Question

Hood Company owns specialized equipment that was purchased in an acquisition of Riding Company. The equipment has a book value of $1,800,000, but according to IFRS 13, it is assessed for impairment on an annual basis. To perform this impairment test, Hood must estimate the “value” of the equipment, comparing the Fair Market Value (value if we sold now) to a value-in-use model (income-based if we keep the asset). It has determined the cash flow estimates related to the equipment based on internal information for the next 7 years to be $165,000 per year. The equipment is assumed to have $50,000 residual value after the 7 years. (Assume the cash flows occur at the end of each year.). Hood company could sell the equipment today for $1,500,000.

a)      Hood determines, using their own assumptions, that the appropriate discount rate for this estimation is 6%. To the nearest dollar, what is the estimated “value in use” using the income based model?

b)     Comparing the Fair Market Value to the Value in Use, should Hood Keep the equipment or sell the equipment? Why?  

Answer 1

A.

Using Income based model at the discount rate of 6% the value in use will be the present value of the expected cash flows to be generated over the period of 7 years , It will also include the salvage value of the equipment after the 7 years discounted at present value.

The company expects to receive $165000 per year for 7 years it means that yearly cash flow is same so annuity factor of discounting can be used.

Thus Annuity factor for 6% for 7 years = { 1- ( 1+r) ^-n } / r = { 1 -( 1+.06)^-7 } / .06

Thus Annuity factor for 6% for 7 years = 5.5824.

Further the 7th year discounting factor for 6% = 0.6650. i.e (=(1+0.06)^-7)

Hence the present value of expected cash flow = Discounted expectd cash flow for 7 years + Discounted residual value,

Present value of expected cash flow = ( $165000 * 5.5824) + ( 50000 * 0.6650)

Thus value in use for equipment at present value = 921096 + 33250 = $954346,

Hence estimated “value in use” using the income based model = $ 954346

please note :  your answer can differ to some extent by $10 to $50 as I have taken 4 decimal point however it will not impact the solution and no one can say it wrong..

B) Here the fair market value i.e if the equipment is sold now is = $ 1500000 and the value in use is $ 954346 which is much lower than the fair market value, as per the rule when analysing the impairment loss the carrying value is compared with the value in use or the fair value whichever is higher and if carrying value is lower than the higher of two impairment loss arises.

so in this case the equipment is liable for Impairment , but the question is should hood keep or sell the equipment is quite clear based on the above value in use calculation , since expected value in use is lower and fair value is higher comany will get higher value by selling now rather than using it, so the hood company should sell the equipment.