Intermediate Financial Accounting I Chapter Two

Fair Value measure and Impairments

of Assets
2.1. Fair Value:
 Definition
 Measurement
 Disclosures
Definition: IFRS 13 defined Fair value is a market-based measurement, not an entity-specific
measurement. For some assets and liabilities, observable market transactions or market
information might be available. The definition of fair value focuses on assets and liabilities
because they are a primary subject of accounting measurement. In addition, this IFRS shall be
applied to an entity’s own equity instruments measured at fair value. For other assets and
liabilities, observable market transactions and market information might not be available.
However, the objective of a fair value measurement in both cases is the same—to estimate the
price at which an orderly transaction to sell the asset or to transfer the liability would take place
between market participants at the measurement date under current market conditions (ie an exit
price at the measurement date from the perspective of a market participant that holds the asset or
owes the liability).

When a price for an identical asset or liability is not observable, an entity measures fair value
using another valuation technique that maximises the use of relevant observable inputs and
minimises the use of unobservable inputs. Because fair value is a market-based measurement, it
is measured using the assumptions that market participants would use when pricing the asset or
liability, including assumptions about risk. As a result, an entity’s intention to hold an asset or to
settle or otherwise fulfil a liability is not relevant when measuring fair value.
A fair value measurement is for a particular asset or liability. Therefore, when measuring fair value
an entity shall take into account the characteristics of the asset or liability. If market participants
would take those characteristics into account when pricing the asset or liability at the measurement
date. The effect on the measurement arising from a particular characteristic will differ depending
on how that characteristic would be taken into account by market participants. These
characteristics includes the condition and location of the asset; and restrictions, if any, on the sale
or use of the asset. The asset or liability might be measured at either: a stand-alone asset or
liability (eg a financial instrument or a non-financial asset); or a group of assets, a group of
liabilities or a group of assets and liabilities (eg a cash-generating unit or a business). For
recognition or disclosure purposes depends on its unit of account.
A fair value measurement assumes that the transaction to sell the asset or transfer the liability
takes place either: in the principal market for the asset or liability; or in the absence of a principal

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market, in the most advantageous market for the asset or liability. Principal market is a market in
which the greatest volume or level of activity, whereas, most advantageous market is the market
that maximises the amount that would be received to sell the asset or minimises the amount that
would be paid to transfer the liability, after taking into account transaction costs and transport
costs. If there is a principal market for the asset or liability, the fair value measurement shall
represent the price in that market (whether that price is directly observable or estimated using
another valuation technique), even if the price in a different market is potentially more
advantageous at the measurement date.
The entity must have access to the principal (or most advantageous) market at the measurement
date. Therefore, the principal (or most advantageous) market (and thus, market participants) shall
be considered from the perspective of the entity, thereby allowing for differences between and
among entities with different activities. Although an entity must be able to access the market,
the entity does not need to be able to sell the particular asset or transfer the particular liability on
the measurement date to be able to measure fair value on the basis of the price in that market.
Even when there is no observable market to provide pricing information about the sale of an
asset or the transfer of a liability at the measurement date, a fair value measurement shall assume
that a transaction takes place at that date, considered from the perspective of a market participant
that holds the asset or owes the liability. That assumed transaction establishes a basis for
estimating the price to sell the asset or to transfer the liability.

Market participants
An entity shall measure the fair value of an asset or a liability using the assumptions that market
participants would use when pricing the asset or liability, assuming that market participants act
in their economic best interest. In developing those assumptions, an entity should consider the
asset or liability; the principal (or most advantageous) market for the asset or liability; and
market participants with whom the entity would enter into a transaction in that market.

The price
Fair value is the price that would be received to sell an asset or paid to transfer a liability in an
orderly transaction in the principal (or most advantageous) market at the measurement date under
current market conditions (i.e an exit price) regardless of whether that price is directly
observable or estimated using another valuation technique. The price in the principal (or most
advantageous) market used to measure the fair value of the asset or liability shall not be adjusted
for transaction costs. Transaction costs shall be accounted for in accordance with other IFRSs.
Transaction costs are not a characteristic of an asset or a liability; rather, they are specific to a
transaction and will differ depending on how an entity enters into a transaction for the asset or
liability. Transaction costs do not include transport costs. If location is a characteristic of the
asset (as might be the case, for example, for a commodity), the price in the principal (or most
advantageous) market shall be adjusted for the costs, if any, that would be incurred to transport
the asset from its current location to that market

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Application to non-financial assets.

A fair value measurement of a non-financial asset takes into account a market participant’s
ability to generate economic benefits by using the asset in its highest and best use or by selling
it to another market participant that would use the asset in its highest and best use.
The highest and best use of a non-financial asset takes into account the use of the asset that is
physically possible, legally permissible and financially feasible meaning: A use that is physically
possible takes into account the physical characteristics of the asset that market participants would
take into account when pricing the asset (eg the location or size of a property).
A use that is legally permissible takes into account any legal restrictions on the use of the asset
that market participants would take into account when pricing the asset (eg the zoning
regulations applicable to a property).
A use that is financially feasible takes into account whether a use of the asset that is physically
possible and legally permissible generates adequate income or cash flows (taking into account
the costs of converting the asset to that use) to produce an investment return that market
participants would require from an investment in that asset put to that use. Highest and best use
is determined from the perspective of market participants, even if the entity intends a different
use
To protect its competitive position, or for other reasons, an entity may intend not to use an
acquired non-financial asset actively or it may intend not to use the asset according to its highest
and best use. For example, that might be the case for an acquired intangible asset that the entity
plans to use defensively by preventing others from using it.

Valuation premise for non-financial assets

The highest and best use of a non-financial asset establishes the valuation premise used to
measure the fair value of the asset, The highest and best use of a non-financial asset might
provide maximum value to market participants through its use in combination with other assets
as a group (as installed or otherwise configured for use) or in combination with other assets and
liabilities (eg a business) ie its complementary assets and the associated liabilities) would be
available to market participants.

The highest and best use of a non-financial asset might provide maximum value to market
participants on a stand-alone basis. If the highest and best use of the asset is to use it on a stand-
alone basis, the fair value of the asset is the price that would be received in a current transaction
to sell the asset to market participants that would use the asset on a stand-alone basis.

Application to liabilities and an entity’s own equity instruments

A fair value measurement assumes that a financial or non-financial liability or an entity’s own
equity instrument (eg equity interests issued as consideration in a business combination) is
transferred to a market participant at the measurement date. The transfer of a liability or an
entity’s own equity instrument assumes; A liability would remain outstanding and the market

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participant transferee would be required to fulfil the obligation. The liability would not be
settled with the counterparty or otherwise extinguished on the measurement date. An entity’s
own equity instrument would remain outstanding and the market participant transferee would
take on the rights and responsibilities associated with the instrument. The instrument would not
be cancelled or otherwise extinguished on the measurement date.
In all cases, an entity shall maximise the use of relevant observable inputs and minimise the use
of unobservable inputs to meet the objective of a fair value measurement, which is to estimate
the price at which an orderly transaction to transfer the liability or equity instrument would take
place between market participants at the measurement date under current market conditions.

Liabilities and equity instruments held by other parties as assets

When a quoted price for the transfer of an identical or a similar liability or entity’s own equity
instrument is not available and the identical item is held by another party as an asset, an entity shall
measure the fair value of the liability or equity instrument from the perspective of a market
participant that holds the identical item as an asset at the measurement date. In such cases, an entity
shall measure the fair value of the liability or equity instrument as follows: (a) using the quoted
price in an active market for the identical item held by another party as an asset, if that price is
available. (b) if that price is not available, using other observable inputs, such as the quoted price
in a market that is not active for the identical item held by another party as an asset.(c) if the
observable prices in (a) and (b) are not available, using another valuation technique, such as: an
income approach (eg a present value technique that takes into account the future cash flows that
a market participant would expect to receive from holding the liability or equity instrument as an
asset; a market approach (eg using quoted prices for similar liabilities or equity instruments held
by other parties as assets.

Valuation techniques
An entity shall use valuation techniques that are appropriate in the circumstances and for which
sufficient data are available to measure fair value, maximising the use of relevant observable
inputs and minimising the use of unobservable inputs. Three widely used valuation techniques
are the market approach, the cost approach and the income approach.

Market approach
The market approach uses prices and other relevant information generated by market transactions
involving identical or comparable (ie similar) assets, liabilities or a group of assets and liabilities,
such as a business. For example, valuation techniques consistent with the market approach often
use market multiples derived from a set of comparable. Multiples might be in ranges with a
different multiple for each comparable. The selection of the appropriate multiple within the
range requires judgement, considering qualitative and quantitative factors specific to the
measurement.

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Valuation techniques consistent with the market approach include matrix pricing. Matrix pricing
is a mathematical technique used principally to value some types of financial instruments, such
as debt securities, without relying exclusively on quoted prices for the specific securities, but
rather relying on the securities’ relationship to other benchmark quoted securities.

Cost approach
The cost approach reflects the amount that would be required currently to replace the service
capacity of an asset (often referred to as current replacement cost).
From the perspective of a market participant seller, the price that would be received for the asset
is based on the cost to a market participant buyer to acquire or construct a substitute asset of
comparable utility, adjusted for obsolescence. That is because a market participant buyer would
not pay more for an asset than the amount for which it could replace the service capacity of that
asset. Obsolescence encompasses physical deterioration, functional (technological) obsolescence
and economic (external) obsolescence and is broader than depreciation for financial reporting
purposes (an allocation of historical cost) or tax purposes (using specified service lives). In
many cases the current replacement cost method is used to measure the fair value of tangible
assets that are used in combination with other assets or with other assets and liabilities.

Income approach
The income approach converts future amounts (eg cash flows or income and expenses) to a
single current (ie discounted) amount. When the income approach is used, the fair value
measurement reflects current market expectations about those future amounts. Those valuation
techniques include, for example, the following: present value techniques (see paragraphs B12–
B30); option pricing models, such as the Black-Scholes-Merton formula or a binomial model (ie
a lattice model), that incorporate present value techniques and reflect both the time value and the
intrinsic value of an option; and the multi-period excess earnings method, which is used to
measure the fair value of some intangible assets.
In some cases a single valuation technique will be appropriate (eg when valuing an asset or a
liability using quoted prices in an active market for identical assets or liabilities). In other cases,
multiple valuation techniques will be appropriate (eg that might be the case when valuing a cash-
generating unit). Valuation techniques used to measure fair value shall be applied consistently.
However, a change in a valuation technique or its application (eg a change in its weighting when
multiple valuation techniques are used or a change in an adjustment applied to a valuation
technique) is appropriate if the change results in a measurement that is equally or more
representative of fair value in the circumstances.

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Fair value hierarchy

To increase consistency and comparability in fair value measurements and related disclosures,
IFRS establishes a fair value hierarchy that categorises into three levels (see IFRS 13, paragraphs
76–90) the inputs to valuation techniques used to measure fair value. The fair value hierarchy
gives the highest priority to quoted prices (unadjusted) in active markets for identical assets or
liabilities (Level 1 inputs) and the lowest priority to unobservable inputs (Level 3 inputs). The
availability of relevant inputs and their relative subjectivity might affect the selection of
appropriate valuation techniques. If an observable input requires an adjustment using an
unobservable input and that adjustment results in a significantly higher or lower fair value
measurement, the resulting measurement would be categorised within Level 3 of the fair value
hierarchy. For example, if a market participant would take into account the effect of a restriction
on the sale of an asset when estimating the price for the asset, an entity would adjust the quoted
price to reflect the effect of that restriction.

Level 1 inputs are quoted prices (unadjusted) in active markets for identical assets or liabilities
that the entity can access at the measurement date. A quoted price in an active market
provides the most reliable evidence of fair value and shall be used without adjustment to
measure fair value whenever available. A Level 1 input will be available for many
financial assets and financial liabilities, some of which might be exchanged in multiple
active markets (eg on different exchanges).
Level 2 inputs are inputs other than quoted prices included within Level 1 that are observable for
the asset or liability, either directly or indirectly. Level 2 inputs include the following: (a)
quoted prices for similar assets or liabilities in active markets. (b) quoted prices for
identical or similar assets or liabilities in markets that are not active. (c) inputs other than
quoted prices that are observable for the asset or liability, for example; (i) interest rates
and yield curves observable at commonly quoted intervals; (ii) implied volatilities; and (iii)
credit spreads.(d) market-corroborated inputs.

Level 3 Unobservable inputs shall be used to measure fair value to the extent that relevant
observable inputs are not available, thereby allowing for situations in which there is little,
if any, market activity for the asset or liability at the measurement date. An entity shall
develop unobservable inputs using the best information available in the circumstances,
which might include the entity’s own data. In developing unobservable inputs, an entity
may begin with its own data, but it shall adjust those data if reasonably available
information indicates that other market participants would use different data or there is
something particular to the entity that is not available to other market participants (eg an
entity-specific synergy).

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To increase consistency and comparability in fair value measures, the IASB established a fair
value hierarchy that provides insight into the priority of valuation techniques to use to determine
fair value. As shown in the below table the fair value hierarchy is divided into three broad levels.

Disclosure
An entity shall disclose information that helps users of its financial statements assess
 For assets and liabilities that are measured at fair value on a recurring or non-recurring
basis in the statement of financial position after initial recognition, the valuation
techniques and inputs used to develop those measurements.
 for recurring fair value measurements using significant unobservable inputs (Level 3), the
effect of the measurements on profit or loss or other comprehensive income for the
period. To meet the objectives stated , an entity shall consider all the following:
( the level of detail necessary to satisfy the disclosure requirements;
( how much emphasis to place on each of the various requirements;
( how much aggregation or disaggregation to undertake; and
( Whether users of financial statements need additional information to evaluate the
quantitative information disclosed.
If the disclosures provided in accordance with this IFRS and other IFRSs are insufficient to meet
the objectives, an entity shall disclose additional information necessary to meet those objectives.
An entity shall determine appropriate classes of assets and liabilities on the basis of the
following: the nature, characteristics and risks of the asset or liability; and the level of the fair
value hierarchy within which the fair value measurement is categorised.

2.2. IMPAIRMENTS
The general accounting standard of lower-of-cost-or-net realizable value for inventories does not
apply to property, plant, and equipment. Even when property, plant, and equipment has suffered
partial obsolescence, accountants have been reluctant to reduce the asset’s carrying amount.
Why? Because, unlike inventories, it is difficult to arrive at a fair value for property, plant, and
equipment that is not somewhat subjective and arbitrary.

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Recognizing Impairments
The credit crisis starting in late 2008 has affected many financial and non-financial institutions.
As a result of this global slump, many companies are considering write-offs of some of their
long-lived assets. These write-offs are referred to as impairments. A long-lived tangible asset is
impaired when a company is not able to recover the asset’s carrying amount either through using
it or by selling it. To determine whether an asset is impaired, on an annual basis, companies
review the asset for indicators of impairments—that is, a decline in the asset’s cash-generating
ability through use or sale. This review should consider internal sources (e.g., adverse changes in
performance) and external sources (e.g., adverse changes in the business or regulatory
environment) of information. If impairment indicators are present, then an impairment test must
be conducted. This test compares the asset’s recoverable amount with its carrying amount. If the
carrying amount is higher than the recoverable amount, the difference is an impairment loss. If
the recoverable amount is greater than the carrying amount, no impairment is recorded.
Recoverable amount is defined as the higher of fair value less costs to sell or value-in-use. Fair
value less costs to sell means what the asset could be sold for after deducting costs of disposal.
Value-in-use is the present value of cash flows expected from the future use and eventual sale of
the asset at the end of its useful life. Illustration 11-15 highlights the nature of the impairment
test.

If either the fair value less costs to sell or value-in-use is higher than the carrying amount, there
is no impairment. If both the fair value less costs to sell and value-in-use are lower than the
carrying amount, a loss on impairment occurs.

Example: No Impairment Assume that Cruz Company performs an impairment test for its
equipment. The carrying amount of Cruz’s equipment is €200,000, its fair value less costs to sell
is €180,000, and its value-in-use is €205,000. In this case, the value-in-use of Cruz’s equipment
is higher than its carrying amount of €200,000. As a result, there is no impairment.7

Example: Impairment Assume the same information for Cruz Company above except that the
value-in-use of Cruz’s equipment is €175,000 rather than €205,000. Cruz measures the

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impairment loss as the difference between the carrying amount of €200,000 and the higher of fair
value less costs to sell (€180,000) or value-in-use (€175,000). Cruz therefore uses the fair value
less cost of disposal to record an impairment loss of €20,000 (€200,000 2 €180,000). Cruz makes
the following entry to record the impairment loss.

Loss on Impairment ………………………………20,000

Accumulated Depreciation—Equipment………………… 20,000
The Loss on Impairment is reported in the income statement in the “Other income and expense”
section. The company then either credits Equipment or Accumulated Depreciation—Equipment
to reduce the carrying amount of the equipment for the impairment. For purposes of homework,
credit accumulated depreciation when recording impairment for a depreciable asset.

Impairment Illustrations Presented below are additional examples of impairments.

Case 1

At December 31, 2016, Hanoi Company has equipment with a cost of $26,000,000, and
accumulated depreciation of $12,000,000. The equipment has a total useful life of four years
with a residual value of $2,000,000. The following information relates to this equipment.

1. The equipment’s carrying amount at December 31, 2016, is $14,000,000 ($26,000,000 -

$12,000,000).

2. Hanoi uses straight-line depreciation. Hanoi’s depreciation was $6,000,000 [($26,000,000 -

$2,000,000) / 4] for 2016 and is recorded.

3. Hanoi has determined that the recoverable amount for this asset at December 31, 2016, is
$11,000,000.

4. The remaining useful life of the equipment after December 31, 2016, is two years. Hanoi
records the impairment on its equipment at December 31, 2016, as follows.

Loss on Impairment ($14,000,000 - $11,000,000) ……. 3,000,000

Accumulated Depreciation—Equipment………………………………..3,000,000
Following the recognition of the impairment loss in 2016, the carrying amount of the equipment
is now $11,000,000 ($14,000,000 - $3,000,000). For 2017, Hanoi Company determines that the
equipment’s total useful life has not changed (thus, the equipment’s remaining useful life is still
two years). However, the estimated residual value of the equipment is now zero. Hanoi continues
to use straight-line depreciation and makes the following journal entry to record depreciation for
2017.

Depreciation Expense ($11,000,000/2)…………………… 5,500,000

Accumulated Depreciation—Equipment ……………………… 5,500,000

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Hanoi records depreciation in the periods following the impairment using the carrying amount of
the asset adjusted for the impairment. Hanoi then evaluates whether the equipment was further
impaired at the end of 2017. For example, the carrying amount of Hanoi’s equipment at
December 31, 2017, is $5,500,000 ($26,000,000 - $12,000,000 - $3,000,000 - $5,500,000). If
Hanoi determines that the recoverable amount at December 31, 2017, is lower than $5,500,000,
then an additional impairment loss is recorded.

Case 2

At the end of 2015, Verma Company tests a machine for impairment. The machine has a
carrying amount of $200,000. It has an estimated remaining useful life of five years. Because of
the unique nature of the machine, there is little market-related information on which to base a
recoverable amount based on fair value. As a result, Verma determines the machine’s
recoverable amount (i.e., the higher of value-in-use and fair value less costs to sell) should be
based on value-in-use. To determine value-in-use, Verma develops an estimate of future cash
flows based on internal company cash budgets (and reflecting cash inflows from the machine and
estimated costs necessary to maintain the machine in its current condition). Verma uses a
discount rate of 8 percent, which should be a pretax rate that approximates Verma’s cost of
borrowing.8 Verma’s analysis indicates that its future cash flows will be

$40,000 each year for five years, and it will receive a residual value of $10,000 at the end of the
five years. It is assumed that all cash flows occur at the end of the year. The computation of the
value-in-use for Verma’s machine is shown in Illustration 11-16. The computation of the
impairment loss on the machine at the end of 2015 is shown in Illustration 11-17.

Carrying amount of machine before impairment loss………………….. $200,000.00

Recoverable amount of machine………………………………………... 166,514.20

Loss on impairment…………………………………………………….. $33,485.80

The company therefore records an impairment loss at December 31, 2015, as follows.

Loss on Impairment……………………………33,485.80
Accumulated Depreciation—Machinery……………… 33,485.80
The carrying amount of the machine after recording the loss is $166,514.20.

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Reversal of Impairment Loss

After recording the impairment loss, the recoverable amount becomes the basis of the impaired
asset. What happens if a review in a future year indicates that the asset is no longer impaired
because the recoverable amount of the asset is higher than the carrying amount? In that case, the
impairment loss may be reversed. To illustrate, assume that Tan Company purchases equipment
on January 1, 2015, for HK$300,000, with a useful life of three years and no residual value. Its
depreciation and related carrying amount over the three years is as follows.

At December 31, 2015, Tan determines it has an impairment loss of HK$20,000 and therefore
makes the following entry.

Loss on Impairment ………………………..20,000

Accumulated Depreciation—Equipment………………20,000
Tan’s depreciation expense and related carrying amount after the impairment is as indicated
below.

At the end of 2016, Tan determines that the recoverable amount of the equipment is HK$96,000,
which is greater than its carrying amount of HK$90,000. In this case, Tan reverses the previously
recognized impairment loss with the following entry.

Accumulated Depreciation—Equipment …………………..6,000

Recovery of Impairment Loss ………………………………………6,000
The recovery of the impairment loss is reported in the “Other income and expense” section of the
income statement. The carrying amount of Tan’s equipment is now HK$96,000 (HK$90,000 +
HK$6,000) at December 31, 2016. The general rule related to reversals of impairments is as
follows. The amount of the recovery of the loss is limited to the carrying amount that would
result if the impairment had not occurred. For example, the carrying amount of Tan’s equipment
at the end of 2016 would be HK$100,000, assuming no impairment. The HK$6,000 recovery is
therefore permitted because Tan’s carrying amount on the equipment is now only HK$96,000.

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However, any recovery above HK$10,000 is not permitted. The reason is that any recovery
above HK$10,000 results in Tan carrying the asset at a value above its historical cost.

Cash-Generating Units
In some cases, it may not be possible to assess a single asset for impairment because the single
asset generates cash flows only in combination with other assets. In that case, companies should
identify the smallest group of assets that can be identified that generates cash flows
independently of the cash flows from other assets. Such a group is called a cash-generating unit
(CGU). For example, Santos Company is reviewing its plant assets for indicators of impairment.
However, it is finding that identifying cash flows for individual assets is very cumbersome and
inaccurate because the cash flows related to a group of assets are interdependent. This situation
can arise if Santos has one operating unit (machining division) that manufactures products that
are transferred to another Santos business unit (packing division), which then markets the
products to end customers. Because the cash flows to the assets in the machining division are
dependent on the cash flows in the packing division, Santos should evaluate both divisions
together as a cash-generating unit in its impairment assessments.

Impairment of Assets to Be Disposed of

What happens if a company intends to dispose of the impaired asset, instead of holding it for
use? Recently, Kroger (USA) recorded an impairment loss of $54 million on property, plant, and
equipment it no longer needed due to store closures. In this case, Kroger reports the impaired
asset at the lower-of-cost-or-net realizable value (fair value less costs to sell). Because Kroger
intends to dispose of the assets in a short period of time, it uses net realizable value in order to
provide a better measure of the net cash flows that it will receive from these assets. Kroger does
not depreciate or amortize assets held for disposal during the period it holds them. The rationale
is that depreciation is inconsistent with the notion of assets to be disposed of and with the use of
the lower-of-cost-or-net realizable value. In other words, assets held for disposal are like
inventory; companies should report them at the lower-of-cost-or-net realizable value. Because
Kroger will recover assets held for disposal through sale rather than through operations, it
continually revalues them. Each period, the assets are reported at the lower-of-cost-or-net
realizable value. Thus, Kroger can write up or down an asset held for disposal in future periods,
as long as the carrying amount after the write-up never exceeds the carrying amount of the asset
before the impairment. Companies should report losses or gains related to these impaired assets
as part of operating income in “Other income and expense.

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