METHODS FOR CALCULATING VALUE IN USE IN ACCOUNTING

METHODS FOR CALCULATING VALUE IN USE IN ACCOUNTING

Methods for Calculating Value in Use in Accounting (India)

Calculating the “value in use” is essential for assessing the recoverable amount of an asset or a cash-generating unit (CGU) in accounting, as required by the Indian Accounting Standards (Ind AS). This calculation is critical for performing impairment tests, ensuring that the carrying amount of an asset is not overstated in the financial statements. Here are the primary methods for calculating value in use in India:

1. Discounted Cash Flow (DCF) Method

The Discounted Cash Flow (DCF) method is one of the most widely used techniques for calculating value in use. This method involves estimating the future cash flows expected to be derived from the asset or CGU and then discounting these cash flows to their present value.

Steps in DCF Method:

Estimate Future Cash Flows: Project the future cash inflows and outflows associated with the asset or CGU. This includes revenue, operating expenses, capital expenditures, and changes in working capital.
Determine the Discount Rate: Select an appropriate discount rate that reflects the time value of money and the risks specific to the asset or CGU. This rate is often based on the weighted average cost of capital (WACC).
Calculate Present Value: Discount the future cash flows to their present value using the selected discount rate.
Sum of Present Values: The sum of these present values represents the value in use.

2. Earnings Before Interest and Taxes (EBIT) Method

The EBIT method involves projecting the earnings before interest and taxes of the asset or CGU and then applying a capitalization rate to these earnings to determine the value in use.

Steps in EBIT Method:

Estimate Future EBIT: Project the future earnings before interest and taxes for the asset or CGU.
Determine the Capitalization Rate: Select an appropriate capitalization rate based on the risk profile and the required rate of return.
Calculate Value in Use: Divide the projected EBIT by the capitalization rate to determine the value in use.

3. Net Present Value (NPV) Method

The NPV method is similar to the DCF method but focuses on the net cash flows, which are the cash inflows minus the cash outflows, and discounts them to their present value.

Steps in NPV Method:

Estimate Net Cash Flows: Project the net cash inflows and outflows for the asset or CGU.
Determine the Discount Rate: Select an appropriate discount rate that reflects the time value of money and the risks specific to the asset or CGU.
Calculate Present Value of Net Cash Flows: Discount the net cash flows to their present value using the selected discount rate.
Sum of Present Values: The sum of these present values represents the value in use.

4. Multi-Period Excess Earnings Method (MEEM)

MEEM is particularly used for intangible assets and involves estimating the excess earnings generated by the asset over multiple periods and then discounting these excess earnings to their present value.

Steps in MEEM:

Estimate Future Excess Earnings: Project the future earnings attributable to the intangible asset, subtracting a charge for the use of other assets.
Determine the Discount Rate: Select an appropriate discount rate that reflects the risks associated with the intangible asset.
Calculate Present Value of Excess Earnings: Discount the excess earnings to their present value using the selected discount rate.
Sum of Present Values: The sum of these present values represents the value in use of the intangible asset.

Key Considerations in Value in Use Calculation

Forecast Accuracy: The accuracy of the future cash flow projections is crucial. Historical data, market trends, and management’s expectations should be considered.
Risk Adjustments: The discount rate should reflect the risks specific to the asset or CGU. Higher risk requires a higher discount rate.
Regulatory Compliance: Ensure compliance with Ind AS 36, which provides guidance on impairment of assets and the calculation of value in use.
Sensitivity Analysis: Perform sensitivity analyses to understand how changes in key assumptions (e.g., discount rate, cash flow projections) affect the value in use.

Calculating the value in use is a fundamental aspect of impairment testing in accounting. The methods described above, particularly the Discounted Cash Flow (DCF) method, are widely accepted and used in India to ensure that the carrying amounts of assets are not overstated in financial statements. Proper application of these methods helps in presenting a true and fair view of the financial position of an entity.