Calculation of Recoverable Amount and Impairment Test in Corporate Accounting

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.