What is the Highest and Best Use in Accounting?

Under the concept of highest and best use, fair value is determined based on the price at which an asset could theoretically be employed in its highest and best use, rather than the use in which the asset is currently employed. The highest and best use concept is subject to the limitations noted below. The highest and best use concept usually only applies to non-financial assets. There is rarely a use for it when valuing liabilities. The highest and best use limitations are as follows:

Must be physically possible. The physical characteristics and location of the asset may limit its alternative uses. For example, machinery that is bolted into a concrete platform may be so immovable that any other potential highest and best uses are not possible.
Must be legally permissible. There may be legal restrictions on how an asset may be used, which bar certain alternative uses. For example, zoning regulations may prevent a plot of land in an industrial area from being used to construct high-rise residential apartments.
Must be financially feasible. The alternative use must incorporate the costs incurred to convert the asset to that use, while still producing investment returns.

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Fair Value Accounting

Example of the Highest and Best Use Concept

A manufacturing company owns a large parcel of land on the edge of a rapidly growing city. The land is currently being used for industrial purposes, housing a small factory. However, due to recent commercial development in the area, real estate appraisers determine that the land would be significantly more valuable if it were used for retail or residential purposes. Even though the factory is still operational, the fair value of the land is assessed based on its highest and best use—redevelopment into a shopping center or apartment complex. This potential use reflects the most profitable, legally permissible, and physically possible use of the land, given current zoning and market conditions. Under the fair value accounting standards, the land’s value is reported based on this alternative use rather than its current use as a factory site. This illustrates how fair value is tied to potential, not just current utility.