Impairment of Fixed Assets
Impairment of a fixed asset is an abrubt decrease of its fair value due to damage, absolecense etc. When impairment of a fixed asset occurs, the business has to decrease its value in the balance sheet and recognize a loss in the income statement.
Following are the important terms to know before studying the topic further:
Recoverable Amount is the value of the benefits we can obtain from a fixed asset. Economic benefits are obtained either by selling the asset or by using the asset. 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 assets such as commission, registration, etc.
Value in Use
Value in use is the present value of the future net cash flows expected to be derived from the continuing use of the asset.
Recognition of Impairment Loss
If the carrying amount exceeds the recoverable amount, an impairment expense amounting to the difference is recognized in the period. If the carrying amount is less than the recoverable amount no impairment is recognized.
On January 1, 2005 Zarlascht Inc. purchased a building for $2 million. Its estimated useful life at that date was 20 years and the company uses straight line depreciation method. On December 31, 2009 the government embarked on a plan to construct a fly-over adjacent to the building and the related installation reduced the access to the building thereby decreasing the value of the building. The company estimated that it can sell the company for $1 million but it has to incur costs of $50,000. Alternatively, it if continues to use it the present value of the net cash flows the building will help in generating is $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 has a cost of $2 million, useful life of 20 years and is used for 5 years so far. This means that accumulated depreciation is $2/20*5 or 0.5 million. Carrying amount is $2 million minus $0.5 million or $1.5 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:
Accumulated Impairment Losses
Reversal of Impairment Loss
If due to any event the impaired asset regains its value the gain is recorded in income statement to the extent of original impairment loss and any excess is considered a revaluation and is credited to revaluation surplus.
Let us extend the example of Zarlascht Inc. In 2010 the government constructed a service road parallel to the high way which improved the recoverable amount to $1.4 million. Depreciation for 2010 was $0.12 million.
Carrying amount as at December 31, 2010 is $1.2 million minus $0.12 million or $1.08 million. 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 Losses