Fair Value: Definition, Calculation, and Importance in Corporate Accounting and Reporting

This article explains the concept of fair value and its importance in corporate accounting and reporting. It covers the calculation of recoverable amount and value in use of an asset, and provides guidance on determining an asset's value-in-use and factors to consider when calculating fair value. The article also discusses the International Financial Reporting Standards framework and International Accounting Standards related to fair value.

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Corporate accounting and
reporting

Fair value
Recoverable amount is the value in use of an asset or the greater of its fair value fewer
costs incurred in its sale. The value in use simply means the money value in present of
future cash flows expected to be generated from an asset. Thus, the concept records the
highest value of cash flows that can be extracted from an asset either by selling it or by
using it. The recoverable amount concept is used in the international financial reporting
standards framework (IFRS). The concept of recoverable amounts is oftentimes used in
the context of determining the impairment of fixed assets.
A company is as per the accounting principles, needed to record on its balance sheet
instances where the recoverable amount of an asset is exceeded by its carrying amount.
This approach is somewhat on similar lines of the concept of lower of cost or market
value, which applies to inventory (Shoaf & Zaldivar, 2005). International Accounting
Standards (IAS) 36 provides accountants with guidance on this topic, stating:
• “If the asset's fair value less the cost of disposal cannot be determined, the
recoverable amount is equal to its value in use.
• If the company intends to sell the asset, the recoverable amount is equal to its fair
value less the cost of disposal.”
It is to be noted that if the fair value of an asset less its cost of disposal, or the asset's
value in use is greater than its carrying amount, then calculating a recoverable amount is
not necessary since the asset is not impaired (Kieso et. al, 2010). In simple terms, the
recoverable amount is the highest value that can be obtained from an asset. We can think
of two general ways we can obtain value from an asset: (a) from using that asset in the
business or (b) by selling it to someone else. The value of (a) is the present value of
expected future cash flows from using the asset. The value of (b) is the fair value of the
asset fewer costs to sell the asset. The higher amount of these two alternatives is the
recoverable amount.
The present value of future cash flows derived from the use of an asset is termed as a
value in use of that particular asset. Companies determine an asset's value-in-use as part
of a process that evaluates if an asset's value is impaired.
Value-in-Use = Present Value of the Asset's Benefits
A formal estimate of the recoverable amount of the asset has to be taken into account in
case a company believes that the asset’s value may be impaired. This approach is
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Fair value
somewhat on similar lines of the concept of lower of cost or market value, which applies
to inventory (Peirson et.al, 2012). Specifically, IAS 36 provides guidance on this topic,
stating: “If the asset's fair value less the cost of disposal cannot be determined, the
recoverable amount is equal to its value-in-use.”
According to IFRS 13 “Fair Value Measurement, the fair value of an asset may be
determined using the most appropriate of three possible approaches – the market
approach, the cost approach and the income approach.”
International Accounting Standard (IAS) 36 also provides guidance as to the factors to
consider when determining an asset's value-in-use:
• Cash Flow: The total amount of money being transferred into and out of a business,
especially as affecting liquidity. The accountant-analyst should also consider possible
variations in the timing of the expected cash flows (Kieso et. al, 2010).
• Discount Rate: the calculation of value-in-use should take into consideration the
time value of money, which is typically represented by the company's weighted average
cost of capital. This rate is then used to discount the asset's benefits over time (Deegan,
2011).
• Other: includes factors such as credit stability, debt coverage ability, going concern
and liquidity position of the company.
The cash flows should be recognized based on recent forecasts as well as pre-defined
budgetary statements prepared and approved by the top management at the beginning of
the financial year. Since companies normally forecast budgets usually for a period not
exceeding five years (Hamilton et. al, 2011). The discount rate used when determining
the present value of the benefits provided by the asset should be one of the following:
• The company's weighted average cost of capital (pre-tax)
• The company's incremental cost to borrow
• The borrowing rate found in "other" relevant markets
Note: Value-in-use is normally estimated using a conservative approach that is "less
than highest-and-best use" of the asset; therefore, the value will typically be lower than
its fair market value.
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Fair value
“fair value less cost to sell” is defined as the price that would be received from selling
the asset less any costs required and needed to make the sale. As per AASB 13 fair value
can be said to be the price that will be attained by selling an asset or payment made to
transfer a liability in a well settled transaction between the participants of market at the
date of measurement.
This term is consistent with the measurement basis in IFRS 5. The recoverable amount of
an asset or a cash-generating unit is the higher of its fair value fewer costs of disposal
and its value in use (McKaig, 2011). If a market price is not available, FVLCS can be
determined using a discounted cash flow (DCF) approach. The calculation of FVLCS
should reflect all future events that would affect the expected cash flows for a typical
market participant that holds the asset. If there is contrary data indicating that market
participants would not use the same assumptions as the entity, the entity should adjust its
assumptions to incorporate the market information (Kieso et. al, 2010). The discount rate
applied to the calculation would be based on what a normal market participant would
consider. The discount rate applied to the calculation would be based on what a normal
market participant would consider.
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Fair value
References
Deegan, C. M. (2011). In Financial accounting theory. North Ryde, N.S.W: McGraw-Hill
Hamilton, K., Hyland, B. and Dodd, J. L. (2011) Impairment: IASB-FASB Comparison.
Drake Management Review. [online]. 1(1), p. 55–67. Available from:
https://pdfs.semanticscholar.org/8d8f/5fd070193d6fa52e79d1dee9cc6632159d8a.pdf
[Accessed 26 May 2018]
Kieso, D., Weygandt, J., Warfield, T., Young, N and Wiecek, I . (2010). Intermediate
accounting. Toronto: John Wiley & Sons Canada.
Kieso, D., Weygandt, J., Warfield, T; Young, N. and Wiecek, I . (2010). Intermediate
accounting. Toronto: John Wiley & Sons Canada.
McKaig, T. (2011). Understanding Impairment Accounting: What It Is and When It Is Used.
Available from:
http://www.financepractitioner.com/accountancy-checklists/understanding-
impairment-accounting-what-it-is-and-when-it-is-used [Accessed 26 May 2018]
Parrino, R, Kidwell, D. and Bates, T. (2012) Fundamentals of corporate finance. Hoboken,
NJ: Wiley
Peirson, G, Brown, R., Easton, S, Howard, P. and Pinder, S. (2015). Business Finance, 12th
ed. North Ryde: McGraw-Hill Australia.
Shoaf, V. and Zaldivar, I.P. (2005). Goodwill impairment: convergence not yet achieved.
Available from:
http://www.freepatentsonline.com/article/Review-Business/133756140.html
[Accessed 26 May 2018]
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