Fixed assets represent long-term assets used by companies and businesses in the generation of revenues and profits. There are several types of fixed assets that companies use, including property, plant, and equipment.
Since most of these assets require high-value investments, accounting standards require companies not to charge the cost of these assets in a single accounting period.
There are several reasons why companies don’t charge assets in a single period. Most importantly, it is because the matching principle of accounting requires companies to charge expenses in the period that they help generate revenues. It is why companies use depreciation to contribute to the value of fixed assets over a period of time.
However, there is still an asset that companies do not depreciate, land. The reason is behind it is that land has an infinite useful life. Other assets, in comparison, have a useful life after which they stop generating revenues for a company.
The only case where land is depreciable is when there are natural resources that companies can extract from it.
When companies purchase land, it may come with a building on it. Therefore, they need to allocate the cost between the land and building.
It is so they can depreciate only the building element and not the land itself. Sometimes, however, companies may also perform some land improvements, which can be depreciable.
What is the land improvement?
Land improvement refers to enhancements made to a plot of land to make it more usable. Usually, these improvements have a useful life and, therefore, are depreciable.
However, if a land improvement does not have a useful life or companies cannot estimate it, then the company cannot depreciate the improvement. Similarly, there are some costs that qualify as land improvements and some which do not.
For companies to consider expenditure on land as improvement, they must meet several requirements. Most importantly, the expenditure should be of capital nature and not revenue nature.
It means that any expense borne on land should enhance its quality, increases its useful life or increasing its value. Any regular maintenance work done to it does not qualify as capital expenditure.
That is the reason why expenditure such as demolishing an existing building and clearing and levelling the land do not qualify as capital expenditure.
Companies perform these actions as a part of regular maintenance and do not affect the value of the land. Demolishing a building also has an impact on the value of the building and not the land.
Other improvements to land, for example, adding elements to it can qualify as improvements. For instance, if a company installs drainage and irrigation systems, landscaping, parking lots, driveways, walkways, outdoor lighting, or fencing, it can recognize it as a land improvement.
Almost all these items have limited lives and, therefore, the company must depreciate them.
The accounting treatment of land improvements comes under the accounting standard for property, plant and equipment. Companies need to calculate all the costs that go into these improvements. However, they must ensure these expenditures are of capital nature.
The initial measurement of the cost of these improvements includes all costs involved in bringing the improvements into working condition.
Once companies measure the initial cost of the improvement, they can use the following journal entry to record the land improvement in their accounts.
Cash or bank
The land improvements represent a fixed asset for a company, which will appear in its Balance Sheet. On the other hand, any payment made against the installation of these improvements reduces the cash or bank balance of the company.
If the company obtains these improvements on credit or any other terms, it can modify the credit side of the double-entry.
Like any other depreciable asset, the accounting treatment for land improvements depreciation is straightforward. Companies need to start by establishing the cost of improvements.
In case they cannot calculate its value, they cannot capitalize it either. After determining the cost, companies need to estimate the useful life of the improvement.
The useful life of an asset can depend on several factors. However, it generally requires judgement. After establishing the useful life, the company needs to decide on the depreciation method to use for depreciating the land improvements.
Usually, companies have two options when it comes to depreciation techniques. These include the straight-line method and double-declining balance techniques.
The journal entry to record depreciation, after calculating it, is as follows.
The above journal entry is similar to a depreciation recording entry for any other fixed asset.
The land is a non-depreciable fixed asset for companies due to its infinite useful life. However, land improvements with useful life are depreciable. Land improvements are any enhancement to land that increases its value. These improvements need to be of capital nature and not revenue nature.
When a company or business acquires an asset, it records it in its financial statements at cost. After every accounting period, the company must also calculate and record a depreciation or amortization charge related to the asset. Sometimes, however, companies must recognize an impairment against the asset under various circumstances as well.
What is the impairment of assets?
Impairment of assets refers to the concept in accounting when the book or carrying value of an asset exceeds its ‘recoverable amount’. IAS 36 defines the recoverable amount of an asset as the higher of its fair value less cost to sell (or net realizable value) and its value in use. When an asset is impaired, the company must record a charge for the impairment expense.
The reason why companies record impairment to assets is to reflect their correct value in the financial statements. It goes in line with the prudence concept of accounting. Furthermore, any asset, whether tangible or intangible, can suffer impairment. Therefore, IAS 36 requires companies to record the impairment whenever it occurs.
Causes of Impairment:
There are many causes of impairment to assets. These causes can be internal or external. Companies must always identify them and evaluate whether they have resulted in impairment of their assets.
1) External factors
External factors can impact an asset’s value and result in impairment. External factors may include economic, social, technological, political, legal or environmental issues. Furthermore, if an asset’s fair value reduces in the market, it may also cause impairment to it. Similarly, changes in the market can also impact the company adversely, causing impairment to its assets.
2) Internal factors
Internal factors are straightforward to identify. Things that cause impairment internally include physical damage to the asset, causing a reduction in its value. Obsolescence of assets also results in impairment losses. Furthermore, if the company alters the way it uses an asset, it may impact its value in use and, therefore, its recoverable value. Lastly, if a company finds evidence that one of its assets is performing worse than anticipated or expected, it may be an indicator of impairment.
Scope of Asset Impairment
IAS 36 – Impairment of Assets has a wide scope and applies to all assets that companies use. However, it does not include assets that have specific standards that take care of impairment. Therefore, impairment of assets does not apply to the following areas of a company:
Assets arising from employee benefits.
Deferred tax assets.
Financial assets or instruments.
Investment property measured at fair value.
Assets classified as held for sale.
All these types of assets have a specific standard that addresses how companies should deal with impairment for them. Therefore, the standard does not apply to these assets. Other than these, the impairment of assets applies to all other assets within a company.
The journal entry to record impairment is straightforward. However, before recording the impairment loss, a company must first determine the recoverable value of the asset. As mentioned above, it is the higher of an asset’s net realizable value and its value in use.
Once a company calculates the recoverable amount of the asset, it must compare it with the asset’s carrying value.
If the carrying value of the asset exceeds the recoverable amount, then the company must recognize an impairment loss. The amount of impairment loss will be the difference between an asset’s carrying value and recoverable amount. The double entry to record an impairment loss is as follows.
The impairment loss becomes a part of the Income Statement and reduces the profits of the company. On the other hand, it also affects the Balance Sheet of the company. That is because it results in a decrease in the value of the asset that suffered the loss.
A company, ABC Co., has total assets worth $1 million after calculating the carrying value at the end of the accounting period. Among these, ABC Co. has a vehicle with a carrying value of $100,000, which has suffered physical damage. According to the company’s calculation, the vehicle has a net realizable value of $80,000 and a value in use of $75,000.
The recoverable amount of the vehicle is its net realizable value of $80,000, which is higher than its value in use. However, it is still lower than the vehicle’s carrying value of $100,000. Therefore, ABC Co. must record an impairment loss of $20,000 ($100,000 – $80,000). The double entry for recording the loss is as follows.
After the loss, ABC Co.’s expenses will increase by $20,000, while its total assets would decrease by the same amount as well.
There are several advantages of impairment of assets. Firstly, it helps companies present a true and fair view to their stakeholders of the true value of their assets. Similarly, it can help stakeholders determine if a company might be facing any failures or damages and can be an indicator of their efficiency and effectiveness. Impairment losses can also help stakeholders determine if a company’s policies or decisions may have failed.
Impairment may also have several disadvantages. Firstly, it is difficult for companies to calculate a recoverable amount. It’s because obtaining a fair value or calculating the value in use of an asset are costly and, sometimes, inaccurate.
Similarly, while the standard shows how to recognize impairment losses, it does not give detailed information about the process that companies can follow.
Impairment is a crucial concept in accounting. Impairment losses come as a result of the carrying value of an asset being different from its recoverable amount. When companies detect an impairment, due to external or internal factors, they must recognize a loss immediately.
Goodwill is an asset representing the future economic benefits arising from other assets acquired in a business combination that are not individually recognized and separately identified. It is recorded and recognizes in the balance sheet as long-term assets when a company purchases another company and owning more than 50% of shares.
How to perform an impairment test for goodwill?
The examination of goodwill impairment involves the following steps:
Assess qualitative factors such as increased costs, deterioration of macroeconomic conditions, declining cash flows, change in management, possible bankruptcy. Such factors help to review if further impairment testing is needed to be carried out.
Compare the fair value of the unit to it carrying amount and include goodwill in the carrying amount as well. If the fair value is greater than the carrying amount, then there is no impairment loss.
Calculate impairment loss as to the difference of carrying amount is greater than the fair value but limited to the value of carrying amount of goodwill.
Stage 1: Preliminary qualitative assessment:
The company must ensure whether the goodwill reflecting in the books would exceed its fair market value. It is to be checked on the basis of macroeconomic developments, political and legal changes, the existence of current competitors, management, and the structure of the company.
If this assessment shows that the goodwill in the balance sheet will not exceed its fair market value, then no further testing is required. But if it exceeds, then the preliminary qualitative assessment is required.
Stage 2: Quantitative assessment:
It consists of calculating the fair value of the reporting unit on which goodwill is based and then comparing the fair value with the book value of goodwill shown in the balance sheet. The company must calculate the relative impact of all factors that may materially affect the value of goodwill.
If this assessment reveals goodwill does not exceed the fair value, then the company must proceed to the next stage of the quantitative assessment.
Stage3: Quantitative assessment:
The company checks the value of individual assets and liabilities of the entity to find its fair value. On the basis of this analysis, if the company determines the goodwill to exceed the fair value, then excess goodwill is treated as an impairment to goodwill. This value is ultimately shown as an impairment loss in the books of accounts.
Journal entry for impairment of goodwill:
Goodwill impairment expense (P&L)
Proportionate goodwill and impairment review:
When goodwill has been calculated on a proportionate basis, it is necessary to gross up goodwill to carry the impairment test. Any impairment loss that arises is first allocated against the recognized and unrecognized goodwill in the normal proportion that the parent and its non-controlled entity share profits and losses.
Any amount which has been written off against the goodwill in the books will not affect the consolidated financial statements and the branch entity.
If the total impairment loss is more than the amount allocated against recognized and goodwill of books, the excess goodwill be allocated against any other assets on a pro-rata basis. This loss will be shared between the parent and non-controlling entity in the normal proportion of their usual sharing of profits and losses.
Gross goodwill and impairment review:
When goodwill has been calculated in gross, any impairment loss will be allocated between the parent and NCI in the normal proportion of their profit and loss sharing ratio.
Example of impairment review of proportionate goodwill:
The year-end impairment review is being conducted on a 65% owned subsidiary. At the date of the review, the carrying amount of assets of the subsidiary was 200 million, and goodwill attributable to the parent was 250 million, and the recovery amount of the subsidiary was 400 million.
Now it is necessary to gross up the goodwill so
Gross goodwill= 250*100/65=384.62 million
Now for the purpose of impairment review, the goodwill of 384.62 million and net assets of 200 million form the carrying amount of cash-generating unit.
Carrying amount of:
The impairment loss, in this case, is less than the total of recognized and unrecognized goodwill, so in this case, goodwill is only impaired, not other assets. Only the parent’s share of goodwill impairment loss will be recorded, i.e.65% of 184.62 million=120.003 million.
Impairment review of gross goodwill:
At the year-end impairment, a review is conducted on 70% owned subsidiary. The carrying amount of net assets was 600 million and gross goodwill of 450 million out of which (60 million allocated to NCI) and the recoverable value of the subsidiary as 700 million.
The impairment review of goodwill is actually the impairment review of goodwill and net assets of NCI as a Cash generating unit for which we can calculate the recoverable value.
This impairment loss will be used to write down the value of goodwill so that goodwill will appear in books at 450-350=100 million
In the PL statement, an impairment loss of 350 million will be charged as an extra-operating expense.
How to perform an impairment test for goodwill?
Start impair testing early. Goodwill can be tested earlier at the beginning. If any impairment indicator arises between the testing date and balance sheet date, the impairment assessment should be updated.
Comply with the disclosure requirements such as
Key assumptions on which management bases its cash flow projections
The period over which cash flows have been projected
The growth rate used to extrapolate cash flow projections beyond the period covered by budgets.
Allocate goodwill to the appropriate Cash generating units: Goodwill doesn’t generate cash flow independently, so the recoverable value can’t be independently measured. So, goodwill acquired in the acquisition is allocated from the acquisition date to each of the Cash generating units that are expected to take advantage of the synergy.
Make sure that the cash flows are consistent with the assets being tested. They must match with each other.
Reconcile the final result by comparing it with the external market data and check whether the economic assumptions made earlier still make sense.
Pay attention to market capitalization. If the market capitalization is lower than the value in use, then the assumptions made about the market environment can be challenged.
Cash flows used in the impairment calculations should be reasonable: Forecasts made in the previous months need to be rechecked and reassessed. Forecasts should be made on the latest management budgets. Greater weightage should be given to evidence sourced from outside.
The impairment test is the testing procedures that perform by the companies on the assets that they have to find out if the assets are impaired that make the carrying value of assets in the reporting date less than the recoverable value of assets.
For example, the company performs the impairment test on the computers that it has as of 31 December 2020 with the carrying value amounting to USD500,000 to see if there any impairment on the computers.
The impairment test is done to find out if the carrying amount of the asset exceeds the recoverable value. The carrying amount of assets means the value of an asset less accumulated depreciation. At the time of the acquisition, the carrying amount of an asset equals its original cost price.
The company must conduct tests at each balance sheet date that if the asset is impaired. If such a situation persists, the firm must estimate the recoverable value of an asset.
The following indicators show the impairment of assets:
The carrying amount of an asset is more than the market capitalization
The proof of its external damage or obsolescence is present
A significant decline in operating profit or net cash flows from the asset
Increase in market interest rates
Negative changes in technology, economic situation, laws, or political situation
How to determine the recoverable value?
If we can’t determine the fair value less costs of disposal then the recoverable amount can be taken as its value in use
The recoverable value of the disposable asset is higher than fair value minus the costs of its disposal and value in use
Value in use:
It represents the present value of future expected cash flows from the continuous use of an asset and its disposal discounted to reflect the underlying risk and time value of money. If the recoverable amount is less than the carrying amount, the carrying amount is reduced to its recoverable amount. This reduction is the impairment loss.
Impairment loss of revalued assets should be recognized as an expense immediately. However, for a revalued asset, an impairment loss is recognized against any revaluation surplus to the extent that such loss doesn’t exceed the revaluation surplus.
If the impairment loss is greater than the carrying amount, then the company must recognize it as liability.
In measuring value in use:
The cash flow projections must be based on the most recent approved financial budgets/projects
Cash flow projections beyond the covered period must be estimated by extrapolation of projects based on forecasts using the declining rate for subsequent periods or a steady rate. This growth rate must not exceed the long-term average growth rate of the product or industry.
Example of impairment of assets:
Company C purchased Company D ltd. and paid USD 1,000,000. The book value of assets was USD 700,000. The extra USD300,000 paid by Company C Ltd. above the book value of assets of D is to be recorded as goodwill. Over the year after purchase, the fair market value of Company D Ltd. fell from USD700,000 to USD400,000.
As a rule, the company is required to test for impairment of assets every year. So, after a year Company C ltd will compare the carrying amount of its assets with the fair value of Company D Ltd, and with the differential amount, the goodwill will be reduced. So, the goodwill, in this case, is the impaired asset. The journal entry for recording impairment loss is:
Journal entry for revaluation:
How to test the impairment?
The measurement of amount of loss involved in impairment involves following steps:
Perform the recoverability test: It involves evaluating whether the future value of asset undiscounted cash flows is less than the book value of the asset. If the cash flow is less then, the impairment loss is calculated.
Measurement of impairment loss: It is calculated by finding the difference between book value and market value of the asset.
The use of undiscounted cash flows in this process assumes that the cash flows are definite and risk-free and the timing of the cash flow is not taken into account.
Tips for impairment test:
Cash flows in the impairment calculations should be reasonable.
Forecasted statements in the prior periods may need to be revisited. It must be based on the latest management reports or budgets or estimates.
It must be backed by reasonable assumptions that should represent management’s best estimate of economic situations that will remain over the remaining lives of the asset. Greater weight should be given to external evidence.
Value in use should comply with the standard:
Future cash flows should be estimated for assets in the present situation. The major problems that might occur in making assumptions about the value in use relate to future restructuring and capital expenditures on investment.
Where management has approved the restructuring plans, the approved budget is likely to include the costs and benefits of the restructuring.
Focus on market capitalization:
Market capitalization below net asset value is an indicator of the impairment test. If the market capitalization is less than the value in use then the impairment test is carried out. The fall in the market value of an asset is the indicator of impairment.
A lower market value acts as a trigger but it doesn’t necessarily mean so. However, when management determines the recoverable value above the market value then the assumptions of market conditions should be checked in the light of available external evidence.
Check the discount rate:
Many companies follow the capital asset pricing method to determine the discount rate. The factors like cost of capital, corporate loan rates, and risks associated with the cash flows are to be taken into account since these may result in an increase in the discount rate.
Reconcile the conclusion with the external market data:
The current economic assumptions made a year ago might not be reasonable in the current scenario. Consumer expenditure is falling due to the economic situations hence cash flow growth assumptions must be reviewed carefully. The analyst reports should be obtained to support growth assumptions.
Compare the assets being tested for impairment with the cash flows coming from that asset:
It is to be ascertained that the cash flows being tested are consistent with the assets being tested. IAS 36 states that cash flows related to assets that generate cash flow independently should not be included in the cash flow forecasts. Cash flows should exclude cash related to financing.
In the accounting world, the asset is defined as an owned resource from which future economic benefits are expected. On the balance sheet of any organization, be it a not-for-profit or for-profit, the carrying amount of all assets is reported.
All such assets are divided into two categories on the balance sheet based on how quickly they can be turned into cash; current assets and non-current assets (also known as fixed assets).
Current assets are resources that are used up within one year, whereas fixed assets or non-current assets have a useful life of more than one year.
In this article, we will discuss how fixed assets are reported on the balance sheet of a not-for-profit organization.
Recognition of Fixed Assets:
As per the generally accepted accounting principles (GAAP) used around the world, every organization should determine a capitalization policy for its assets.
A capitalization policy for each organization defines a certain threshold amount over which any expenditure incurred would be qualified as a capital expenditure and hence, will be reported on the balance sheet.
On the other hand, any expense incurred under the threshold would be categorized as revenue expenditure and hence, expensed out on the income statement. For small non-profit organizations, the capitalization criterion usually ranges between $500 and $1,000.
The other criterion that an asset has to meet to be recognized as a fixed asset is having a useful life of more than one year.
In other words, the asset should be able to provide benefits throughout the period in which it is used, and the specified period must be of more than one year.
Once an asset is classified as a fixed asset, it is recorded in the books of accounts in the year of purchase.
Cost of Asset:
The fixed asset is recognized at cost plus any expenses incurred to bring it to its current condition of use.
However, if the tangible asset is a contribution, then it must be recognized at its fair value on the date of donation except when the fair value cannot be reasonably determined when it is recorded at a nominal amount.
The following entry is recorded in the accounting journals if the fixed asset is purchased through cash:
DR Fixed Asset xx
CR Cash xx
On the other hand, if the fixed asset is a contribution, then the following journal entry is reported:
DR Fixed Asset xx
CR Contribution Revenue xx
Calculation of Depreciation:
The fixed asset after being recorded is depreciated every period it is used. Non-profit organizations usually use a straight-line method to depreciate their assets.
In other words, the cost of assets less salvage value is evenly distributed throughout the asset’s useful life. The formula to calculate depreciation is:
Depreciation = (Cost – Salvage Value) / Useful Life
Depreciation is expensed out each year as a non-cash expense on the statement of activities also known as the statement of operations.
The accumulated depreciation i.e. the sum of depreciation expense up to the reporting date is reported under the amount of the fixed asset on the statement of financial position of the non-profit organization.
Accounting depreciation is the use and tear and wears of tangible assets allocated by the company over the useful life of assets generally governed by corporate laws and accounting standards.
The recognition of accounting depreciation is driven by accounting principles and standards such as US GAAP or IFRS or the country’s financial reporting standard.
Depreciation is a non-cash item and does not represent actual cash movements. Despite being a non-cash item, it appears on the income statement and ultimately in balance sheet getting accumulated to compute written down value of the asset.
So, this non-cash item is ought to be reported by the company. Accounting depreciation is also popularly called book depreciation.
Accounting depreciation is computed using different methods such as:
The most popular method is the straight-line method of depreciation. It distributes depreciation equally over all the periods of asset’s useful lives.
Other methods are accelerated methods allowing for higher depreciation in the earlier years and lower in the subsequent years.
For example, the double-declining method allows for twice the rate of straight-line depreciation in the earlier years.
Example of accounting depreciation
Majestic Inc purchases equipment worth $100,000 with a salvage value of $10,000 and a useful life of 10 years.
In this case, the straight-line method of depreciation is used meaning equal depreciation over the useful life of assets.
Depreciation = (purchase price- salvage)/Useful life = (100,000-10,000)/10 = $ 9000 per year
Tax depreciation is depreciation computed as per tax laws and to be reported on the tax return. It is subject to a tax deduction as per jurisdiction. BY deducting depreciation, tax authorities allow individuals and businesses to reduce taxable income.
However, the taxpayer cannot claim depreciation for all the assets. The conditions are specified in tax laws in order to be eligible for depreciation.
The regulations are country-specific and if countries have several tax jurisdictions like the US, it can be jurisdiction-specific.
The tax laws publish specifications of assets’ class, the period in which they are placed to use and the applicable depreciation allowed for such assets.
In the United States, the Internal Revenue Service is handed the responsibility to publish materials on depreciation.
Example of tax depreciation
Majestic Inc purchases equipment worth $100,000 with a salvage value of $10,000 and a useful life of 10 years.
Now, tax depreciation is as per IRS. IRS may require the equipment to be depreciated over the 7-year property as an accelerated method.
This will result in higher depreciation in the earlier years. The rate keeps changing with conditions. For example, if the equipment is placed in the third quarter of the year, there will be a separate rate for such equipment.
In a nutshell, following are differences between accounting and tax depreciation can be summarized as under:
Depreciation is prepared as per accounting purposes and complies company laws
Depreciation is prepared to comply with tax laws.
The company has a choice in depreciation methods, rates, and useful life.
The company has to use the depreciation rate and method as per tax law.
It is based on accounting principles, governed by accounting principles and accounting board.