Calculation of Recoverable Amount and Impairment Test in Corporate Accounting

This article explains the process of calculating recoverable amount and carrying out impairment test in corporate accounting. It covers the steps involved in determining the value in use and fair value less cost of selling, and the factors to be considered while making assumptions for future cash flows. The article also provides a sample calculation and journal entries for impairment loss.

CORPORATE ACCOUNTING

Answer a.
In order to calculate the recoverable amount we need to calculate the value in use and fair value
less cost of selling. After the calculation of the value in use and the fair value less cost of selling
we choose the higher value and that value is known as the recoverable amount. The recoverable
amount is used carry out impairment test. In the impairment test the recoverable amount is
compared to the carrying amount of the cash generating unit. A cash generating unit can be
defined as a pool of several assets that have the company in generation of cash flows. (Edwards,
2014)
As stated above in order to determine the recoverable amount we will need the value in use. It is
calculated by determining the present value of the future cash generation buy a given cash
generating unit. (Girard, 2014)
Step 1- Forecast the future cash inflows of the company that is expected to be derived from the
cash generating unit.
Step 2- Determine the timing of these cash flow and also the possibility of variations.
Step 3- In order to calculate the present value be required discount rate. The discount rate can be
calculated based on certain factors and assumptions. Few factors that can be taken into
consideration are liquidity and risk bearing. (McLaney & Adril, 2016)
Since the cash flows are forecasted you important points have to be kept in mind. They are-
1. The reasons and assumptions behind the forecasted cash flows should be valid as it gives
an idea of the remaining useful life of individual assets.
2. The company should not include any reconstruction charges that the company hasn't
committed for. (Paul, 2014)
3. The company should not include any borrowing cost or tax receipt of payment or any
kind of capital expenditure that enhances the efficiency of the assets.
4. The company should make forecast based on current financial statements and reports
prepared by the management.
The company should compare the actual performance with the forecasted performance and try to
identify the difference between the two so that corrective measures can be undertaken.
In order to calculate the present value of the cash flows there are two approaches that can be
followed traditional approach and expected cash flow approach. However, it is observed that the

result obtained from both the approaches is the same. It is also observed that the traditional
approach uses only a single set of projected cash flows and a single discount rate. The discount
rate is ascertained based on the risk that has been taken. The probabilities of the cash flow
generation differ and therefore different discount rates are being used. (Pratt, 2009)A company
should go for traditional approach when there are similar assets available in the market. The
company is expected to maintain consistency in terms of interest either use real interest over the
years or use nominal interest over the years consistently. The cash flows that are used while
carrying out the calculation are pre tax. Only those companies that use Capital Asset pricing
model prefers to use post tax cost of equity for the determination of discount rate.
The amount received on selling an asset less the disposal cost is known as the fair value less cost
of sell. However the acid should be sold to a knowledgeable and a person willing to buy the
asset. (Rogers, 2015)
● The simplest way to determine the fair value less cost of disposal issue is to know the
value mentioned in the sales agreement and then deducting any incremental cost that
would be incurred while making the sale.
● It is possible that there is no sales agreement in such a case if the acid has a ready market
then the market price should be known and the cost of disposal should be deducted.
(Schroeder, 2014)
● In the absence of the both the situations which means that neither there is a sales
agreement not there is a ready market for sale. In such a case the company should obtain
information about the amount it expects to receive if the asset is sold at the end of the
reporting period in an arm’s length transaction.
If the market value of the asset is not available then the company should go for discounted cash
flow approach also known as DCF. In order to carry out the valuation with the help of this
approach the following points have to be followed. (Scott, 2014)All the cash flows that are
expected to arise in the future events should be considered while calculating the fair value in use.
● As we know that there are many assumptions that have to be taken in order to estimate
the future cash flows. Such assumptions should be reliable and should be in consideration
with the current scenario.

● If it is observed that the assumptions made by the company is different from that of the
market participants then the management of the companies should make required changes
in the assumptions taken. (Siciliano, 2015)
● If there is any kind of transaction cost that has been incurred in the process of disposal of
an asset then it should be considered while doing the calculations.
● The cost involvement inserting the expected cash flow generation from an acid should be
high so that the results achieved are accurate and reliable.
The fair value less cost of sell should fully reflect the risk and uncertainty on holding the Asset.
However, the adjustment for Risk can be made by adjusting the cash flows are the discount rate.
We know that business is dynamic in nature and therefore the discount rate keeps on changing
along with the expected cash generation. (Taillard, 2013)

Answer b:
Account
Carrying
Amount Recoverable Amount Impaiment
Factory 61200 59,020 2,180
Franchise 14000 1,981
Furniture 9000 1,273
Inventory 4000 566
Goodwill 3000 3,000
Total CA 91200
82,200 9,000 3,820
27,000
The distribution of impairment loss on the basis of carrying value is given below:
Particulars Carrying Amount Ratio Impairment Loss
Franchise 14000 0.52 1,981
Furniture 9000 0.33 1,273
Inventory 4000 0.15 566
27,00
0 3,820
The journal entries are as follows:
Particulars Dr Amt Cr Amt
Accumulated Impairment Loss ...
…..Dr 9,000.00
To Factory 2,180.00
To Franchise 1,980.74
To Furniture 1,273.33
To Inventory 565.93
To Goodwill 3,000.00

(Being impairment on assets realised)
Impairment loss……Dr 9,000.00
To accumulated impairment loss 9,000.00

Bibliography
Edwards, M. (2014). Valuation for Financial Reporting: Fair Value Measurement in Business
Combinations, Early Stage Entities, Financial Instruments and Advanced Topics . Hoboken:
John Wiley & Sons Inc.
Girard, S. L. (2014). Business finance basics. Pompton Plains, NJ: Career Press.
McLaney, E., & Adril, D. P. (2016). Accounting and Finance: An Introduction. United
Kingdom: Pearson.
Paul, K. (2014). Managing extreme financial risk. Oxford: Academic Press, Elsevier.
Pratt, J. (2009). Financial Reporting for Managers: A Value-Creation Perspective. Hoboken:
John Wiley & Sons, Inc.
Rogers, C. G. (2015). Financial Reporting of Environmental Liabilities and Risks after
Sarbanes-Oxley . Hoboken, N.J.: John Wiley & Sons.
Schroeder, R. G. (2014). Financial Accounting Theory and Analysis: Text and Cases. Hoboken:
John Wiley & Sons.
Scott, W. R. (2014). Financial Accounting Theory. Toronto: Pearson.
Siciliano, G. (2015). Finance for Nonfinancial Managers. New York: McGraw-Hill.
Taillard, M. (2013). Corporate finance for dummies. Hoboken, N.J.: Wiley.