5.2 Highest and Best Use of Nonfinancial Assets Other Than Nonfinancial Derivative Assets

5.2.1 General

ASC 820-10

The Fair Value Measurement Approach

55-1 The objective of a fair value measurement is to estimate the price at which an orderly transaction to sell the asset or to transfer the liability would take place between market participants at the measurement date under current market conditions. A fair value measurement requires a reporting entity to determine all of the following:

The particular asset or liability that is the subject of the measurement (consistent with its unit of account)
For a nonfinancial asset, the valuation premise that is appropriate for the measurement (consistent with its highest and best use)
The principal (or most advantageous) market for the asset or liability
The valuation technique(s) appropriate for the measurement, considering the availability of data with which to develop inputs that represent the assumptions that market participants would use when pricing the asset or liability and the level of the fair value hierarchy within which the inputs are categorized.

Highest and Best Use for Nonfinancial Assets

35-10A A fair value measurement of a nonfinancial asset takes into account a market participant’s ability to generate economic benefits by using the asset in its highest and best use or by selling it to another market participant that would use the asset in its highest and best use.

To satisfy the fair value measurement objective, an entity, for nonfinancial assets (other than nonfinancial derivative assets), must determine the fair value on the basis of the valuation premise that is appropriate for the measurement (in a manner consistent with the asset’s highest and best use).

The unit of valuation (also referred to as the “valuation premise”) for nonfinancial assets (other than nonfinancial derivative assets) is the asset’s highest and best use. ASC 820-10-20 defines a nonfinancial asset’s highest and best use as the “use of a nonfinancial asset by market participants that would maximize the value of the asset or the group of assets and liabilities (for example, a business) within which the asset would be used.” The highest and best use must be determined from a market participant’s perspective, regardless of the entity’s current or intended use of the nonfinancial asset. The fair value measurement takes into account a market participant’s ability to generate economic benefits by putting the asset to its highest and best use or by selling it to another market participant that would do so.1 However, an entity is not required to perform an exhaustive search to identify the asset’s highest and best use and may presume that its current use is the highest and best use if market or other factors do not suggest otherwise.

In determining the highest and best use of a nonfinancial asset, an entity must consider whether the nonfinancial asset’s value is maximized through its use either (1) in combination with other assets or other assets and liabilities or (2) on a stand-alone basis. To make such a determination, the entity will need to evaluate the potential use of the asset. Such an evaluation involves consideration of the following:

Uses of the asset that are physically possible, legally permissible, and financially feasible.
The entity’s current and intended use of the asset.

These concepts are further discussed in Sections 5.2.2 and 5.2.3.

The concept of the highest and best use does not apply to financial assets, nonfinancial derivative assets, liabilities, or instruments classified in stockholders’ equity. ASU 2011-04 removed from ASC 820 the application of this concept to financial assets and financial liabilities. Paragraphs BC45 through BC47 of ASU 2011-04 explain the rationale for this decision and state:

BC45. Before the amendments, Topic 820 specified that the concepts of highest and best use and valuation premise applied when measuring the fair value of assets, but it did not distinguish between financial assets and nonfinancial assets.

BC46. In its discussions with the IASB, the Board considered the IASB’s rationale for proposing in its Exposure Draft on fair value measurement that those concepts would not apply to financial assets or to liabilities. The IASB reached that conclusion for the following reasons:

Financial assets do not have alternative uses because a financial asset has specific contractual terms and can have a different use only if the characteristics of the financial asset (that is, the contractual terms) are changed. However, a change in characteristics causes that particular asset to become a different asset. The objective of a fair value measurement is to measure the asset that exists at the measurement date.
Even though a reporting entity may be able to change the cash flows associated with a liability by relieving itself of the obligation in different ways, the different ways of doing so are not alternative uses. Moreover, although a reporting entity might have entity-specific advantages or disadvantages that enable it to fulfill a liability more or less efficiently than other market participants, those entity-specific factors do not affect fair value.
Those concepts were originally developed within the valuation profession to value nonfinancial assets, such as land.

BC47. The Board agreed with the IASB that the concepts of highest and best use and valuation premise are relevant when measuring the fair value of nonfinancial assets and are not relevant when measuring the fair value of financial assets or the fair value of liabilities. The Boards also concluded that those concepts do not apply to instruments classified in shareholders’ equity because those arrangements, similar to financial instruments, typically have specific contractual terms. Paragraphs BC50–BC69 below describe the Boards’ rationale in developing the requirements for measuring the fair value of financial assets and financial liabilities with offsetting positions in market risks and counterparty credit risk.

5.2.2 Use in Combination or on a Stand-Alone Basis

ASC 820-10

Valuation Premise for Nonfinancial Assets

35-10E The highest and best use of a nonfinancial asset establishes the valuation premise used to measure the fair value of the asset, as follows:

The highest and best use of a nonfinancial asset might provide maximum value to market participants through its use in combination with other assets as a group (as installed or otherwise configured for use) or in combination with other assets and liabilities (for example, a business).
1. If the highest and best use of the asset is to use the asset in combination with other assets or with other assets and liabilities, the fair value of the asset is the price that would be received in a current transaction to sell the asset assuming that the asset would be used with other assets or with other assets and liabilities and that those assets and liabilities (that is, its complementary assets and the associated liabilities) would be available to market participants.
2. Liabilities associated with the asset and with the complementary assets include liabilities that fund working capital, but do not include liabilities used to fund assets other than those within the group of assets.
3. Assumptions about the highest and best use of a nonfinancial asset shall be consistent for all of the assets (for which highest and best use is relevant) of the group of assets or the group of assets and liabilities within which the asset would be used.
The highest and best use of a nonfinancial asset might provide maximum value to market participants on a standalone basis. If the highest and best use of the asset is to use it on a standalone basis, the fair value of the asset is the price that would be received in a current transaction to sell the asset to market participants that would use the asset on a standalone basis.

35-11A The fair value measurement of a nonfinancial asset assumes that the asset is sold consistent with the unit of account specified in other Topics (which may be an individual asset). That is the case even when that fair value measurement assumes that the highest and best use of the asset is to use it in combination with other assets or with other assets and liabilities because a fair value measurement assumes that the market participant already holds the complementary assets and associated liabilities.

In accordance with ASC 820, the fair value of a nonfinancial asset (other than a nonfinancial derivative asset) may be determined on a combined or stand-alone basis, whichever maximizes the asset’s value. There are various ways in which an asset can be combined either with a group of assets or with other assets or liabilities (such as a business). ASC 820-10-35-10E(a) outlines certain considerations related to situations in which the highest and best use of a nonfinancial asset reflects its use in combination with other assets or with other assets and liabilities.

ASC 820-10-55-3 states that the effect on the fair value measurement of “a nonfinancial asset used in combination with other assets as a group (as installed or otherwise configured for use) or in combination with other assets and liabilities (for example, a business) . . . depends on the circumstances” and gives the following five examples related to this topic:

The fair value of the asset might be the same whether the asset is used on a standalone basis or in combination with other assets or with other assets and liabilities. That might be the case if the asset is a business that market participants would continue to operate. In that case, the transaction would involve valuing the business in its entirety. The use of the assets as a group in an ongoing business would generate synergies that would be available to market participants (that is, market participant synergies that, therefore, should affect the fair value of the asset on either a standalone basis or in combination with other assets or with other assets and liabilities).
An asset’s use in combination with other assets or with other assets and liabilities might be incorporated into the fair value measurement through adjustments to the value of the asset used on a standalone basis. That might be the case if the asset is a machine and the fair value measurement is determined using an observed price for a similar machine (not installed or otherwise configured for use), adjusted for transportation and installation costs so that the fair value measurement reflects the current condition and location of the machine (installed and configured for use).
An asset’s use in combination with other assets or with other assets and liabilities might be incorporated into the fair value measurement through the market participant assumptions used to measure the fair value of the asset. For example, if the asset is work-in-process inventory that is unique and market participants would convert the inventory into finished goods, the fair value of the inventory would assume that market participants have acquired or would acquire any specialized machinery necessary to convert the inventory into finished goods.
An asset’s use in combination with other assets or with other assets and liabilities might be incorporated into the valuation technique used to measure the fair value of the asset. That might be the case when using the multiperiod excess earnings method to measure the fair value of an intangible asset because that valuation technique specifically takes into account the contribution of any complementary assets and the associated liabilities in the group in which such an intangible asset would be used.
In more limited situations, when a reporting entity uses an asset within a group of assets, the reporting entity might measure the asset at an amount that approximates its fair value when allocating the fair value of the asset group to the individual assets of the group. That might be the case if the valuation involves real property and the fair value of improved property (that is, an asset group) is allocated to its component assets (such as land and improvements).

In a speech at the 2009 AICPA Conference on Current SEC and PCAOB Developments, Evan Sussholz, then a professional accounting fellow in the SEC’s Office of the Chief Accountant, addressed the determination of the highest and best use of a nonfinancial asset. Mr. Sussholz stated, in part:

Question #2: What is the highest and best use for the asset?

To answer this question, a reporting entity should identify all of the potential uses of the asset within each potential exit market and determine if the value of the asset would be maximized by using the asset on a standalone basis (that is, an in-exchange valuation premise) or in conjunction with other assets (that is, an in-use valuation premise).

For example, market participants may derive value from a customer related intangible asset through its use as a stand-alone asset such as renting the customer list to third parties. Alternatively, a market participant may derive value from a customer related intangible asset through its use in combination with other assets such as trademarks, fixed assets, and goodwill. The reporting entity should determine the asset’s highest and best use based on the use that maximized the fair value of the individual asset or group of assets in which the asset is being used.

The highest and best use of a nonfinancial asset (other than a nonfinancial derivative asset) might result in maximum value for market participants on a stand-alone basis. If the fair value is determined on a stand-alone basis, the fair value of the asset is the price that would be received in a current transaction to sell the asset to market participants that would use the asset on a stand-alone basis.

ASC 820-10-35-11A clarifies that regardless of whether the highest and best use of a nonfinancial asset is on a combined or stand-alone basis, the fair value of the nonfinancial asset must be measured on the basis of a sale of the nonfinancial asset that is consistent with its unit of account, as specified in other Codification topics. The reason for this requirement is that when fair value is determined under an assumption that the highest and best use of the asset is in combination with other assets or with other assets and liabilities, it is assumed that “the market participant already holds the complementary assets and associated liabilities.”

5.2.3 Potential Uses of the Asset

5.2.3.1 General

In determining the valuation premise (i.e., the highest and best use of a nonfinancial asset), an entity must consider the asset’s potential uses. The entity then uses this information to determine whether the nonfinancial asset’s highest and best use is on a combined or stand-alone basis.

5.2.3.2 Physically Possible, Legally Permissible, and Financially Feasible

ASC 820-10

Highest and Best Use for Nonfinancial Assets

35-10B The highest and best use of a nonfinancial asset takes into account the use of the asset that is physically possible, legally permissible, and financially feasible, as follows:

A use that is physically possible takes into account the physical characteristics of the asset that market participants would take into account when pricing the asset (for example, the location or size of a property).
A use that is legally permissible takes into account any legal restrictions on the use of the asset that market participants would take into account when pricing the asset (for example, the zoning regulations applicable to a property).
A use that is financially feasible takes into account whether a use of the asset that is physically possible and legally permissible generates adequate income or cash flows (taking into account the costs of converting the asset to that use) to produce an investment return that market participants would require from an investment in that asset put to that use.

In determining the highest and best use of a nonfinancial asset (other than a nonfinancial derivative asset), an entity must assess the following two characteristics:

Physical possibility — ASC 820 requires an entity to consider the physical characteristics of the asset. In doing so, an entity must take certain considerations into account, including the asset’s location or size and whether its physical characteristics allow for potential alternative uses that would maximize its value from a market-participant perspective. The highest and best use of a nonfinancial asset should not represent a use that is physically impossible. For example, it would not be physically possible to relocate a parcel of land, though it may be physically possible to relocate certain other types of nonfinancial assets, such as machinery or equipment. However, an entity would determine the cost of such relocation (including any installation or other relevant costs) in determining whether it would maximize value to a market participant. See further discussion of financial feasibility below.
Legal permissibility — ASC 820 requires an entity to consider the legally permissible uses of a nonfinancial asset to determine fair value from a market-participant perspective. The highest and best use of a nonfinancial asset should represent a use that is legally permissible. The consideration of legal permissibility takes into account whether a particular use is legally permissible both currently and in the future. That is, an entity is not necessarily precluded from considering legally permissible uses in the future. For example, market participants may consider the possibility that current legal restrictions, such as zoning ordinances, may change in the future and adjust the pricing of an asset accordingly. Therefore, the fair value measurement should take into account the risk of uncertainty that legal restrictions may change and the costs a market participant would incur to transform the asset’s use. Such costs may include, but are not limited to, costs imposed by a governmental entity or regulator. See Example 5-1 for a related illustration.

In evaluating physically possible and legally permissible uses of a nonfinancial asset (other than a nonfinancial derivative asset), entities must consider “financial feasibility” from a market-participant perspective in accordance with ASC 820-10-35-10B(c). As part of this evaluation, an entity determines whether the asset would generate adequate investment returns (e.g., cash flows) that market participants would demand to put the asset to that use. In performing this evaluation, an entity effectively would need to assess the return on invested capital, including the risks and uncertainties related to both the investment returns and the potential costs of generating such returns. Further, an entity would have to consider the targeted return on market participants’ invested capital.

Example 5-1

Zoning Requirements That Apply to a Parcel of Land

Entity A holds a parcel of land that is zoned for residential use as of the measurement date; however, the highest and best use of the land is commercial use. Although A may consider the possibility that the land could be rezoned at some point in the future when performing its fair value measurement, it would also need to consider the risks of rezoning (e.g., the risk that the land might not be rezoned) and the cost of transforming the asset. Depending on the cost of transforming the asset, the fair value of A’s land would be between the residential value and the commercial value.

5.2.3.3 Current or Intended Use

ASC 820-10

Highest and Best Use for Nonfinancial Assets

35-10C Highest and best use is determined from the perspective of market participants, even if the reporting entity intends a different use. However, a reporting entity’s current use of a nonfinancial asset is presumed to be its highest and best use unless market or other factors suggest that a different use by market participants would maximize the value of the asset.

35-10D To protect its competitive position, or for other reasons, a reporting entity may intend not to use an acquired nonfinancial asset actively, or it may intend not to use the asset according to its highest and best use. For example, that might be the case for an acquired intangible asset that the reporting entity plans to use defensively by preventing others from using it. Nevertheless, the reporting entity shall measure the fair value of a nonfinancial asset assuming its highest and best use by market participants.

Nonfinancial assets should be valued on the basis of the assumptions market participants would use. In performing this valuation, a market participant would consider its ability to generate economic benefits by putting the asset to its highest and best use or by selling it to another market participant that would do so. Further, the assessment should be from a market participant’s perspective, even if the entity determines that it would use the asset differently. In other words, an entity should consider a market participant’s, but not its own, assumptions regarding the use or disposition of a nonfinancial asset. While a market participant could use the asset in a different way than the entity does, if no market or other factors suggest a different use by market participants, the current use of the asset by the entity is presumed to be its highest and best use.

ASC 820-10-35-10D provides guidance on nonfinancial assets whose intended use differs from their highest and best use (e.g., defensive intangible assets). Even if they are intangible rather than tangible, these assets must still be measured at fair value in accordance with ASC 820. That is, even if an entity does not intend to use a nonfinancial asset or intends to use it in a way other than its highest and best use, the entity must measure the asset at fair value under ASC 820 on the basis of its highest and best use.

For example, an entity may decide not to use the acquired trade name of a competitor but may intend to keep the name (rather than sell it) solely to prevent others from using it. In this case, the asset is determined to have value to the acquirer, albeit this value is defensive (i.e., because others are prevented from using the asset). When measuring the fair value of a defensive intangible asset in accordance with ASC 820, an acquirer should assume its highest and best use by market participants.

5.2.3.4 ASC 820 Examples

ASC 820-10

Example 1: Highest and Best Use and Valuation Premise

Case B: Land

55-30 A reporting entity acquires land in a business combination. The land is currently developed for industrial use as a site for a factory. The current use of land is presumed to be its highest and best use unless market or other factors suggest a different use. Nearby sites have recently been developed for residential use as sites for high-rise apartment buildings. On the basis of that development and recent zoning and other changes to facilitate that development, the reporting entity determines that the land currently used as a site for a factory could be developed as a site for residential use (that is, for high-rise apartment buildings) because market participants would take into account the potential to develop the site for residential use when pricing the land.

55-31 The highest and best use of the land would be determined by comparing both of the following:

The value of the land as currently developed for industrial use (that is, the land would be used in combination with other assets, such as the factory, or with other assets and liabilities)
The value of the land as a vacant site for residential use, taking into account the costs of demolishing the factory and other costs (including the uncertainty about whether the reporting entity would be able to convert the asset to the alternative use) necessary to convert the land to a vacant site (that is, the land is to be used by market participants on a standalone basis).

The highest and best use of the land would be determined on the basis of the higher of those values. In situations involving real estate appraisal, the determination of highest and best use might take into account factors relating to the factory operations, including its assets and liabilities.

Case C: In-Process Research and Development Project

55-32 A reporting entity acquires an in-process research and development project in a business combination. The reporting entity does not intend to complete the project. If completed, the project would compete with one of its own projects (to provide the next generation of the reporting entity’s commercialized technology). Instead, the reporting entity intends to hold (that is, lock up) the project to prevent its competitors from obtaining access to the technology. In doing this, the project is expected to provide defensive value, principally by improving the prospects for the reporting entity’s own competing technology. To measure the fair value of the project at initial recognition, the highest and best use of the project would be determined on the basis of its use by market participants. For example:

The highest and best use of the in-process research and development project would be to continue development if market participants would continue to develop the project and that use would maximize the value of the group of assets or of assets and liabilities in which the project would be used (that is, the asset would be used in combination with other assets or with other assets and liabilities). That might be the case if market participants do not have similar technology, either in development or commercialized. The fair value of the project would be measured on the basis of the price that would be received in a current transaction to sell the project, assuming that the in-process research and development would be used with its complementary assets and the associated liabilities and that those assets and liabilities would be available to market participants.
The highest and best use of the in-process research and development project would be to cease development if, for competitive reasons, market participants would lock up the project and that use would maximize the value of the group of assets or of assets and liabilities in which the project would be used. That might be the case if market participants have technology in a more advanced stage of development that would compete with the project if completed and the project would be expected to improve the prospects for their own competing technology if locked up. The fair value of the project would be measured on the basis of the price that would be received in a current transaction to sell the project, assuming that the in-process research and development would be used (that is, locked up) with its complementary assets and the associated liabilities and that those assets and liabilities would be available to market participants.
The highest and best use of the in-process research and development project would be to cease development if market participants would discontinue its development. That might be the case if the project is not expected to provide a market rate of return if completed and would not otherwise provide defensive value if locked up. The fair value of the project would be measured on the basis of the price that would be received in a current transaction to sell the project on its own (which might be zero).

Footnotes

See Chapter 7 for discussion of the concept of market participants.

Confidential and Proprietary — for Use Solely by Authorized Personnel

This publication provides comprehensive guidance; however, it does not address all possible fact patterns, and the guidance is subject to change. Consult a Deloitte & Touche LLP professional regarding your specific issues and questions.