Final answer:
When an item's estimated future cash flows are below its net book value, the company must assess for impairment and potentially write down the value. This involves calculating the present discounted value of future cash flows using an appropriate discount rate that factors in time value of money and market assessments.
Step-by-step explanation:
If an item's estimated future cash flows, also referred to as future benefits, falls below its net book value, this may suggest that the asset is impaired and cannot recover the amount recorded as an asset. In such cases, the company must write down the value of the asset to its recoverable amount, which is the higher of an asset's fair value less costs to sell and its value in use.
The process of evaluating whether an impairment is needed involves calculating the present discounted value of the estimated future cash flows. If this present discounted value is less than the net book value of the asset, an impairment loss needs to be recognized. These calculations can be complex, as they require selecting an appropriate discount rate which should reflect current market assessments and time value of money.
Differences in the present discounted value can occur based on the discount rate applied, hence it is important to consider potential capital gains from the future sale of the asset and any expected income, such as dividends, when determining the most suitable discount rate. The goal is to determine what you are willing to pay in the present for a stream of future benefits.