Companies require assets to operate and generate revenues. Usually, these assets come from their operations over the years. Some companies may acquire them while others can also produce them. Either way, these assets contribute to the activities that companies perform. While companies have various asset types, fixed assets are usually the most crucial long-term resources.
In accounting, companies must record fixed assets under two methods. The first involves using their historical cost as a base. This method requires companies to account for assets at the purchase cost. With time, companies can spread that cost to match the revenues they help generate. This process is called depreciation and is common for most fixed assets.
The second method involves using the asset’s fair value. Initially, companies determine that value at the purchase time. They use it to record the asset in their books. After specific intervals, companies revaluate the asset and update the fair value. This way, the value may increase over time, although it may also decrease. This method also requires companies to charge depreciation.
What Is Impairment Loss?
The critical issue with the historical cost method of recording assets is the failure to address impairment. In other words, this method does not consider a decrease in asset value over time. The fair value method does so automatically as it depends on the market rate for that asset. If the value decreases, companies record it as an impairment.
IAS 36 Impairment of Assets seeks to address the issue with that. This standard applies to specific assets and does not cover all resources. However, it is crucial in recording the decrease in the value of an asset over time. Commonly, impairment describes a significant reduction in a fixed asset’s recoverable value. Therefore, it represents the difference between that value and the asset’s carrying value.
IAS 36 defines the recoverable value of an asset as “the higher of its fair value fewer costs of disposal and its value in use”. On the other hand, the definition of carrying value under the standard is, “the amount at which an asset is recognized after deducting any accumulated depreciation (amortization) and accumulated impairment losses thereon”. These definitions are crucial in determining the amount of impairment loss on an asset.
Essentially, impairment loss denotes the reduction in the value of an asset, either fixed or intangible. This loss can come from the asset’s quality, quantity or market value declining. By charging impairment, companies can present a more accurate value in the financial statements. Several factors can contribute to the impairment loss for an asset. These factors may be internal or external.
Overall, impairment loss represents the reduction in the value of an asset due to several factors. In accounting, it is crucial in presenting an accurate financial picture. For the company charging the impairment loss, it represents an expense. On the other hand, it also decreases the value reported in the balance sheet for the underlying asset.
What Is the Accounting for Impairment Loss?
The accounting for impairment losses is straightforward. Companies must determine the two values crucial in determining the loss amount. As mentioned, these include the carrying and recoverable values of the asset. The former represents the asset’s value in the financial statements. Usually, it requires its historical cost and deducting the accumulated depreciation from the value.
The recoverable value, however, can be challenging to determine. This amount does not represent an actual figure that is readily available. Instead, it is the higher of the asset’s fair value less selling costs and value in use. The former calculation requires companies to establish the market value of the underlying resource. Once they do so, they must determine and deduct the costs to sell it from that amount.
On the other hand, calculating the value in use may require complex calculations. This value comes from the present value of the future cash flows that the company expects the asset to derive. In other words, it is the discounted inflows from the asset less any discounted outflows. This calculation is more complex as it requires companies to forecast cashflows. On top of that, it also entails judgment from the company’s side.
Once companies determine the fair value less cost to sell and value in use, they must compare them. The higher amount among these will represent the asset’s recoverable value. After that, they must further compare that value with the carrying value. If the recoverable value is higher, the company must continue recognizing the asset at the carrying value. In contrast, if it is lower, then companies must calculate and charge the impairment loss.
Once companies determine the impairment loss on an asset, they must write off the amount. This process requires them to increase their expenses in the income statement for that loss. On the other hand, it also entails reducing the asset’s value to reach a new carrying value. This carrying value must match the recoverable amount calculated for the asset. Overall, the accounting for impairment loss impacts the balance sheet and income statement simultaneously.
How to record impairment loss journal entry?
Once companies understand the accounting for impairment loss, they can record it without complexities. As mentioned above, the process involves increasing expenses while reducing the asset’s value. However, this reduction does not happen directly to the asset’s cost. Instead, companies use a contra asset account to record the impairment loss. This account is similar to the accumulated depreciation account.
Therefore, the journal entries for impairment loss are similar to depreciation. However, the actual accounts used for them differ. On top of that, the presentation and disclosures also vary. Overall, companies can record impairment loss journal entries as follows.
|Accumulated impairment loss
As mentioned, the accumulated impairment loss is the contra asset account to reduce the asset’s value. This account holds all the impairment losses for assets over their life.
A company, ABC Co., acquires a plant which it estimates to have a useful life of 10 years. After five years, the carrying value of that plant reaches $500,000. However, ABC Co. obtains evidence that suggests the plant’s actual worth may have decreased. Therefore, the company suspects the asset to have incurred an impairment loss.
ABC Co. determines the fair value of the plant to be $420,000 in the market. However, it also estimates a selling expense of $20,000 to sell the asset. The asset’s fair value less cost to sell will be $400,000 ($420,000 – $20,000). On the other hand, the company also calculates the plant’s value in use to be $380,000. ABC Co. calculates this value by discounting the estimated future cash flows from the asset.
Therefore, ABC Co. can calculate the recoverable value for the plant as the higher of these two figures. Since the fair value less cost to sell is higher, it will become the recoverable value. Therefore, ABC Co. can calculate the impairment loss. This loss will be as below.
Impairment loss = Recoverable amount – Carrying value
Impairment loss = $400,000 – $500,000
Impairment loss = $100,000
ABC Co. then records the impairment loss journal entry as follows.
|Accumulated impairment loss
Impairment loss represents the difference between an asset’s recoverable and carrying values. This loss generates from various sources. Nonetheless, companies must account for them in their books. An impairment loss is an expense that reduces the underlying asset’s value. The accounting standard IAS 37 deals with the process of recording impairment losses.