Fair value less costs to sell

What Is Fair Value Less Costs to Sell?

Fair value less costs to sell is a specific measurement used in financial accounting to determine the value of an asset or a group of assets, primarily when they are intended for disposal or assessed for impairment. It represents the estimated price that would be received for selling an asset in an orderly transaction, minus the direct costs that would be incurred to complete the sale. This valuation method is crucial for ensuring that assets are not overstated on a company's balance sheet.

The concept falls under the broader umbrella of asset valuation within financial accounting standards, particularly International Financial Reporting Standards (IFRS). It helps entities present a more realistic picture of the recoverable amount of their assets, especially non-current assets classified as held for sale or those undergoing an impairment test.

History and Origin

The concept of fair value less costs to sell gained prominence with the evolution of global accounting standards, particularly through the International Accounting Standards Board (IASB) and its International Financial Reporting Standards (IFRS). Before the formalization of this concept, assets were often carried at their historical cost, which could sometimes misrepresent their true economic value, especially if market conditions deteriorated or if an asset was intended for immediate sale.

A significant milestone in the adoption of this measurement was the issuance of IFRS 5 Non-current Assets Held for Sale and Discontinued Operations by the IASB in March 2004. This standard specifically requires that non-current assets (or disposal groups) classified as held for sale be measured at the lower of their carrying amount and fair value less costs to sell.³¹,³⁰ Similarly, for impairment testing, IAS 36 Impairment of Assets, initially issued by the International Accounting Standards Committee (IASC) and later revised by the IASB, introduced "fair value less costs to sell" as a component of the recoverable amount.²⁹ These developments aimed to enhance the relevance and reliability of financial reporting by reflecting current market conditions and disposal intentions.

Key Takeaways

• Fair value less costs to sell is a measurement used in accounting for assets intended for sale or subject to impairment.
• It is calculated by taking the fair value of an asset and subtracting the direct selling expenses.
• This metric is critical under IFRS 5 for assets held for sale and under IAS 36 for determining the recoverable amount of impaired assets.
• It ensures that assets are not carried at a value higher than what the entity expects to realize from their sale after incurring disposal costs.
• The application of fair value less costs to sell can lead to the recognition of an impairment loss if the calculated amount is less than the asset's carrying amount.

Formula and Calculation

The formula for fair value less costs to sell is straightforward:

Where:

• Fair Value: This is the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date.²⁸ It represents an exit price based on market assumptions.²⁷
• Costs to Sell: These are the incremental direct costs attributable to the disposal of an asset. Examples include legal costs, stamp duty, sales commissions, and other similar transaction taxes.²⁶ Costs of removing the asset and direct incremental costs to bring an asset into condition for its sale may also be included.²⁵

It is important to note that the costs to sell do not include finance costs or income tax expenses.

Interpreting the Fair Value Less Costs to Sell

Interpreting fair value less costs to sell involves comparing this calculated amount to the asset's carrying amount on the financial statements. Under accounting standards like IFRS, an asset classified as held for sale is measured at the lower of its carrying amount and its fair value less costs to sell.²⁴,²³

If the fair value less costs to sell is lower than the asset's carrying amount, it indicates that the asset's value has diminished, and an impairment loss must be recognized. This adjustment ensures that the asset is not reported at an inflated value, providing a more accurate representation of its true economic worth to potential buyers or investors. Conversely, if the fair value less costs to sell is higher than the carrying amount, no impairment is recognized based on this metric, although other impairment indicators may still require assessment.

Furthermore, in the context of impairment testing under IAS 36, the recoverable amount of an asset is the higher of its fair value less costs to sell and its value in use.²² Therefore, the fair value less costs to sell serves as a critical benchmark in determining whether an asset is impaired and how much its value should be written down.

Hypothetical Example

Consider Tech Innovations Inc., a company that decides to sell an old manufacturing machine. The machine's carrying amount on its balance sheet is $50,000. Tech Innovations identifies potential buyers and estimates the machine's fair value (the price it could receive in an orderly transaction) to be $45,000.

However, to sell the machine, Tech Innovations estimates it will incur the following direct costs:

• Sales commission: $2,000
• Legal fees for sale contract: $500
• Dismantling and removal costs: $1,500

To calculate the fair value less costs to sell:

Fair Value = $45,000
Costs to Sell = $2,000 + $500 + $1,500 = $4,000

Fair Value Less Costs to Sell = $45,000 - $4,000 = $41,000

Now, compare this to the machine's carrying amount:

• Carrying Amount: $50,000
• Fair Value Less Costs to Sell: $41,000

Since the fair value less costs to sell ($41,000) is lower than the carrying amount ($50,000), Tech Innovations Inc. would recognize an impairment loss of $9,000 ($50,000 - $41,000) in its income statement. The machine's value on the balance sheet would then be written down to $41,000.

Practical Applications

Fair value less costs to sell is a fundamental concept with several practical applications in financial accounting and reporting, particularly under IFRS.

• Assets Held for Sale: When a company commits to a plan to sell a non-current asset or a disposal group (a group of assets to be disposed of together, including related liabilities), IFRS 5 requires that these assets cease depreciation and be measured at the lower of their carrying amount and fair value less costs to sell.²¹,²⁰,¹⁹ This ensures that assets that are no longer being used to generate cash flows through operations are presented at their expected net realizable value.
• Impairment Testing: Under IAS 36 Impairment of Assets, entities must assess at each reporting period whether there is any indication that an asset may be impaired. If an indication exists, the recoverable amount of the asset is estimated. The recoverable amount is defined as the higher of an asset's fair value less costs to sell and its value in use.¹⁸,¹⁷ If this recoverable amount is less than the asset's carrying amount, an impairment loss is recognized.¹⁶ This ensures that assets are not carried above the amount expected to be recovered through use or sale.
• Discontinued Operations: For components of an entity classified as discontinued operations, the assets within these operations are often classified as held for sale and measured using the fair value less costs to sell principle. This measurement impacts how the results of these operations are presented separately in the income statement.¹⁵

Limitations and Criticisms

While fair value less costs to sell aims to provide more relevant and timely financial information, it is not without limitations and criticisms, many of which are shared with broader fair value accounting principles.

One primary concern is the subjectivity involved in determining fair value, especially for assets that do not have active and liquid markets.¹⁴,¹³ In such cases, management must use observable or unobservable inputs and valuation techniques that can introduce estimations and judgments, potentially leading to inconsistencies or even manipulation.¹²,¹¹ For instance, the use of Level 3 inputs (unobservable inputs reflecting an entity's own assumptions about market participant assumptions) can make fair value measurements less reliable.¹⁰ This subjectivity was a significant point of contention during the 2008 financial crisis, where critics argued that fair value accounting exacerbated losses by forcing write-downs of assets in illiquid markets.⁹,⁸

Another criticism centers on the potential for increased volatility in financial statements. Because fair value less costs to sell is dependent on current market value and market conditions, fluctuations can lead to significant swings in reported asset values and, consequently, in earnings and equity.⁷,⁶ This volatility can make it challenging for investors to assess a company's stable performance and can promote pro-cyclicality, where falling asset prices lead to further write-downs, potentially exacerbating economic downturns.⁵ Some academics and practitioners have argued that while fair value accounting aims for transparency, the complexities and potential for estimation errors can sometimes obscure rather than clarify a firm's true financial position.⁴,³

Fair Value Less Costs to Sell vs. Fair Value

While often used in conjunction, "fair value less costs to sell" is distinct from "fair value."

The confusion often arises because fair value less costs to sell incorporates fair value as its starting point. However, the crucial difference lies in the deduction of "costs to sell," which are specific, direct incremental expenses associated with the disposal of the asset. This deduction makes fair value less costs to sell a net realization amount, whereas fair value is a gross market price.

FAQs

1. Why is "costs to sell" subtracted from fair value?

Costs to sell are subtracted from fair value to arrive at the net amount a company expects to receive from the sale of an asset. This net amount provides a more realistic measure of the economic benefit that can be recovered, especially when an asset is intended for disposal. It reflects the cash outflow directly associated with the selling process.

2. Is fair value less costs to sell always lower than the carrying amount?

No, not necessarily. Fair value less costs to sell will only be lower than the carrying amount if the asset has lost value relative to its book value, leading to an impairment loss. If the market value of the asset (after deducting selling costs) is higher than its carrying amount, no downward adjustment is made in most accounting contexts (e.g., for assets held for sale, they are measured at the lower of carrying amount and fair value less costs to sell).

3. What types of costs are included in "costs to sell"?

"Costs to sell" include only the incremental direct costs attributable to the disposal of an asset. Examples commonly include legal fees, stamp duties, sales commissions, and direct costs to prepare the asset for sale, such as specific dismantling or removal expenses incurred specifically for the sale. General administrative overheads or finance costs are typically not included.¹