Understanding Recoverable Amount And Impairment Test In Accounting

What is Recoverable Amount and Impairment Test?

The recoverable amount of a particular asset is the higher of the ‘value in use’ and ‘fair value less cost of selling’. While carrying out an impairment test, recoverable amount is compared to the carrying amount. For the purpose of the impairment test, recoverable amount for each asset in the cash generating unit is determined.  A cash generating unit is a pool of assets that helps the company to generate cash inflows. (Edwards, 2014)

As we know, we will require ‘value in use’ to determine the recoverable amount. Therefore, let us now understand about it. Value in use can be defined as the present value of the estimated future cash flows derived by a particular cash generating unit. The calculation of value in use includes the following:

• A forecast of the future cash flows that the company is expecting to derive from the asset.(Girard, 2014)
• Possibility of the variations of these cash flows and the timing at which these cash flow are expected to be generated.
• A discount rate is required to calculate the present value of the cash flows. Therefore, there is a requirement of discount rate which can be determined by taking various factors into consideration such as liquidity, risk bearing etc.(McLaney & Adril, 2016)

The cash flow projects that are made by the company while measuring value in use:

• Must be ascertained based on certain valid reasons and supportable assumptions as it would represent the economic condition of the remaining life of the asset.
• It should be based on the current forecast, financial reports and budgets made and approved by the management (Pratt, 2009). However, it should exclude any cash outflows that would arise on the reconstruction until the company has no commitment for it.
• Certain item should always be excluded such as borrowing cost, capital expenses and tax receipts or payments those results into the improvement or enhancement of any asset.

It is highly recommended to compare the estimates of the cash flows made earlier to the actual cash flows. It will help the company to know the variance and then the management will be able to take corrective measure towards it so that the company is able to make adequate estimates in the future.  This should compulsorily be done when the company has been continuously understating or overstating the cash flow projections. (Schroeder, 2014)

The present value is calculated by any of the two approaches- ‘traditional’ or expected’ ‘cash flow approach. The result of the impairment test will be same irrespective of the approach that we follow. In the traditional cash flow approach, a single set of projected cash flows and only one discount rate is used (Siciliano, 2015). The discount rate that is used is in relation to the level of risk undertaken. In the expected cash flow approach, the probabilities of the cash flows are not the same and therefore, different discount rates are used.

If there are similar assets available in the market then one should go for the traditional cash flow approach. A company should maintain consistency in regards to the discount rate i.e. it should either use real rate every year or use nominal rate consistently. The cash flows that are used in the calculation of value in use should be pre tax and pre tax discount rates. Since many companies use the capital asset pricing model- they use post tax cost of equity in order to determine the discount rate.

Fair value less cost of sell is easier to understand as it is the amount that can be obtained from the selling an asset in the market to a knowledgeable and a person willing to obtain that asset less the cost required to dispose the asset.

• The most evident way to determine the fair value less cost of selling is by determining the price mentioned in a sales agreement in which the adjustment will be made if there will be any incremental cost that will be incurred while disposing off the asset.
• There may not be sales agreement, but it might have a ready market for sale. In such a case the market price should be determined and the cost of disposal should be deducted.(Zyla, 2013)
• If both the above situations are not available i.e. if there is no sale agreement and also there is no ready market then the entity should obtain the information regarding the amount that it would receive if it sells the asset at the end of the reporting period in an arm’s length transaction after subtracting the cost that will be incurred in relation to this disposal.

There is an alternative available if the market price is not available. The alternative approach is called the discounted cash flow approach or DCF. In order to carry out the valuation through this approach, we need to keep the following points in mind:

• All the future events that will have an effect on the cash flows directly or indirectly should be taken into consideration while calculating the fair value in use.(Scott, 2014)
• There should not be a high cost involvement in ascertaining the stream of future cash flows.
• The assumptions that are market based should be reliable and in accordance to the current scenario.
• If there is difference in the assumptions stated by the company and the market participants. Then in such a case, the company must make changes to the assumptions.(Schroeder, 2014)
• Any transaction cost that is incurred in the process of disposal shall be considered.

Risk and uncertainty should be reflected in the value in use as well as Fair value less cost of sell. An adjustment in the risk can be made by either adjusting the cash flows or adjusting the discount rate. However, it is difficult to determine the discount rate because of so many assumptions and the dynamic nature of the business activities.

Solution 2:

Account	Carrying Amount	Recoverable Amount	Impairment
Factory	195200	1,87,922	7,278
Trademark	45000		6,735
Vehicle	28000		4,191
Inventory	12000		1,796
Goodwill	10000		10,000
Total CA	290200
	2,60,200	30,000	12,722
			85,000

The distribution of the impairment loss on the basis of the carrying amount is shown below:

Particulars	Carrying Amount	Ratio	Impairment Loss
Trademark	45000	0.53	6,735
Vehicle	28000	0.33	4,191
Inventory	12000	0.14	1,796
	85,000		12,722

The journal entries are as follows:

Particulars	Dr Amt	Cr Amt
Accumulated Impairment Loss ……..Dr	30,000.00
To Factory		7,278.00
To Equipment		6,735.18
To Building		4,190.78
To Inventory		1,796.05
To Goodwill		10,000.00
(Being impairment on assets realised)
Impairment loss……Dr	30,000.00
To accumulated impairment loss		30,000.00

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.

Pratt, J. (2009). Financial Reporting for Managers: A Value-Creation Perspective. Hoboken: John Wiley & Sons, Inc.

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.

Zyla, M. L. (2013). Fair value measurement. Hoboken: Wiley.