I am confused about the difference among value in use, fair value and future cash flows. Can someone please explain the difference with an example? I’d really appreciate it. I am even more confused because this link says that “By definition “value in use” means the present value of the future cash flows expected to be derived from an asset.”
This is in reference to a question in Schweser:
Effective BV: 800K
Expected future cash flows: 825K
Fair value: 790K
Value in use: 785K
Selling cost: 30K
Thanks for your help.
I think for the exam it is important to know first of all that both terms are (among other things) relevant for the determination of impairment of equipment, in particular with IFRS.
The rule says:
Impairment = Recoverable amount – Net carrying amount
Recoverable amount = max(Fair value less cost to sell; Value in use)
Fair value is nothing else than an estimate of the potential market price of the equipment in question (as your article points out, one should take into account the reliability of this estimate).
Value in use on the other hand is an estimate of the net cash flows (inflows-outflows) discounted to today’s value.
You have a Coffee machine which you use to sell coffee to your neighbors in the morning at the parking lot of your apartment complex.
What is the fair value of your machine?? Go to Amazon and check out what similar used machines are worth currently and there is your estimate
What is Value in use? This is a bit tougher but also possible to estimate. You sell $10 worth of coffee every morning, meanwhile you spend $5 for beans, paper cups, etc. So each day your net inflow of cash is $5. Let’s estimate that your machine will fall apart in 2 years, because coffee machines tend to do that (at least the ones I bought so far). Then you discount all those future cash flows back to today and there is your value in use.
If I well understood what I learnt Value in Use and Expected Future Cash Flow are quite similar, except Futur Cash Flow doesn’t take into account value of time, and any other disposal, while value in use does.
Fair value is the price you can have if you sell the asset on the market.
I might be wrong so if someone can confirm or infirm that would be nice
For the record, I call dibs on the business idea of selling coffee in the parking lot of an apartment complex. A friend of mine, who happens to be a real whiz when it comes to legal matters, told me that calling dibs in a forum is equivalent to a patent.
You might be thinking of the US GAAP rule regarding impairment. Here we test whether:
future undiscounted Cash Flows are smaller the carrying value
If so, the impairment loss is measured as the difference between the asset’s fair value and carrying amount.
(*) when you have an asset, you will have 2 options:
Option 1: Sell your Asset on 2nd Market. -----> Fair value - Selling cost is used for measure value of your asset
Option 2: Continue use this Asset ------> Discounted Cash Flow form this Asset (Value in use) is used for measuer value of your asset
You will choose greater option. So, Recoverable Amount = Max( Fair Value - Selling cost; Value in use)
Impairment = Carrying Value - Recoverable Amount
(*) Your question:
Recoverable Amount = Max (790-30; 785)= 785
Impairment = 800- 785 = 15