflect risks associated with the appraised project rather then the organisation undertaking the project
  • Good decision making relies on understanding the business, and be considered in the context of the organisation's strategy, as well as economic, social (e.g. labour practices), environmental (e.g. pollution) and competitive factors
  • Project cash flows should be estimated incrementally
  • Assumptions used should be supported by reasoned judgement and include techniques such as sensitivity analyses
  • Post-completion reviews of audits of decisions should include an assessment of the decision-making process and the results, benefits and outcomes of the decision.

In discussing the second principle above, the guide notes that the opportunity cost of capital is fundamental to investment decisions. It discusses some of the practical issues that can be encountered in determining the opportunity cost of capital under the weighted average cost of capital (WACC) approach, including difficulties in determining the cost of equity capital due to challenges and limitations in applying techniques such as the Capital Asset Pricing Model (CAPM). The paper notes the following in relation to how these issues are addressed under International Financial Reporting Standards:

To provide organizations flexibility in applying and estimating the cost of capital, International Accounting Standard 36, Impairment of Assets... suggests that an organization could also take into account its incremental borrowing rate and other market borrowing rates. As an entirely debt-funded organization would be of high risk, there is always an implied equity (i.e., risk absorbing capital) element and this concentrating risk will have a higher implied cost. Therefore, professional accountants in business should be aware of the disadvantages associated with these methods and apply them appropriately given the organizational context. For example, depending on the debt-equity ratio the cost of debt, the nominal borrowing rate, and the WACC will provide varying values. Thus, for a lowly-leveraged organization, the use of the incremental borrowing rate as the cost of capital could lead to an inappropriately low estimate for cost of funds in use.

The principle that investment analyses to consider wider external impacts is in many respects similar to the idea of 'integrated thinking' in the International Integrated Reporting Council (IIRC) draft integrated reporting framework. The guide notes that the investment analysis should "probe behind cash flow estimates to understand both the nature of a positive NPV and the source of value over the opportunity cost of capital". The port goes on to note the difficulties in quantification of aspects of environmental and social performance and the current emphasis on 'hard' measures of performance. In the specific example of undervaluing ecosystems, it draws on earlier research undertaken by the World Council for Sustainable Development, and notes a worst case outcome of "undermined business performance by failing to identify new cost-saving or revenue-generating opportunities or to highlight potentially costly liabilities".

Click for IFAC press release (link to IFAC website).

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