Impairment of Assets: Calculation of Recoverable Amount, Value in Use, Fair Value less Cost of Disposal

This article explains the accounting of impairment of assets and how to calculate recoverable amount, value in use, and fair value less cost of disposal. It defines each term and provides formulas for their calculation. An example is also given to illustrate the process. The article is relevant for accounting students and professionals.

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ACCOUNTING OF IMPAIRMENT OF ASSETS
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Topic: calculate Recoverable amount, value in use, Fair value less cost of disposal

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Accounting of Impairment of Assets
The treatment of impairment of assets is addressed under IAS 36. According to IAS
36, an organization should not carry its asset at an amount higher than its
recoverable amount. However, some intangible assets and goodwill are excepted
from this requirement (Shamrock, 2012, p. 45). IAS 36 states that companies should
carry out an impairment test annually to ascertain whether or not its assets are
impaired. Before determining a recoverable amount of an asset, values of its value in
use and fair value less cost of disposal should be known first. This paper seeks to
illustrate the definition and calculation of recoverable amount, value in use, and fair
value less cost of disposal (Weygandt, et al., 2015, p. 61).
Recoverable amount
According to IAS 36 Impairment of Assets, Recoverable amount is defined as, "the
higher of fair value less costs to sell (FVLCTS) and value in use" (Everingham, et al.,
2007, p. 101). In other words, the recoverable amount refers to the highest amount
that can be generated from an entity's asset. There are two ways in which value can
be obtained from an asset: First, an asset can be used by a company to generate
cash flows. Second, value can be realized from selling off an asset to another person
or entity.
Why calculate recoverable amount? Recoverable amount is a test for impairment. It
is presumed that the management of a company will choose the highest amount to
maximize the entity's value that is why the expected amount from value in use or fair
value less costs to sell should be compared and choose the highest amount as the
recoverable amount (Bragg, 2016, p. 152).

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There are two formulas for calculating the recoverable amount;
a) Recoverable amount= Value in Use
b) Recoverable Amount= Fair Value – Cost of Disposal
Where:
Fair Value refers to the price an entity would receive by selling an asset
Cost of Disposal refers to the cost associated with selling an asset.
Note: There is a challenge when it comes to calculating the recoverable amount of
an asset that must be combined by other assets (cash-generating unit) to generate
cash flows. In such a case the recoverable amount for the cash-generating unit is
calculated.
Value in Use
The value in use refers to an amount that would be realized in the future by using an
asset to generate cash flows. The value in use is calculated by determining the
weighted (probable) future cash flows of an asset or cash generating unit. The cash
flows should, however, be discounted using a discount rate to address the risks
associated with the cash flows. At the end of the useful life of the asset, its
disposable value (if any) should be added to the cash flows to obtain the asset's
value in use (Dagwell, et al., 2015, p. 73).
The value in Use is calculated as shown below:
The value in Use = Discounted cumulated cash flows + Disposable Value (If any).

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Fair Value of an Asset
The fair value of an asset refers to an amount at which such an asset can be sold
after deducting the cost associated with the sale. According to the Generally
Accepted Accounting Principles (GAAP), there are three approaches to determining
the fair value of an asset. The market approach is based on the costs realized from
selling a similar or identical asset in the market. The cost approach is based on the
cost an entity is likely to occur when replacing the asset. Lastly, the income
approach considers the future cash flows, revenue, and income associated with the
asset (Hilton & O'Brien, 2009, p. 193). In the case of a cash-generating unit, fair
value is determined for the entire unit. The market approach is mostly used because
it relies on a realistic figure in the market as compared to the use of estimations and
assumptions under the cost and income approaches (Deegan, 2013, p. 221).
GAAP further provides three levels of information that can be applied when valuing
information. The first level of information is based on the quoted price of similar
assets in the financial markets. The second level of information is based on
observable price inputs of identical assets in the market. The third level of
information is based on unpredictable information in the market that is likely to
influence the price of an asset (Everingham, et al., 2007, p. 121).
Fair Value is calculated as shown below:
Fair Value = Sales amount – Cost of sales

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Calculating Recoverable amount, Value in Use and Fair value less Cost of
disposal using example
Example
In 2010, a production company bought equipment for $3 million. The estimated
useful life of the equipment is eight years. In 2014, the equipment was rendered
obsolete because of technological advancement in the industry. The company is
faced with two options. First, the company could sell the equipment for $ 1,000,000.
However, it would incur a cost of sale of $ 80,000 (transporting the equipment to
buyer's premises). Second, the company should keep the equipment and realize an
accumulative discounted cash flow of $ 900,000, over the next three years. At the
end of eight years, the equipment will have a residual value of $ 90,000. Calculate
the recoverable amount of the equipment.
Solution
 If the equipment is sold today, the company will realize $ 1,000,000 from its
sales. The cost of the sale would be $ 80,000. Therefore, the equipment's fair
value less Cost of disposal is $ 1,000,000 -$ 80,000 =$ 920,000.
 If the equipment is put into use, an accumulative discounted cash flow of $
900,000 would be realized in additional to $ a residual value of $ 90,000.
Therefore, the value in use of the equipment is $ 900,000 + $ 90,000 = $
990,000.
 The recoverable amount is the higher value between the value in use and fair
value less cost of disposal. Therefore, the recoverable amount of the
equipment would be $ 990,000 (value in use).

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References List
Bragg, S. M., 2016. Accounting Best Practices. New York: John Wiley & Sons.
Dagwell, R., Wines, G. & Lambert, C., 2015. Corporate Accounting in Australia.
Sydney: Pearson Higher Education AU.
Deegan, C., 2013. Financial accounting theory. 4th Edition ed. North Ryde, N.S.W:
McGraw-Hill Education.
Everingham, G. K., Kleynhans, J. E. & Posthumus, L. C., 2007. Principles of
Generally Accepted Accounting Practice. New Delhi: Juta and Company Ltd.
Hilton, A. & O’Brien, P., 2009. Inco Ltd.: Market value, fair value, and management.
Journal of accounting research, 47(1), pp. 179-211.
Samarasekeraa, N., Chang, M. & Tarca, A., 2012. IFRS and accounting quality: The
impact of enforcement, Crawley, Western Australia: University of Western Australia.
Shamrock, S. E., 2012. IFRS and US GAAP: A Comprehensive Comparison. New
York: Wiley.
Weygandt, J. J., Kimmel, P. D. & Kieso, D. E., 2015. Financial & Managerial
Accounting. New York: John Wiley & Sons.