Question

21. Assume an entity measures the fair value of an asset by discounting future cash flows from that asset. Which fair value measurement approach is being used?
a. Market.
b. Income.
c. Cost.
d. Observable inputs.

22. In determining the fair value of a nonfinancial asset, assessing the highest and best use of the asset must consider all but which one of the following?
a. What is physically possible.
b. What is financially feasible.
c. How the reporting entity would use the asset.
d. What is legally permissible.

**Please provide computations and explanations. Thank you!!

Answer 1

Income Approach is being used.

Explaination: The income approach converts future amounts (e.g cash flows or income and expenses) to a single current (i.e discounted) amount. When the income approach is used, the fair value measurement reflects current market expectatios about those future amounts.

It is a present value of all future earnings from an entity whose fair values are being evaluated or in other words all future cash flows to be discounted at current date to get fair value or the asset/liability.

Assumptions to the all future cash flows and an appropriate discount rate would be based on the other market participant's views. Related risks and uncertainty would require to be considered and would be taken into either in cash flow or discount rate.

Example:

An entity has estimated its next year earning (cash flow) based on certain probability which can be mentioned below:

Year	Possible Cash Flows ($)	Probability	Probability weighted cash flows
1	700	20%	140
2	800	40%	320
3	900	40%	360
		Total Expected cash flows	820
		Risk free rate	6%
		Present Value of Cash flow	820 x (1.06) = $ 773.58

Highest and Best Use

Explaination: The highest and best use is a valuation concept used to value many non-financial assets (e.g real estate). The highest and best use of a non-financial asset must be physically possible, legally permissible and financially feasible.

A fair value measurement of a non-financial asset takes into account a market participant's ability to generate economic benifits 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 the best use is determined from market participant perspective. It does not matter whether the entity intends to use the asset differently.

Example:

An entity bought some land which is intended to be used for business purposes. However, the entity now wants to sell this piece of land at its fair value. One has to evaluate all possible use of this land before concluding its fair value. Tha land could be to make a commercial palace which could be more in value comparing when it is used for business purposes. The commercial palace value would be considered its highest and best use if the same is allowed in its near location and conditions.