Calculating Recoverable Amount And Impairment Test – Guide

What is Recoverable Amount?

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

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

Particulars	Carrying Amount	Ratio	Impairment Loss
Franchise	14000	0.52	1,981
Furniture	9000	0.33	1,273
Inventory	4000	0.15	566
	27,000		3,820

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

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.