Value in use of an asset :
Estimating the value in use of an asset involves the following steps:
(a) estimating the future cash inflows and outflows arising from continuing use of the asset and from its ultimate disposal; and
(b) applying the appropriate discount rate to these future cash flows.
Basis for Estimates of Future Cash Flows
In measuring value in use:
(a) cash flow projections should be based on reasonable and supportable assumptions that represent management’s best estimate of the set of economic conditions that will exist over the remaining useful life of the asset. Greater weight should be given to external evidence;
(b) cash flow projections should be based on the most recent financial budgets/forecasts that have been approved by management. Projections based on these budgets/forecasts should cover a maximum period of five years, unless a longer period can be justified; and
(c) cash flow projections beyond the period covered by the most recent budgets/forecasts should be estimated by extrapolating the projections based on the budgets/forecasts using a steady or declining growth rate for subsequent years, unless an increasing rate can be justified. This growth rate should not exceed the long-term average growth rate for the products, industries, or country or countries in which the enterprise operates, or for the market in which the asset is used, unless a higher rate can be justified.
Detailed, explicit and reliable financial budgets/forecasts of future cash flows for periods longer than five years are generally not available. For this reason, management’s estimates of future cash flows are based on the most recent budgets/forecasts for a maximum of five years. Management may use cash flow projections based on financial budgets/forecasts over a period longer than five years if management is confident that these projections are reliable and it can demonstrate its ability, based on past experience, to forecast cash flows accurately over that longer period.
Cash flow projections until the end of an asset’s useful life are estimated by extrapolating the cash flow projections based on the financial budgets/ forecasts using a growth rate for subsequent years. This rate is steady or declining, unless an increase in the rate matches objective information about patterns over a product or industry lifecycle. If appropriate, the growth rate is zero or negative.
Where conditions are very favourable, competitors are likely to enter the market and restrict growth. Therefore, enterprises will have difficulty in exceeding the average historical growth rate over the long term (say, twenty years) for the products, industries, or country or countries in which the enterprise operates, or for the market in which the asset is used.
In using information from financial budgets/forecasts, an enterprise considers whether the information reflects reasonable and supportable assumptions and represents management’s best estimate of the set of economic conditions that will exist over the remaining useful life of the asset.
Composition of Estimates of Future Cash Flows
Estimates of future cash flows should include:
(a) projections of cash inflows from the continuing use of the asset;
(b) projections of cash outflows that are necessarily incurred to generate the cash inflows from continuing use of the asset (including cash outflows to prepare the asset for use) and that can be directly attributed, or allocated on a reasonable and consistent basis, to the asset; and
(c) net cash flows, if any, to be received (or paid) for the disposal of the asset at the end of its useful life.
Estimates of future cash flows and the discount rate reflect consistent assumptions about price increases due to general inflation. Therefore, if the discount rate includes the effect of price increases due to general inflation, future cash flows are estimated in nominal terms. If the discount rate excludes the effect of price increases due to general inflation, future cash flows are estimated in real terms but include future specific price increases or decreases.
Projections of cash outflows include future overheads that can be attributed directly, or allocated on a reasonable and consistent basis, to the use of the asset.
When the carrying amount of an asset does not yet include all the cash outflows to be incurred before it is ready for use or sale, the estimate of future cash outflows includes an estimate of any further cash outflow that is expected to be incurred before the asset is ready for use or sale. For example, this is the case for a building under construction or for a development project that is not yet completed.
To avoid double counting, estimates of future cash flows do not include:
(a) cash inflows from assets that generate cash inflows from continuing use that are largely independent of the cash inflows from the asset under review (for example, financial assets such as receivables); and
(b) cash outflows that relate to obligations that have already been recognised as liabilities (for example, payables, pensions or provisions).
Future cash flows should be estimated for the asset in its current condition. Estimates of future cash flows should not include estimated future cash inflows or outflows that are expected to arise from:
(a) a future restructuring to which an enterprise is not yet committed; or
(b) future capital expenditure that will improve or enhance the asset in excess of its originally assessed standard of performance.
Because future cash flows are estimated for the asset in its current condition, value in use does not reflect:
(a) future cash outflows or related cost savings (for example, reductions in staff costs) or benefits that are expected to arise from a future restructuring to which an enterprise is not yet committed; or
(b) future capital expenditure that will improve or enhance the asset in excess of its originally assessed standard of performance or the related future benefits from this future expenditure.
A restructuring is a programme that is planned and controlled by management and that materially changes either the scope of the business undertaken by an enterprise or the manner in which the business is conducted5 .
39. When an enterprise becomes committed to a restructuring, some assets are likely to be affected by this restructuring. Once the enterprise is committed to the restructuring, in determining value in use, estimates of future cash inflows and cash outflows reflect the cost savings and other benefits from the restructuring (based on the most recent financial budgets/forecasts that have been approved by management).
Illustration 5 given in the Illustrations attached to the Standard illustrates the effect of a future restructuring on a value in use calculation.
40. Until an enterprise incurs capital expenditure that improves or enhances an asset in excess of its originally assessed standard of performance, estimates of future cash flows do not include the estimated future cash inflows that are expected to arise from this expenditure (see Illustration 6 given in the Illustrations attached to the Standard).
41. Estimates of future cash flows include future capital expenditure necessary to maintain or sustain an asset at its originally assessed standard of performance.
42. Estimates of future cash flows should not include:
(a) cash inflows or outflows from financing activities; or
(b) income tax receipts or payments.
Estimated future cash flows reflect assumptions that are consistent with the way the discount rate is determined. Otherwise, the effect of some assumptions will be counted twice or ignored. Because the time value of money is considered by discounting the estimated future cash flows, these cash flows exclude cash inflows or outflows from financing activities. Similarly, since the discount rate is determined on a pre-tax basis, future cash flows are also estimated on a pre-tax basis.
The estimate of net cash flows to be received (or paid) for the disposal of an asset at the end of its useful life should be the amount that an enterprise expects to obtain from the disposal of the asset in an arm’s length transaction between knowledgeable, willing parties, after deducting the estimated costs of disposal.
The estimate of net cash flows to be received (or paid) for the disposal of an asset at the end of its useful life is determined in a similar way to an asset’s net selling price, except that, in estimating those net cash flows:
(a) an enterprise uses prices prevailing at the date of the estimate for similar assets that have reached the end of their useful life and that have operated under conditions similar to those in which the asset will be used; and
(b) those prices are adjusted for the effect of both future price increases due to general inflation and specific future price increases (decreases). However, if estimates of future cash flows from the asset’s continuing use and the discount rate exclude the effect of general inflation, this effect is also excluded from the estimate of net cash flows on disposal.
Foreign Currency Future Cash Flows
Future cash flows are estimated in the currency in which they will be generated and then discounted using a discount rate appropriate for that currency. An enterprise translates the present value obtained using the exchange rate at the balance sheet date (described in Accounting Standard (AS) 11, Accounting for the Effects of Changes in Foreign Exchange Rates, as the closing rate).
Discount Rate
The discount rate(s) should be a pre tax rate(s) that reflect(s) current market assessments of the time value of money and the risks specific to the asset. The discount rate(s) should not reflect risks for which future cash flow estimates have been adjusted.
A rate that reflects current market assessments of the time value of money and the risks specific to the asset is the return that investors would require if they were to choose an investment that would generate cash flows of amounts, timing and risk profile equivalent to those that the enterprise expects to derive from the asset. This rate is estimated from the rate implicit in current market transactions for similar assets or from the weighted average cost of capital of a listed enterprise that has a single asset (or a portfolio of assets) similar in terms of service potential and risks to the asset under review.
When an asset-specific rate is not directly available from the market, an enterprise uses other bases to estimate the discount rate. The purpose is to estimate, as far as possible, a market assessment of:
(a) the time value of money for the periods until the end of the asset’s useful life; and
(b) the risks that the future cash flows will differ in amount or timing from estimates.
As a starting point, the enterprise may take into account the following rates:
(a) the enterprise’s weighted average cost of capital determined using techniques such as the Capital Asset Pricing Model;
(b) the enterprise’s incremental borrowing rate; and
(c) other market borrowing rates.
51. These rates are adjusted:
(a) to reflect the way that the market would assess the specific risks associated with the projected cash flows; and
(b) to exclude risks that are not relevant to the projected cash flows.
Consideration is given to risks such as country risk, currency risk, price risk and cash flow risk.
To avoid double counting, the discount rate does not reflect risks for which future cash flow estimates have been adjusted.
The discount rate is independent of the enterprise’s capital structure and the way the enterprise financed the purchase of the asset because the future cash flows expected to arise from an asset do not depend on the way in which the enterprise financed the purchase of the asset.
When the basis for the rate is post-tax, that basis is adjusted to reflect a pre-tax rate.
An enterprise normally uses a single discount rate for the estimate of an asset’s value in use. However, an enterprise uses separate discount rates for different future periods where value in use is sensitive to a difference in risks for different periods or to the term structure of interest rates.