Recoverable Amount
Recoverable amount is the higher of fair value less costs to sell (FVLCTS) and value in use. The carrying value of a fixed asset is compared with recoverable amount to find out impairment loss, if any.
Recoverable amount is the concept introduced by IAS 36 Impairment of Assets. The US GAAP impairment guidance doesn't mentions recoverable amount.
The carrying amount (i.e. book value) of a fixed asset represents the economic benefits i.e. future cash flows that the asset embodies. These cash flows can come in two forms: either through sale of the asset in open market or through continued use in the operations of the business.
Fair Value Less Cost to Sell (FVLCTS)
Fair value less cost to sell is the measure of value of ‘net’ economic benefits embedded in a fixed asset that can be unlocked in event of the sale of the asset. As the name shows, it equals the fair value minus the costs that the company will incur in selling the asset such as transaction costs, irrecoverable taxes, delivery and transportation costs, etc. The fair value of the asset is the amount at which it can be sold to a knowledgeable and willing buyer in an arm’s length transaction.
Value in Use
The value in use is the present value of the expected future net cash flows generated by the asset. It is calculated by finding out probability-weighted future cash flows of the asset (or the cash-generating unit containing the asset, if no cash flows can be identified for the asset itself) and discounting those cash flows using a discount rate that reflects the risk of the cash flows. Both the cash flows and the discount rate are pre-tax inputs.
Example
Pankaj, Inc. operates a hotel facility in a hot tourist destination. The facility was constructed at a cost of $30 million 5 years back and it is depreciated on a straight-line basis (total useful life of 15 years and residual value of 20%). There are indications that the property is not performing as expected due to (a) opening of a competing hotel nearby, (b) a significant drop in number of tourists to the area, etc.
There is a 40% probability that the property will generate net cash flows of $4 million per annum over the next 10 year and 60% probability that the cash flows would only be $2 million per annum.
The property’s net operating income (NOI) is $3 million and the appropriate capitalization rate based on past transactions of similar nature is 15%. 5% of the proceeds from sale would be expended in closing the deal.
Assuming that the asset has zero residual value and the appropriate discount rate is 10%, find out the recoverable amount and see if the property is impaired.
First, we need to work out the carrying value of the property. The depreciable cost is $24 million (=$30 million × (1 – 0.2), which results in annual depreciation expense of $1.6 million (=$24 million divided by 15). The 5-year accumulated depreciation works out to $8 million ($1.6 million × 5). The carrying amount/value at the end of 5th year is $22 million (=$30 million - $8 million).
Next, we need to work out both the fair value less cost to sell (FVLCTS) and value in use. Because no readily available market data exist to find out the value of the property, the direct capitalization method is used to work out the fair value of property. Under the direct capitalization method, value of property equals net operating income divided by a capitalization rate (which reflects comparable transactions). In this case, property value is $20 million ($3 million divided by 15%). After incorporating the disposal costs, the FVLCTS works out to $19 million (=$20 million × (1 – 0.05)).
Even though FVLCTS calculated above is lower than the property’s carrying value, we can’t conclude, as yet, that the property is impaired. We must work the present value of net cash flows of the property over the next 10 years. Expected cash flow each year over the next 10 years works out to $2.8 million (= 0.4× $4 million + 0.6 × $2 million). Discounting them at 10% gives us a value in use of $17.2 million (worked out using Excel PV function PV(10%,10,-2.8)).
Recoverable amount is $19 million, i.e. the higher of the fair value less cost to sell (which is $19 million) and the value in use (which is $17.2 million). Comparing this with the carrying value of the property (which is $22 million) shows that an impairment loss of $3 million (=$22 million - $19 million) must be recognized.
by Obaidullah Jan, ACA, CFA and last modified on