Review of discount rate / WACC in a discounted cash flow analysis ("DCF") of different subsidiaries within the client Group

Your client may have a number of subsidiaries in different countries / different regions. From holding company, the Company records investments in subsidiaries on its company's balance sheet. When there is indication of impairment, the holding company is usually required to estimate the recoverable amount via the following:

- estimated value-in-use; or
- fair value less cost of disposal

The recoverable amount is higher of one the above.

In estimating the value-in-use, a discount rate will be applied in estaming the value-in-use. Developing an understanding of client's discount rate estimation process is essential for the auditor the test the reasonableness of the discount rate. Typically, your audit client would use weighted average cost of capital (i.e. WACC) as its discount rate. Hence, it is important to know how client gather cost of debt, cost of equity, market premium and beta. These need to be supported by proper source (i.e. print out from Bloomberg).

When a discount rate has been estimated, it is important to perform the review of the discount rate against the industry disocunt rate/ country discount rate/ or even the discount rate within the Group.

Of course, country risk need to be considered. Generally, we would expect the discount rate for a developed nation is lower than the discount rate in an emerging market. As the risk is higher for emerging market.

Hence, it is important to understand and test the discount rate estimation process and perform review of the end result.

Increasing labour cost and its impact on net realisable value of inventories

In current economy situation, almost all entities have to face the challenges of increasing labour costs. It is not easy to manage the labour costs, as the need may fluctuate from day-to-day, whilst the number of headcount is "sticky" in economic term - i.e. headcount of a company would not change drastically within short period of time. Moreover, the change of regulation may have an impact on the labour costs - for intsance, the increase in social security fund in China.

The increasing labour cost would have an impact on net realisable value of the inventories. Why?

The above is especially true for businesses operating in manufacturing environment. Some of the labour cots represent direct labour to the company, who capitalised direct labour cost as finished goods upon completion of production, and charged to cost of sales upn sales of that particular item.

When a manufacturing accept a sales order for a particular model, they would draft a budget to estimate the raw material, labour and overhead costs. On this basis, they would propose a pricing for the customer. The pricing quote may be valid for a period of 1 year or more. In an environment where labour cost is increasing, the direct labour costs incurred may cause the inventory costs to go higher and higher and resulted in erosion of gross profit margin.

This will be very challenging for business to manage, especially for projets with minimal margin - these projects are sensitive to all the costs incurred to produce these items. The increase in direct labour cost may trigger a net realisable value write-down.

As a result, auditor need to understand how this process is being managed and concentrate on projects with minimal GP margin.

Audit of inventory: difference between allowance for stocks obsolescence and write-down of net realisable value

Dealing with the value of the inventory, auditor should have a clear idea in mind on the difference between allowance for stocks obsolescence and write-down of net realisable value of an inventory. Although the term has not been clearly defined and could be over-lapping, there are clearly two factors need to be considered.

Let's examine the following example.

Company XYZ purchased a product A from its supplier and recorded its inventory at purchased cost of US$50 dollar per item. XYZ marketed product A for a selling price of US$54 dollar.

The stocks remained unsold after 2 months, and due to the decreasing raw material prices, the product A buying price for XYZ has decreased to US$48, and the customer is asking for a buying price of US$52 dollar. Is there any net realisable value issue require XYZ to write down its inventory to US$48, prevailing purchase price? The answer is no. According to the accounting standard for inventory - the inventories need to be stated at the lower of cost and net realisable value. The cost of product A was US$50, while the selling price (i.e. net realisable value) was US$52. Hence, no write down is required.

A write-down is required when the market price / selling price drop below US$50.

This is the concept of net realisable value which generally deals with the fluctuation of selling price.

Allowance for stocks obsolescence deals with the long standing stocks, where the specific products remain relatively unsold after a pro-longed period (based on the industry standard). For instance, Company XYZ purchased 50 items of product B, which was expected to be sold within 3 months, whilst the inventory turnover for the industry is about 4 months. However, after 9 months, 10 items of product B remain unsold. This could be due to the commcerial obsolescence where product B is no longer in demand by the market. Management of Company XYZ should evaluate this and consider to provide allowance for stocks obsolescence.

Generally, allowance for stocks obsolescence deal with long standing stocks.