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FINANCE Solution 1: Determination of recoverable amount for each asset in the cash generating unit

   

Added on  2021-05-31

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FINANCE

Solution 1:The recoverable amount of a particular asset is the higher of the ‘value in use’ and ‘fair valueless cost of selling’. While carrying out an impairment test, recoverable amount is comparedto the carrying amount. For the purpose of the impairment test, recoverable amount for eachasset in the cash generating unit is determined. A cash generating unit is a pool of assets thathelps the company to generate cash inflows.[ CITATION Edw14 \l 1033 ]As we know, we will require ‘value in use’ to determine the recoverable amount. Therefore,let us now understand about it. Value in use can be defined as the present value of theestimated future cash flows derived by a particular cash generating unit. The calculation ofvalue in use includes the following:A forecast of the future cash flows that the company is expecting to derive from theasset.[ CITATION Gir14 \l 1033 ]Possibility of the variations of these cash flows and the timing at which these cashflow are expected to be generated.A discount rate is required to calculate the present value of the cash flows. Therefore,there is a requirement of discount rate which can be determined by taking variousfactors into consideration such as liquidity, risk bearing etc.[ CITATION McL16 \l 1033 ]The cash flow projects that are made by the company while measuring value in use:Must be ascertained based on certain valid reasons and supportable assumptionsas it would represent the economic condition of the remaining life of the asset.It should be based on the current forecast, financial reports and budgets made andapproved by the management [ CITATION Pra09 \l 1033 ]. However, it shouldexclude any cash outflows that would arise on the reconstruction until thecompany has no commitment for it.Certain item should always be excluded such as borrowing cost, capital expensesand tax receipts or payments those results into the improvement or enhancementof any asset.It is highly recommended to compare the estimates of the cash flows made earlier to theactual cash flows. It will help the company to know the variance and then the managementwill be able to take corrective measure towards it so that the company is able to makeadequate estimates in the future. This should compulsorily be done when the company has

been continuously understating or overstating the cash flow projections.[ CITATION Sch14 \l1033 ]The present value is calculated by any of the two approaches- ‘traditional’ or expected’ ‘cashflow approach. The result of the impairment test will be same irrespective of the approachthat we follow. In the traditional cash flow approach, a single set of projected cash flows andonly one discount rate is used [ CITATION Sic15 \l 1033 ]. The discount rate that is used is inrelation to the level of risk undertaken. In the expected cash flow approach, the probabilitiesof the cash flows are not the same and therefore, different discount rates are used.If there are similar assets available in the market then one should go for the traditional cashflow approach. A company should maintain consistency in regards to the discount rate i.e. itshould either use real rate every year or use nominal rate consistently. The cash flows that areused in the calculation of value in use should be pre tax and pre tax discount rates. Sincemany companies use the capital asset pricing model- they use post tax cost of equity in orderto determine the discount rate.Fair value less cost of sell is easier to understand as it is the amount that can be obtained fromthe selling an asset in the market to a knowledgeable and a person willing to obtain that assetless the cost required to dispose the asset.The most evident way to determine the fair value less cost of selling is by determiningthe price mentioned in a sales agreement in which the adjustment will be made ifthere will be any incremental cost that will be incurred while disposing off the asset.There may not be sales agreement, but it might have a ready market for sale. In such acase the market price should be determined and the cost of disposal should bededucted.[ CITATION Zyl13 \l 1033 ]If both the above situations are not available i.e. if there is no sale agreement and alsothere is no ready market then the entity should obtain the information regarding theamount that it would receive if it sells the asset at the end of the reporting period in anarm’s length transaction after subtracting the cost that will be incurred in relation tothis disposal.There is an alternative available if the market price is not available. The alternativeapproach is called the discounted cash flow approach or DCF. In order to carry out thevaluation through this approach, we need to keep the following points in mind:

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