Value in use

What Is Value in Use?

Value in use (VIU) is a specific method used in financial reporting to determine the recoverable amount of an asset. It represents the present value of the future cash flow expected to be derived from an asset or a cash-generating unit (CGU) through its continued use and eventual disposal. This concept is crucial for assessing potential impairment loss in accordance with certain accounting standards, particularly International Financial Reporting Standards (IFRS). Value in use reflects an entity's specific expectations about an asset's future economic benefits, rather than its market-based selling price.

History and Origin

The concept of value in use gained prominence with the development of international accounting standards, specifically International Accounting Standard (IAS) 36, "Impairment of Assets." This standard was initially issued by the International Accounting Standards Committee in June 1998 and later adopted by the International Accounting Standards Board (IASB) in April 2001. IAS 36 aims to ensure that assets are not carried in the financial statements at more than their recoverable amount, which is defined as the higher of fair value less costs to sell and value in use. The standard consolidated existing requirements on asset recoverability from previous standards, emphasizing a systematic approach to identifying and recognizing impairment²⁸. The detailed guidance within IAS 36 on calculating value in use reflects the IASB's commitment to providing a robust framework for asset valuation in the absence of readily observable market prices.

Key Takeaways

• Value in use (VIU) is the present value of future cash flows expected from an asset's continued use and ultimate disposal.
• It is a critical component in impairment testing under IFRS (IAS 36) to determine an asset's recoverable amount.
• The calculation involves projecting future cash inflows and outflows and discounting them back to their present value using an appropriate discount rate.
• Value in use is entity-specific, based on the company's expectations, and differs from fair value, which is market-based.
• Estimating value in use requires significant judgment and assumptions about future economic conditions and operational performance.

Formula and Calculation

The calculation of value in use involves discounting estimated future cash flows to their present value. The general formula for value in use (VIU) is:

$VIU = \sum_{t=1}^{n} \frac{CF_t}{(1+r)^t} + \frac{RV}{(1+r)^n}$

Where:

• (CF_t) = Expected net cash flow from the asset in period (t). This includes cash inflows from the continuing use of the asset and cash outflows necessary to generate those inflows²⁷.
• (r) = The pre-tax discount rate that reflects current market assessments of the time value of money and the risks specific to the asset²⁶. This rate should reflect a weighted average cost of capital (WACC) that is adjusted to be pre-tax²⁵.
• (n) = The number of periods over which the cash flows are projected, typically based on the asset's useful life.
• (RV) = Residual value or disposal proceeds at the end of the asset's useful life.

The cash flow projections should be based on reasonable and supportable assumptions that represent management's best estimate of the economic conditions over the asset's remaining useful life. IAS 36 explicitly states that these projections should typically derive from the latest financial budgets or forecasts approved by management²⁴. It also stipulates that cash flow projections should exclude cash flows from future restructurings to which the entity is not yet committed, or from improving or enhancing the asset's performance²³.

Interpreting the Value in Use

Interpreting value in use involves comparing the calculated VIU to the asset's carrying amount on the balance sheet. Under IFRS (IAS 36), an asset's recoverable amount is the higher of its value in use and its fair value less costs to sell²². If the carrying amount of an asset or cash-generating unit exceeds its recoverable amount, the asset is considered impaired. An impairment loss is then recognized, reducing the asset's carrying amount to its recoverable amount²¹.

This comparison ensures that assets are not overstated on the balance sheet and that their reported value reflects their expected future economic benefits. A lower value in use compared to the carrying amount indicates that the asset is not expected to generate sufficient future cash flows to cover its book value, signaling a potential overvaluation.

Hypothetical Example

Consider a manufacturing company, "Widgets Inc.," that owns a specialized machine with a carrying amount of $1,000,000. Due to a shift in market demand, the company needs to assess if this machine is impaired.

1. Project Future Cash Flows: Widgets Inc. estimates the net cash flows the machine will generate over its remaining five-year useful life:

   • Year 1: $300,000
   • Year 2: $280,000
   • Year 3: $250,000
   • Year 4: $200,000
   • Year 5: $150,000
   • Estimated residual value at end of Year 5: $50,000

2. Determine Discount Rate: Widgets Inc.'s internal pre-tax discount rate, reflecting the risk specific to this machine, is 10%.

3. Calculate Value in Use:

   • Present Value (PV) Year 1: ( \frac{$300,000}{(1+0.10)^1} = $272,727 )
   • PV Year 2: ( \frac{$280,000}{(1+0.10)^2} = $231,405 )
   • PV Year 3: ( \frac{$250,000}{(1+0.10)^3} = $187,829 )
   • PV Year 4: ( \frac{$200,000}{(1+0.10)^4} = $136,603 )
   • PV Year 5: ( \frac{$150,000}{(1+0.10)^5} = $93,138 )
   • PV Residual Value: ( \frac{$50,000}{(1+0.10)^5} = $31,046 )

   Total Value in Use = $272,727 + $231,405 + $187,829 + $136,603 + $93,138 + $31,046 = $952,748.

4. Compare to Carrying Amount:
   The calculated value in use ($952,748) is less than the machine's carrying amount ($1,000,000).

5. Impairment Test:
   Widgets Inc. would then compare this value in use to the machine's fair value less costs to sell. If the value in use is still the higher of the two recoverable amounts, and it is less than the carrying amount, an impairment loss of $47,252 ($1,000,000 - $952,748) would be recognized on the income statement. This reduces the machine's value on the balance sheet to $952,748, reflecting its true economic worth to the company based on its expected future use.

Practical Applications

Value in use is primarily applied in impairment testing under IFRS. Companies with significant fixed assets and intangible assets, such as manufacturing plants, specialized machinery, or large development projects, regularly use value in use calculations. This is particularly relevant when there are indicators that an asset may be impaired, such as a significant decline in market value, adverse changes in the economic environment, or evidence of physical damage or obsolescence¹⁹, ²⁰.

Beyond general impairment, value in use is specifically critical for:

• Goodwill Impairment: When testing goodwill for impairment, the recoverable amount of the cash-generating unit to which the goodwill is allocated is determined. Value in use often plays a key role here, especially if a reliable fair value less costs to sell cannot be determined¹⁸.
• Asset Write-downs: When the recoverable amount of an asset falls below its carrying amount, a write-down is necessary. Value in use provides the quantitative basis for determining the extent of this write-down, ensuring that financial statements accurately reflect the asset's current economic reality¹⁷.
• Strategic Decision-Making: Although primarily an accounting measure, the underlying projections for value in use can inform management decisions regarding asset utilization, capital allocation, and investment in capital expenditure¹⁶.
• Compliance and Transparency: Timely recognition of impairment based on value in use helps companies comply with accounting standards and provides greater transparency to investors about the true financial health and future earnings potential of the company's assets¹⁵. Public companies, especially those registered with bodies like the SEC, face scrutiny regarding their impairment disclosures, emphasizing the importance of robust valuation methodologies¹⁴.

Limitations and Criticisms

While value in use is a fundamental concept in asset impairment, it faces several limitations and criticisms:

• Subjectivity of Projections: The calculation of value in use relies heavily on future cash flow projections, which are inherently subjective and dependent on management's assumptions about future economic conditions, sales volumes, operating costs, and technological changes¹³. These assumptions can be difficult to verify and may introduce a degree of bias.
• Discount Rate Selection: Choosing an appropriate discount rate is challenging. IAS 36 requires a pre-tax discount rate, but market-observable rates are typically post-tax, leading to practical difficulties and potential inconsistencies in application¹². Small changes in the discount rate can significantly impact the calculated value in use, affecting whether an impairment is recognized.
• Exclusion of Future Enhancements: IAS 36 mandates that cash flow projections for value in use should only consider the asset's current condition, excluding cash flows from future restructurings or enhancements¹¹. This can be a source of complexity and criticism, as it requires adjusting management's internal budgets that might already incorporate such plans¹⁰.
• Difficulty with Standalone Assets: For assets that do not generate independent cash flows (e.g., a specific machine within a larger production line), value in use must be determined for the smallest group of assets that does generate independent cash flows, known as a cash-generating unit (CGU)⁹. Identifying and allocating cash flows to specific CGUs can be complex.
• Potential for Manipulation: The subjective nature of cash flow forecasts and discount rates can open avenues for earnings management. Companies might use their discretion to delay impairment recognition or manage the size of impairment losses by adjusting these estimates⁸. This aspect has been a subject of academic research and regulatory scrutiny, prompting calls for enhanced disclosures to increase transparency⁷.

Value in Use vs. Fair Value

Value in use and fair value are both measures used to determine an asset's recoverable amount, but they differ significantly in their underlying perspectives. The distinction is crucial, particularly under IFRS (IAS 36), which considers the higher of the two.

Confusion often arises because both involve discounting future cash flows. However, the core difference lies in whose perspective the valuation is taken from: the current entity using the asset for its specific operations (Value in Use) or a hypothetical market participant buying/selling the asset in an arm's-length transaction (Fair Value). For example, a specialized machine might have a high value in use for a company due to unique internal synergies, but a lower fair value if there isn't a broad market of buyers for that specific asset.

FAQs

Q1: When is value in use typically calculated?

A1: Value in use is calculated when there are indicators that an asset may be impaired, meaning its carrying amount on the balance sheet might be higher than its recoverable amount. For certain assets like goodwill or intangible assets with indefinite useful lives, it must be assessed annually regardless of impairment indicators³.

Q2: Can value in use be higher than an asset's fair value?

A2: Yes, value in use can be higher than an asset's fair value less costs to sell. This often occurs when an asset provides significant entity-specific synergies or benefits that are not readily transferable or valued by the general market². In such cases, the recoverable amount for impairment testing would be the higher value in use.

Q3: What kind of assets are most impacted by value in use calculations?

A3: Value in use calculations most significantly impact long-lived non-financial assets, including property, plant, and equipment (PPE), intangible assets (like brands, patents, licenses), and goodwill. These assets are often specialized or unique, lacking active markets to determine a reliable fair value, making the entity-specific value in use calculation more relevant for impairment testing.

Q4: Does value in use account for inflation?

A4: Yes, value in use calculations should account for inflation. The cash flow projections should either be in nominal terms (including the effects of inflation) discounted by a nominal discount rate, or in real terms (excluding inflation) discounted by a real discount rate. Consistency between the nature of the cash flows and the discount rate is essential for an accurate net present value calculation¹.

Q5: Is value in use used under U.S. GAAP?

A5: Under U.S. Generally Accepted Accounting Principles (U.S. GAAP), the primary impairment test for most long-lived assets focuses on comparing the asset's carrying amount to its undiscounted future cash flows for recoverability, and then to its fair value for measuring the impairment loss. While U.S. GAAP does use discounted cash flow techniques to estimate fair value, it does not explicitly define or use "value in use" as a separate recoverable amount measure in the same way IFRS (IAS 36) does. The primary focus under U.S. GAAP is fair value.