How to determine the fair value of a machine?
“We have a machine and we need to determine its fair value.
We purchased the machine about 2 years ago for 50 000 USD and then we paid 10 000 USD to make adjustments for us.
We are actually using the machine in our business. How can we determine its fair value?”
Answer: Consider IFRS 13 Fair Value Measurement
This is a great question, because determining of the fair value of non-financial assets is quite challenging and believe me, it often requires lots of judgment because market prices are simply not always available.
I’m not going to speak here why someone would need the fair value of a machine and also, I’m not going to give you one recipe, because, as I’ve said in the beginning of this episode, it is not possible.
But, I will give you some hints.
Rules for determining fair value
First of all, you should take a look to the standard IFRS 13 Fair Value Measurement that speaks about main principles of how to set the fair value of anything.
And, IFRS 13 makes a few notes about non-financial assets, too.
But, what is the fair value?
It is the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date.
For non-financial assets, there is one special rule:
The fair value of non-financial assets must reflect the highest and best use of the asset from the perspective of market participants.
Highest and best use means that market participants would maximize the value of the asset (or the group of assets).
So when you are valuing your own non-financial assets, you must always think of the highest and best use of these assets.
Is there any alternative use of the asset?
What would the fair value of an asset be if we use it in a different way?
Just as a short illustration, let’s say you are developing the land for the industrial use – let’s say you want to build a warehouse and a plant on that land.
But, in your environment, many developers started to build residential apartments on surrounding lands, so what you should do is to think about the potential residential use of your land.
Let’s say that the value of the industrial land is CU 100 000, but the value of the same land for residential use is CU 140 000.
Plus, you would need to pay CU 10 000 to get all the permissions, zoning decisions, etc. to make it possible or to change the land from industrial to residential – so the net value of the residential land is 140 000 less 10 000 = CU 130 000.
And now you see that the highest and best use for your land is not industrial but residential use and its fair value is 130 000.
Normally, you assume that the current use of your asset is the highest and best use, but I told you about this example just to make sure you remember this point.
Valuation techniques
Let’s get back to our machine.
OK, there’s no market data about your 2-year old customized machine.
In this case, you need to use certain valuation technique.
IFRS 13 permits 3 valuation techniques:
- Market approach – here you determine the fair value of your machine with reference to market transactions with identical or similar machines. I would say this is out of question here, because there’s no identical or similar machine due to certain level of customization.
- Income approach – here, you need to estimate the future cash flows from the asset and discount them to the present value,
- Cost approach – or replacement cost approach under which fair value is the amount required to replace your current asset.
Which valuation technique should you use?
There’s no priority defined in the standards, but you should definitely maximize the use of observable inputs to these techniques (like market prices) and minimize the use of unobservable inputs.
If you don’t have the market prices, then again, the use of observable inputs is out of question.
However, you should use the technique that is appropriate for your circumstances and sometimes you can use more than one technique.
Certainly, when you use more than one technique to value your asset, it can happen that the fair value will not be the same.
In this case, you should take a reasonable look at these fair values and select the one that is most representative of the fair value in your circumstances.
It requires a lot of your judgment and that’s why I said that I could not give you one recipe for everything.
Illustration: valuation techniques
Let’s just illustrate it all on our machine from today’s question.
Let’s assume first that the machine’s current use is its highest and best use, so we don’t need to take other alternatives into account.
And let’s assume that the machine can generate the cash flows on a stand-alone basis, so we can apply income approach and cost approach, too.
Because the machine was customized significantly, it would be not reasonable to apply market approach.
Again – this is judgmental, because if customization is just small, then you can apply market approach with adjustments.
Now, let’s say that you want to apply income approach first.
You list all assumed revenues from the machine, all assumed expenses to maintain the machine and you discount it to the present value – you get the amount of CU 75 000.
Then you want to apply cost approach, too. You need to take many factors into account, like the current condition of a machine, physical wear and tear, current customization cost, installation cost and you get the amount of CU 65 000.
So which fair value to select?
Well, use your judgment again.
I would say that the cost approach is more representative, because it requires less judgments and the inputs are less subjective than at income approach.
At income approach, you determined the cash inflows based on some forecasts, but they are also subject to high degree of uncertainty.
On the other hand under cost approach, you probably took the current selling prices of identical machines into account from real vendors, so this input is less subjective.
Thus I would say that the fair value is 65 000 CU as determined under cost approach.
See – it is very challenging, because every situation and asset is different and you need to apply common sense many times.
Any questions? Please let me know below. Thank you!
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14 Comments
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Wow, thanks for the great insight Silvia.
I have a question about a class of fixed assets that we have in our company, namely bins (skips – large metal containers that are used for waste management)
The useful life of these bins is currently 10 years however, we are able to repair the bins if and when needed and once we have repaired it, the useful life is extended.
Initially we wanted to revaluate the bins as they will have a residual value, however we were advised that we cannot revalue this class of PPE and should rather make changes in our accounting policy.
This asset class makes up a large amount of our PPE in our AFS and after reading this article where you mentioned the different valuation methods it dawned on me that I might be able to revalue the asset type.
Any insights into this please?
Hi Liezel,
I would say that in your case, very important quote is “once we have repaired it, the useful life is extended”. So, I would not revalue the bins before making any repairs or maintenance that extends their useful life, because you should take the current condition of the bin into account (not the condition after the repair).
As for the residual value – you can always change the accounting estimate prospectively. For example, let’s say that cost is 100, residual value is 0 and useful life is 10 years, thus after 4 years, the carrying amount would be 60 (100/10*4, if we use straight-line method). Then at the end of year 4, you realize that the bins will have residual value of 10 at the end of year 10, so you are changing the accounting estimate and from the year 5, annual depreciation charge would be (60-10)/6, being carrying amount less residual value divided by the remaining useful life.
Then let’s say that in the year 7, you will repair the bins, the repair costs CU 50 and after it, you expect that the remaining useful life will be 10 years. So, carrying amount before repairs is 60-50/6*3 (you depreciated 3 years with the new charge); that is 35; you capitalize the repair cost of 50 (because it enhances the asset, not merely keeps it operating during its original useful life), so your carrying amount is 85 and new useful life is 10 years… I hope you get the point.That’s one approach to it.
Another approach is to estimate useful life to 20 years right at the beginning and account for a major overhauling as I described here, it really depends on your assessment of the circumstances – although, this approach is more commonly used for very specific assets like airplanes. I hope this helps.
Pls sir i need an answer to these question below;
Xyz ltd,had a herds of 5,three year old animals on 1 January,2003.on 1 July 2003,a 3 and half year old animal was purchased.the fair values less estimated point of sale costs were as follows:
Three year old anima at 1 january 2003 #450.
Three and half year old animal at 1 juicy 2003 #480.
Four year old animal at 31 december 2003 520.
Required:determine the fair value of the asset and show how the change in fair value would be accounted for in the financial statement.
What is the proper way of recognising work in progress and cost of sales in a long term contracts at the end of each financial year? Our company has been manufacturing large power station pipes since 2017 and have been recognising revenue as per the milestones prescribed and achieved.
Hi, Silvia
Are the inputs used in the valuation of non-financial assets, as described above, classified into Level 3 inputs? Can we state that the inputs used in application of market approach are Level 1 or 2 inputs while cost and income valuation techniques use only level 3 inputs?
Hi Silvia,
I have a question which is not clear to me.
When we apply revaluation model in IAS 16, we determine fair value but do not deduct cost to sell. Same is the case with IAS 40.
But when we apply IAS 41, we deduct cost to sell from fair value for measurement purpose.
Why is it so?
Hi Silva
Thanks for this post and for all you do in the IFRS universe. If an entity were to acquire a loan book from another entity which has a book value of lets say R 1 000 000 then could they argue that the carrying amount at the acquisition date is a fair approximation of Fair value ? I would think so as the most appropriate approach in this case would be the income approach where we are discounting the future cash flows as per the loan book contractual terms which in any case would amount to the carrying amount of the loan book purchases as it would have been already calculated at amortized cost using an amortisation schedule ?
Hi Silvia , plz tell what does following para of IAS 16 means ? “If an entity rents some assets and then ceases to rent them, the assets should be transferred to inventories at their carrying amounts as they become held for sale in the ordinary course of business. [IAS 16.68A]” thanks
Hi Sammy, you missed one important thing from that paragraph – when an entity in the course of its ordinary activities, routinely sells an asset (that it previously held for rentals to others….). I better explain in on the example: car hire company normally rents out the cars to others. It may have a policy of selling each car older than 2 years. If this is the case, then the car is held as PPE while it is being rented, and then when the car hire company decides to sell the car after 2 years, the car is transferred to inventories. S.
Dear Silvia,
Can we convert property revaluation reserves to ordinary share capital? Is it proper accounting if we want to issue new ordinary shares without having to pay cash for it?
thanks
Dear AKM,
no, you cannot. Property revaluation reserve decreases as you depreciate your property, or it is derecognized upon derecognition of your assets. S.
Thanks ….very useful, as always.
Great Explanation !! Thanks.
What a great insight. Just, thanks!