Valuation of biological assets
Based on May 2009 IFRIC Agenda decision
By Ajith Ratnayake, FCMA
IAS 41 Agriculture requires biological assets to be recognised at fair value, unless the fair value cannot be determined reliably. Determination of an appropriate discount rate is essential to ensure that the valuation is reliable.
An inappropriate low discount rate can result in excessive and misleading ‘day one’ profits. This article explains the manner in which an appropriate discount rate could be selected based on the May 2009 IFRIC Agenda Decision.
Prescribed accounting treatment for biological assets
IAS 41 Agriculture prescribes the accounting treatment for biological assets for financial statements prepared in compliance with International Financial Reporting Standards (IFRS).
It requires measurement of a biological asset at fair value less cost to sell, other than when fair value cannot be measured reliably. Changes in fair value less cost to sell are recognised in profit or loss. Fair value of an asset is the amount for which it could exchanged between knowledgeable, willing parties in an arm’s length transaction.
Where market determined prices or values are not available, the present value of expected net cash flows from the asset discounted at a current market-determined rate is used to determine fair value. The objective of a calculation of the present value of expected cash flows is to determine the fair value of a biological asset in its present location and condition. An entity considers this in determining an appropriate discount rate to be used.
The IFRIC agenda decision clarifies as to how this is done in practice.
IFRIC Agenda Decision
International Financial Reporting Interpretations Committee (IFRIC) is the Committee which provides guidance on financial reporting issues not specifically addressed in IFRSs. When IFRIC considers that guidance already available is sufficient to address an issue, IFRIC publishes an agenda decision which preparers can use to interpret the requirements.
IFRIC agenda decisions are made after a due process which involves publication of a tentative decision, receiving views from the public, publication of views submitted in the website, and a formal decision at a meeting which is open to the public.
In May 2009, IFRIC published an agenda decision on the selection of a discount rate for biological assets. It stated that when an entity incurs an initial cost with respect to a biological asset, paragraph 24 of IAS 41 notes that cost may approximate fair value when little biological transformation has taken place since the cost was incurred. In these situations the IFRIC noted that the discount rate selected would be expected to result in a value that approximates that cost.
The IFRIC also noted that IAS 39 and other material recently published by the IASB provide extensive guidance on estimating fair values for assets that do not have readily observable prices in active markets that would also be relevant for biological assets.
Guidance available in IAS 39
Specific guidance in relation to the use of valuation techniques, where the asset does not have an active market is available in paragraphs AG74 to AG79 of IAS39 in a section titled “No active market: valuation technique”.
In relation to the selection of a discount rate when using a discounted cash flow technique to value a biological asset, the following guidance adopted from IAS39 paragraphs AG76, AG76A and BC104 are particularly relevant.
nInitial acquisition or origination
The initial acquisition or origination of an asset is a market transaction that provides a foundation for estimating fair value. (Adopted from the first sentence of IAS 39, AG 77)
- Need for calibration
Periodically, an entity calibrates the valuation technique and tests it for validity using prices from observable current market transactions in the same asset. An entity obtains market data from the same market where the asset was originated. (Adopted from an extract of IAS 39, AG 76)
- Evidence of fair value and subsequent changes
The best evidence of the fair value of an asset at initial recognition is the transaction price, unless the fair value of the asset is evidenced by comparison with other observable current market transactions in the same asset (without modification or repackaging) or based on a valuation technique whose variables include data from observable markets. The application of the said requirement may result in no gain or loss being recognised on the initial recognition of an asset. In such a case, gain or loss shall be recognised after initial recognition only to the extent that it arises from a change in a factor (including time) that market participants would consider in setting a price. (Adopted from an extract of IAS 39, AG 76 and 76A)
- Recognition of need for safeguards on recognising up-front gains or losses
The Board concluded that an entity may recognise a gain or loss at inception only if fair value is evidenced by comparison with other observable current market transactions in the same instrument (ie without modification or repackaging) or is based on a valuation technique incorporating only observable market data.
The writer is Director General of Sri Lanka Accounting and Auditing Standards Monitoring Board.
The Board concluded that that those conditions were necessary and sufficient to provide reasonable assurance that fair value was other than the transaction price for the purpose of recognising up-front gains or losses. (Extract from IAS 39, BC 104)
It appears that the IFRIC considered that the guidance referred to above are applicable for biological assets in view of paragraphs 10 and 11 of IAS 8, which requires management to consider the requirements and guidance in standards dealing with similar and related issues in making judgments in developing and applying an accounting policy, in the absence of a standard or interpretation that specifically applies to a transaction.
The discounted cash flow calculation can be done using either current prices, or using inflows and outflows adjusted for inflation. Use of inflation adjustments would complicate the calculations as plants of different ages would require different cash flows. It can be mathematically demonstrated that the use of consistent inflation adjustments, with appropriate adjustments to the discount rate, does not result in net present values, which are different from discounted cash flows which are not adjusted for inflation. Therefore, it is recommended that current cost and prices are used in the cash flow.
A cash flow is prepared for the complete life of the plant, at current cost and prices. Based on the IFRIC agenda decision, the discount rate is determined so that the net present value approximates initial cost at the time of planting. This would also satisfy the need for calibration and the avoidance of ‘day one profit.’
A recalculation is done in subsequent years, based on the new current cost and prices. The fair value calculated at different points of time, would reflect prices prevailing at that time.