Key Points
- The income approach estimates fair value by discounting expected future cash flows to present value at a rate reflecting their risk.
- IFRS 13.B12 lists discounted cash flow, multi-period excess earnings, and option pricing models as income approach techniques.
- Over 70% of Level 3 fair value measurements in European audit files rely on some form of income approach.
- Selecting the wrong discount rate or mixing nominal cash flows with a real discount rate is the fastest route to a misstated fair value.
What is Income Approach?
IFRS 13.62 identifies three valuation approaches: the market approach, the income approach, and the cost approach. The income approach applies when the item being measured generates (or is expected to generate) cash flows that a market participant would price. IFRS 13.B10 specifies that techniques under this heading include present value techniques, option pricing models (such as Black-Scholes-Merton or binomial lattice models), and the multi-period excess earnings method.
The core mechanic is straightforward: project the cash flows a market participant would expect, then discount them at a rate reflecting the risk of those flows not materialising. IFRS 13.B14 distinguishes two present value approaches. The discount rate adjustment technique uses a single set of expected cash flows and a risk-adjusted discount rate. The expected present value technique (Technique 1 or Technique 2 per IFRS 13.B25) probability-weights multiple scenarios and discounts at a rate closer to risk-free. ISA 540.13(a) requires the auditor to evaluate whether the chosen technique is appropriate for the asset or liability being measured. Getting the discount rate wrong by even one percentage point on a long-duration projection can shift the conclusion from "no impairment" to a material write-down.
Worked example: Dupont Ingenierie S.A.S.
Client: French engineering services firm, FY2025, revenue EUR 92M, IFRS reporter. Dupont holds a customer relationship intangible asset recognised at EUR 4,200,000 following a 2023 business combination under IFRS 3. The asset must be remeasured at fair value for the annual impairment indicator assessment. No active market exists for customer relationship intangibles, and a cost approach would not capture the economic benefit. The income approach (multi-period excess earnings method) is selected.
Step 1 — Project attributable cash flows
Dupont's finance team isolates revenue attributable to the acquired customer base: EUR 14,800,000 in FY2025, declining at 8% annually as contracts expire or are renegotiated. Operating margin on these contracts is 11%. After deducting contributory asset charges for the workforce (EUR 620,000) and working capital (EUR 185,000), the excess earnings attributable to the customer relationship intangible are EUR 823,000 in year one.
Documentation note: "Revenue attribution per client-level revenue analysis. Attrition rate of 8% based on three-year historical customer retention data (FY2022-FY2025). Contributory asset charges derived from replacement cost of assembled workforce and a market return on net working capital per IFRS 13.B17. Excess earnings of EUR 823,000 in year one."
Step 2 — Determine the discount rate
Dupont derives a risk-adjusted discount rate specific to the intangible asset. Starting from the entity's post-tax WACC of 9.4%, the team adds a 2.5% premium for the asset-specific risk of customer attrition exceeding the projected rate. The resulting post-tax rate is 11.9%. Grossing up for the French corporate tax rate of 25% produces a pre-tax discount rate of 14.2%.
Documentation note: "Discount rate of 14.2% (pre-tax) derived per IFRS 13.B18. WACC components: risk-free rate 2.9% (10-year OAT yield, 31 December 2025), equity risk premium 5.6%, beta 1.05 (engineering services sector), debt spread 1.3%. Asset-specific premium of 2.5% for customer concentration and attrition risk. Sensitivity tested at 12.7% and 15.7% pre-tax."
Step 3 — Calculate present value
The projected excess earnings over six years (matching the estimated remaining useful life of the customer relationships) are discounted at 14.2%:
| Year | Excess earnings | Discount factor (14.2%) | Present value |
|---|---|---|---|
| 1 | EUR 823,000 | 0.8757 | EUR 720,800 |
| 2 | EUR 717,000 | 0.7669 | EUR 549,700 |
| 3 | EUR 620,000 | 0.6714 | EUR 416,300 |
| 4 | EUR 531,000 | 0.5879 | EUR 312,200 |
| 5 | EUR 449,000 | 0.5148 | EUR 231,100 |
| 6 | EUR 374,000 | 0.4508 | EUR 168,600 |
| Total | EUR 2,398,700 |
Documentation note: "Fair value of customer relationship intangible estimated at EUR 2,398,700 using the multi-period excess earnings method per IFRS 13.B10. No terminal value applied (finite useful life of six years). Sensitivity: at 12.7% discount rate, fair value is EUR 2,520,000; at 15.7%, fair value is EUR 2,284,000. Classified as Level 3 under IFRS 13.86 because the attrition rate and contributory asset charges are unobservable inputs significant to the measurement."
Step 4 — Compare to carrying amount and conclude
The carrying amount (after two years of amortisation on the original EUR 4,200,000 over seven years) is EUR 3,000,000. The fair value of EUR 2,398,700 indicates a potential impairment of EUR 601,300. The engagement team escalates this to the impairment test under IAS 36 for the CGU containing the intangible.
Documentation note: "Income approach fair value of EUR 2,398,700 compared to carrying amount of EUR 3,000,000. Shortfall of EUR 601,300 triggers formal recoverable amount assessment at CGU level per IAS 36.22."
Conclusion: the income approach valuation of EUR 2,398,700 is defensible because the cash flow projections trace to client-level revenue data, the attrition rate is supported by historical retention analysis, contributory asset charges follow IFRS 13.B17, and the discount rate build-up is sourced from observable market inputs with an explicit asset-specific adjustment.
Why it matters in practice
- Teams frequently omit contributory asset charges when applying the multi-period excess earnings method. IFRS 13.B17 requires the income approach to isolate the cash flows attributable to the specific intangible being measured. Without deducting a fair return on contributory assets (workforce, working capital, fixed assets), the model attributes too much value to the intangible and overstates fair value. ISA 540.18 directs the auditor to evaluate whether the assumptions are reasonable, which includes testing the completeness of contributory charges.
- Entities mix nominal cash flows with a real (inflation-stripped) discount rate, or vice versa. IFRS 13.B46 requires internal consistency between the cash flows and the discount rate. Nominal cash flows must pair with a nominal rate. Real cash flows must pair with a real rate. The mismatch inflates or deflates the present value by the embedded inflation assumption, and auditors who test the discount rate in isolation without confirming whether the cash flows are stated in nominal or real terms miss the error entirely.
Income approach vs. market approach
| Dimension | Income approach | Market approach |
|---|---|---|
| Input source | Entity's cash flow projections, discount rates, growth assumptions | Comparable transactions, quoted prices, trading multiples |
| Best suited for | Unique assets with no traded comparables (intangibles, long-term contracts, complex instruments) | Assets with active markets or numerous recent comparable transactions |
| Primary audit risk | Discount rate selection and cash flow projection bias | Comparability of selected transactions and adjustments applied |
| Hierarchy level | Typically Level 3 (unobservable inputs dominate) | Typically Level 2 (observable inputs from similar items) |
| Standard reference | IFRS 13.B10-B30 | IFRS 13.B5-B7 |
The choice between approaches matters because it determines the disclosure burden and the level of audit scrutiny. A Level 3 income approach measurement triggers the full set of IFRS 13.93 disclosures (quantitative unobservable inputs, sensitivity analysis, reconciliation of opening to closing balances). A Level 2 market approach measurement requires far less. Auditors who accept an income approach valuation without first considering whether a market approach would produce a more observable measurement risk missing a classification error that affects both the balance sheet and the notes.
Related terms
Frequently asked questions
When should I use the income approach instead of the market approach?
Use the income approach when no active market exists for the item being measured, or when comparable transactions are too dissimilar to produce a reliable indication of value. IFRS 13.61 requires the entity to select techniques consistent with one or more of the three approaches, prioritising the approach with the most observable inputs. For intangible assets, customer relationships, and long-term contracts without traded comparables, the income approach is typically the only viable technique.
Does the income approach always use discounted cash flows?
No. IFRS 13.B10 includes option pricing models (Black-Scholes-Merton, lattice models) and the multi-period excess earnings method under the income approach umbrella. The common thread is that each technique converts future economic benefits into a present value. The choice depends on the characteristics of the asset or liability. Employee stock options, for example, are measured using option pricing models rather than a traditional discounted cash flow projection.
How do I audit the discount rate in an income approach model?
Obtain management's discount rate build-up and test each component against observable market data: risk-free rate against government bond yields, equity risk premium against published surveys, beta against sector comparables. ISA 540.18 requires the auditor to evaluate the reasonableness of assumptions. Pay particular attention to asset-specific premiums, which are unobservable and prone to management bias. Compare the final rate to rates disclosed by listed peers measuring similar assets.