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IFRS Question 035: How to determine a 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?

IFRS Answer 035

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:

  1. 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.
  2. Income approach – here, you need to estimate the future cash flows from the asset and discount them to the present value,
  3. 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.

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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!