By Yuriy Smirnov Ph.D.
Asset impairment occurs when the carrying amount of an asset exceeds its recoverable amount. The impairment test is required when there are some indications or reasonable assumption that the recoverable amount of an asset declines rapidly. Asset impairment accounting affects asset reduction in the balance sheet and impairment loss recognition in the income statement.
Please note that goodwill and some tangible assets are required to make an annual impairment test.
The carrying amount or current book value is calculated by deducting from the initial cost of an asset any related accumulated depreciation and accumulated impairment loss.
Fair value is the price of an asset that can be traded between market participants at a measurement date.
Value in use is the present value of all expected future cash flows to be generated by an asset.
The recoverable amount of an asset is the highest value in use and fair value less all related disposal cost.
Impairment loss is the amount by which the carrying value of an assets exceeds its recoverable amount.
An asset impairment procedure requires four stages to be completed.
If the impairment test shows an excess of carrying amount over the recoverable amount, the impairment loss must be recognized by adjusting the entry in the general journal.
Please note that US GAAP does not allow restoration of previously recognized impairment losses! Some other accounting standards, including IFRS, do allow recvery of impairment losses.
The restoration entry to be made depends on whether or not the gain on the revaluation of an asset exceeds its accumulated impairment losses.
If accumulated impairment losses cover asset appreciation, recovery of asset impairment should be recorded as follows:
If asset appreciation exceeds accumulated impairment losses, a double entry should be made in the general journal. The first one debits Accumulated Impairment Losses and credits Gain on Revaluation for the whole amount of relevant accumulated impairment losses. The second entry recognizes revaluation surplus by debiting the Asset account and crediting the Revaluation Reserve for the difference between asset appreciation and accumulated impairment losses.
Winsdor House LLC, a real estate development company, has bought an old office building for $6,750,000. Total reconstruction costs amounted to $3,500,000. An accountant estimates the useful life of the building as 25 years, and the company decides to use the straight-line depreciation method with no residual value.
In 4 years, the real estate market drops dramatically, so Winsdor House LCC can sell the office building for $7,000,000 not including the sale cost of $350,000. Alternatively, the present value of cash flows generated by the office building is $7,270,000.
If there is a strong indication that the recoverable amount will drop significantly, the asset impairment test must be performed. The recoverable amount of the office building is $7,270,000 because value in use (present value of expected cash flows) is higher than the fair value of $6,650,000 ($7,000,000 - $350,000).
To calculate the carrying value, we need to know depreciation expense and accumulated depreciation. Since the straight-line depreciation method is used, the annual depreciation expense will be $410,000.
Annual depreciation expense = ($6,750,000 + $3,500,000 ) ÷ 25 = $410,000
For the 4 years, the accumulated depreciation amounted to $1,640,000.
Accumulated depreciation = $410,000 × 4 = $1,640,000
Thus, the carrying amount is $8,610,000.
Carrying amount = $10,250,000 – $1,640,000 = $8,610,000
As the carrying amount exceeds the recoverable amount, the impairment loss of $1,340,000 must be recognized.
Impairment loss = $8,610,000 – $7,270,000 = $1,340,000
Finally, the depreciation schedule must be adjusted to the amount of impairment loss recognized. As the office building has no residual value, the depreciable amount equals the carrying amount after revaluation.
Carrying amount = $8,610,000 – $1,340,000 = $7,270,000
Considering that 21 years is left to the end of the building’s useful life, the adjusted annual depreciation expense will be $346,190.48.
Annual depreciation expense = $7,270,000 ÷ 21 = $346,190.48
Assume that the real estate market will recover in three years. Winsdor House LLC can now sell the office building for $8,500,000. Alternatively, the present value of expected cash flows is estimated as $7,950,000.
Accumulated depreciation = $1,640,000 – $346,190.48 × 3 = $2,678,571.43
The current carrying amount is $10,250,000 less accumulated depreciation of $2,678,571.43 and accumulated impairment losses of $1,340,000 or $6,231,428.57.
The surplus of the recoverable amount over the carrying amount is the building’s appreciation.
Building appreciation = $8,500,000 – $6,231,428.57 = $2,268,571.43
As this amount exceeds previously accumulated impairment losses, the gain on revaluation reserve must be recognized.
Revaluation reserve = $2,268,571.43 – $1,340,000 = $928,571.43
The asset impairment’s restoring entry would be:
At the last step, the annual depreciation expense must be adjusted. Assume no residual value adjusted depreciable amount equals the carrying value after revaluation of $8,500,000. Considering that 18 years is left to the end of the building’s useful life, the adjusted annual depreciation expense will be $472,222.22.
Annual depreciation expense = $8,500,000 ÷ 18 = $472,222.22
Please note that asset impairment recovering is allowed under IFRS and prohibited under US GAAP!