ACCTING3501 Corporate Accounting
How to calculate Recoverable amount, Value in use, Fair value less cost of disposal.
A company needs to record in its books of accounts if the recoverable amount of assets held by them exceeds their carrying amount. The process of identification of such assets and recoding them is known as the impairment test. The difference between the two amounts is known as impairment loss. The determination of recoverable amount is a complex job and so it is very difficult to ascertain the recoverable amount for each asset separately. Therefore, the recoverable amount for the cash generating unit (CGU) is determined. Cash generating asset is the pool of assets that helps in generating cash inflow. Such assets which are contained in the unit must have an active market or could be consumed within the company itself. Few disclosures that a company has to make is when there is a transfer of any particular asset from one CGU to another, if the company has reversed any impairment losses or if it has made any sort of payments. However, the recoverable amount is dependent that is derived from the cash flows and also the efficiency by which the assets are being used (Alvarez, 2013).
The impairment test for a normal asset and a CGU is done almost in the same manner. the recoverable amount that is ascertained is compared with the carrying amount. The difference between the two is allocated among all the assets of the CGU in the ratio of their carrying value (Easton, 2010). The value of each asset gets decreased because impairment loss is deducted against each asset that is contained in the cash generating unit.
In order to determine the recoverable amount, we require the value in use and the fair value less cost of disposal. Let us now understand the process to determine the value in use (Fridson & Alvarez, 2012).
Value in use can be determined by calculating the present value (PV) of the future cash flows that are expected to be generated from the CGU (Girard, 2014). The steps that have to be followed for calculating value in use are as follows:
- The company must be efficient enough to estimate the future cash flows using the information available.
- Estimates are based on certain assumptions and are a judgemental process. Therefore, the management must state about the variations that might occur.
- In order to calculate the present value, the company will require a discount rate which is based on certain assumptions. The other factors that are taken into consideration is risk bearing as well as liquidity.
The estimations of cash flows that are made by the company must be:
- The economic condition of the asset based on its remaining life has to be determined. The estimation of the cash flows or the remaining life should be based on proper reasons or valid assumptions.
- The company must record any reconstruction charges in its book if it has not promised it earlier (Ittelson, 2009).
- The budgets and estimations that are made by the company using the data for the current year and not the past years.
- Any capital expense, tax receipt or payment and borrowing cost should be excluded while doing the calculation.
The estimations are based on the judgement and there may be variation on comparing it with the actual results. The management of the company must find out the reasons behind such variations and take corrective measures for future.
In order to calculate the present value, there are two approaches that can be adopted. The first one is the traditional approach and the second one is the cash flow approach. The result of the impairment test under both the situations will be