Value in Use
Value in use equals the present value of the cash flows generated by an asset or a cash generating unit. Impairment loss, if any, under IFRS is determined by comparing the carrying amount of an asset of CGU to the higher of the fair value less cost to sell or the value in use of the asset.
A company can recover economic benefits from an asset or a cash-generating unit by either selling the asset at its fair value or continuing to use it in its operations. When an asset is sold, the net proceeds equal the fair value less cost of sell. It forms one leg of the asset or CGU’s worth. When the asset or CGU is not sold but is instead used by the company in its continuing operations, its value comes from the revenue it earns in future net of any associated costs or any savings which the asset causes. This leg of asset’s value to a company is called value in use and it is estimated by discounting the net incremental cash flows of the asset to the impairment test date.
The value in use must be determined for each individual asset. However, if it is not practical, value in use most be worked out for the cash-generating unit containing the asset. A cash-generating unit is the smallest group of assets for which net cash flows can be identified.
The estimation of expected cash flows must consider the probability and timing of cash flows. The present value must be determined using a discount rate which reflects the current risk-free interest rate plus any risk premia which are relevant to the asset such as liquidity risk, currency risk, etc. The cash flows and the discount rate must both be consistent i.e. real discount rate to be used with real cash flows and nominal discount rate with nominal cash flows. They both should be on a pretax basis.
The discount rate most appropriate to work out value in use is the rate that would prevail in the market to finance an asset with identical cash flow and risk pattern. If no such rate is available, the company’s pretax cost of capital, incremental borrowing rate, etc. can be used.
Example: calculating value in use
ABC, Inc. is a public transit system operator licensed by the government to ply 70,000 kilometers per bus. The company has a fleet of 150 buses right now whose carrying amount is $30 million and remaining useful life is 4 years. Recently, the government announced a policy to phase out the diesel-based buses and introduce a more energy-efficient buses. ABC, Inc. is allowed to run the buses only for 50,000 kilometers next year and this threshold will decrease by 5,000 kilometers per annum. Each bus generates average revenue of $3 per kilometer and has variable cost per kilometer of $1.5 and the whole fleet has a fixed cost of $1 million per annum. Find out the fleet’s value in use if the appropriate discount rate is 10%. And if the fleet’s fair value less cost to sell is $15 million, find out the amount if impairment loss.
The following schedule shows the calculation of net cash flows and their discounted present value for the remaining useful life of the fleet:
|Contribution margin per kilometer per bus||60,000||52,500||45,000||37,500|
|Total contribution margin for 500 buses||9,000,000||7,875,000||6,750,000||5,625,000|
|Pre-tax cash flows||8,000,000||6,875,000||5,750,000||4,625,000|
|Present value factor @ 10%||0.9091||0.8264||0.7513||0.6830|
|Present value of pre-tax cash flows||7,272,727||5,681,818||4,320,060||3,158,937|
|Value in use (i.e. sum of PV of cash flows)||20,433,543|
Because the value in use if higher than the fair value less cost to sell, it is the recoverable amount. Because the carrying amount exceeds the recoverable amount by $9,566,457, this is the impairment loss that must be recognized.