Fixed asset impairment is a reduction in the value of a long-term fixed asset (like property, plant, or equipment) when its book value exceeds its recoverable amount. This reflects a decrease in the asset’s future economic benefits. Impairment can happen due to various reasons, such as physical damage, economic downturns, obsolescence, and changes in business operations.
Key Takeaways:
- Regular assessment of fixed assets for impairment is essential to prevent overstated asset values on the balance sheet.
- Determining the recoverable amount—which involves calculating fair market value (FMV) less costs to sell and value in use—is crucial for assessing impairment.
- When an impairment loss is recognized, it is recorded as an expense on the income statement and reduces the asset’s carrying value to its recoverable amount. This affects overall financial performance.
Why Is Fixed Asset Impairment Used?
Fixed asset impairment is used to ensure that financial statements accurately reflect the economic reality of your company’s assets. It serves several critical purposes:
- Accurate asset valuation: Fixed asset impairment prevents overstatement of asset values on the balance sheet. It ensures that assets are recorded at their recoverable amount, which is the higher of its FMV, less cost to sell, and its value in use.
- Improved financial reporting: It provides a more realistic picture of your company’s financial health. It enhances the reliability and credibility of financial statements for investors, creditors, and other stakeholders.
- Informed decision-making: Fixed asset impairment also helps management make informed decisions about asset utilization, disposal, or restructuring and identifies assets that are no longer generating adequate returns.
- Ensured compliance: Adherence to accounting standards (GAAP or IFRS) requires the recognition of impairment losses when applicable.
How to Determine Recoverable Amount or FMV
FMV is the price a willing buyer would pay a willing seller, both with reasonable knowledge of relevant facts, in an arms-length transaction. The recoverable amount is the greater of FMV less selling costs, or its value in use. The FMV is generally determined with a comparable sales analysis, and the common methods used to determine value in use are the income approach, cost approach, and valuation models.
Comparable Sales Analysis to Determine FMV
Identify assets with similar characteristics, such as age, size, condition, and location. Analyze recent sales by comparing the prices of recently sold similar assets, and make adjustments as needed.
Income Approach
This involves projecting the asset’s future ability to generate income. Determine the capitalization rate by calculating the appropriate rate of return for the asset. Then, calculate the FMV by dividing the estimated net operating income by the capitalization rate.
Cost Approach
Determine the cost to replace the asset with a similar one. Then, account for depreciation by subtracting accumulated depreciation from the replacement cost. If applicable, add the value of the land to the depreciated cost.
Valuation Models
For complex assets, use specialized valuation models, like discounted cash flow analysis or option pricing models.
When Is Fixed Asset Impairment Used?
Fixed asset impairment is usually evaluated at the end of each year. It is used when there is evidence that the asset’s carrying value (historical cost minus accumulated depreciation) exceeds its recoverable amount.
That indicates that the asset is no longer generating the expected future economic benefits. Essentially, impairment testing is triggered when there are signs that the asset’s value has decreased to a point where it is no longer recoverable through its continued use or disposal.
Common indicators for impairment testing include:
- Decline in market value: A decrease in the asset’s market price due to an economic downturn or changes in consumer demand.
- Increased competition: Increased competition can reduce the asset’s profitability and, consequently, its value.
- Changes in interest rates: Higher interest rates can reduce the present value of future cash flows generated by the asset.
- Obsolescence: Technological advancements or changes in consumer preferences can render the asset outdated.
- Physical damage: Accidents, natural disasters, or wear and tear can reduce the asset’s value or utility.
- Underutilization: If an asset isn’t used to its full capacity, its value may be impaired.
- Operational losses: Consistent losses generated by the asset indicate potential impairment.
- Changes in laws or regulations: New laws or regulations can affect the asset’s value or usage.
- Acquisition problems: Overpayment for an asset during an acquisition can lead to impairment.
- Business restructuring: Changes in business strategy or operations may render certain assets unnecessary.
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How to Record the Journal Entry for Fixed Asset Impairment
Suppose a manufacturing company owns a piece of machinery that was purchased for $1,000,000 with accumulated depreciation of $400,000. Due to technological advancements, the machinery is now expected to generate significantly less cash flow than previously estimated. On June 30, the company determined the FMV less costs to sell is $450,000 and the value in use is $420,000.
Impairment loss calculation:
- Carrying value: $1,000,000 – $400,000 = $600,000
- Recoverable amount: The higher of FMV less costs to sell ($450,000) and value in use ($420,000) is $450,000.
- Impairment loss: $600,000 – $450,000 = $150,000
Journal entry:
Date | Account | Debit | Credit |
|---|---|---|---|
June 30 | Impairment Loss - Machinery | 150,000 | |
Allowance for Impairment - Machinery | 150,000 | ||
(To record fixed asset impairment) |
Explanation:
- Impairment Loss – Machinery: This income statement account is debited to recognize the expense incurred due to the asset’s decreased value. It should be shown as an operating expense on the statement of profit or loss.
- Allowance for Impairment – Machinery: This balance sheet account is credited. It is a contra-asset account that is netted with the machinery account to reduce the asset’s carrying value.
The depreciation expense for the machinery will be calculated based on the new carrying value of $450,000 and its remaining useful life. If the recoverable amount of the asset increases in the future, you may be able to reverse the impairment loss under certain circumstances—but only up to the amount of the original impairment.
Frequently Asked Questions (FAQs)
A manufacturing plant’s value plummets due to declining product demand. Because of the decrease in demand, the company’s machinery is expected to produce less income and cash flow and thus its value has significantly declined. The company must reduce the book value of the equipment and recognize a loss.
To assess impairment of fixed assets, companies typically follow two steps.
- Identify impairment indicators, which include factors like significant decline in market value, changes in legal factors, economic conditions, or internal factors like asset underutilization.
- Compare the asset’s carrying value with its recoverable amount. If the carrying value exceeds the recoverable amount, an impairment loss is recognized for the difference. The asset’s value is reduced to the recoverable amount.
Impairment losses are reported as expenses on the income statement. Specifically, they are shown within the operating expenses section. The exact location may vary depending on your company’s specific accounting policies and financial reporting framework.
An asset should be impaired when its FMV is less than its carrying value, which is calculated as historical cost minus accumulated depreciation. This can be caused by physical damage to the asset, legal changes surrounding the asset, or a change in consumer demand.
Bottom Line
Fixed asset impairment ensures that assets are reported at their recoverable amount. The general idea is to avoid overstating fixed assets if their adjusted basis (after depreciation) is greater than their FMV. By diligently assessing the impairment of assets, you can avoid overstating their financial position and make informed decisions about allocating resources.
