Impairment of Fixed Assets

Impairment of a fixed asset refers to an abrupt decrease in the economic benefits that an asset can generate due to damage, obsolescence etc. Impairment is recognized by reducing the book value of the asset in the balance sheet and recording impairment loss in the income statement.

While depreciation is the systematic write-off of a fixed asset's total cost to income statement to satisfy the matching principle, impairment loss is a one-off adjustment necessitated by unexpected external or internal changes.

Accounting standards require companies to evaluate whether a asset is impaired at the end of each financial year. Important indicators of impairment include physical damage, technological obsolescence, increase in interest rates, decrease in profitability, corporate restructuring, etc. Impairment tests are conducted to identify whether impairment loss is required to be recognized.

Determination of impairment loss

Impairment occurs when the carrying amount (book value) of an asset exceeds its recoverable amount

Recoverable amount is the value of economic benefits we can obtain from an asset. Economic benefits are obtained either by selling the asset or by using the asset in operations. Hence, the recoverable amount equals the higher of fair value less costs to sell and value in use.

Fair value less costs to sell

Fair value less costs to sell is the current market value minus the costs that would be incurred in selling the asset such as commission, registration, etc.

Value in use

Value in use is the present value of future net cash flows expected to be derived from continuing use of an asset.

Recognition of impairment loss

If the carrying amount exceeds the recoverable amount, an impairment expense equal to the difference is recognized in the period. If the carrying amount is less than the recoverable amount, no impairment loss needs to be recognized.

Example

On January 1, 20X5 Zarlascht Inc. purchased a building for $2 million. Its estimated useful life at that date was 20 years and the company uses the straight-line depreciation method. On December 31, 20X9 the government embarked on a plan to construct a fly-over adjacent to the building which would reduce access to the building thereby decreasing its value. The company estimated that it can sell the building for $1 million but it would have to incur costs of $50,000. Alternatively, if it continues to use it, the present value of the net cash flows the building will generate amounts to $1.2 million.

The basic rule is to recognize impairment if carrying amount exceeds the recoverable amount.

First, we need to determine the carrying amount. The building's cost is $2 million, useful life is 20 years and has been used for 5 years so far. This means that accumulated depreciation is $2/20×5 or 0.5 million and carrying amount is $1.5 million (i.e. $2 million minus $0.5 million).

Second, we need to determine the recoverable amount. Recoverable amount is the higher of fair value less costs to sell and value in use. Fair value less costs to sell in this scenario is $1 million minus $0.05 million or $0.95 million. Value in use is the present value of future cash flows which amounts to $1.2 million. Recoverable amount is the higher of $0.95 million and $1.2 million.

Carrying amount is $1.5 million while recoverable amount is $1.2 million. An impairment loss of $0.3 million is to be recognized. The journal entry would be:

Impairment Loss300,000
Accumulated Impairment Losses300,000

Reversal of impairment loss

If due to any event the impaired asset regains its value, the gain is first recorded in income statement to the extent of original impairment loss and any excess is considered a revaluation and is credited to revaluation surplus.

Example

Let us extend the example of Zarlascht Inc. In 20X0 the government constructed a service road parallel to the high way which improved the recoverable amount to $1.4 million. Depreciation for 20X0 was $0.12 million.

Carrying amount as at December 31, 20X0 is $1.08 million (=$1.2 million minus $0.12). The recoverable amount is $1.4 million which shows that the building has to be appreciated by $0.32 million. $0.3 of this amount is to be credited to income statement because the original impairment loss routed through income statement was $0.3 million. The additional $0.02 million will be credited to revaluation reserve.

The journal entry would be:

Accumulated Impairment Losses300,000
Building20,000
Gain in Value of Building300,000
Revaluation Surplus20,000

by Obaidullah Jan, ACA, CFA and last modified on
Studying for CFA® Program? Access notes and question bank for CFA® Level 1 authored by me at AlphaBetaPrep.com

XPLAIND.com is a free educational website; of students, by students, and for students. You are welcome to learn a range of topics from accounting, economics, finance and more. We hope you like the work that has been done, and if you have any suggestions, your feedback is highly valuable. Let's connect!

Copyright © 2010-2021 XPLAIND.com