Subject 3. Impairment and revaluation of long-lived assets

Impairment of Long-Lived Tangible Assets Held for Use

Sometimes a long-term asset may lose some of its revenue generating ability prior to the end of its useful life. e.g., a significant decrease in the market value, physical change, or use of the assets. If the carrying amount of the asset is determined to be not recoverable, an asset impairment occurs and the carrying value should be written down. The amount of written-down is recorded as a loss.

GAAP and IFRS differ as to the methodology used to determine impairment.

GAAP methodology of determining impairment uses a two-step recoverability test. Occurrence of an impairment differs from recognition of an impairment. An impairment, whether recognized in financial reports or not, occurs as long as an asset's carrying value cannot be fully recovered in the future. However, only impairments that meet certain conditions are recognized in financial reports. SFAS 121 provides a two-step process:

  • Recoverability test. Impairment must be recognized when the carrying value of the assets exceeds the undiscounted future cash flows from their use and disposal.

  • Loss measurement: The excess of the carrying amount over the fair value of the assets. If fair value is not available, the present value of future cash flows discounted at the firm's incremental borrowing rate should be used. That is:

    Impairment Loss = Book Value - Either Fair Value or Present Value of Future Cash Flows

Conversely, IFRS methodology uses a one step approach. This approach requires that impairment loss be calculated if "impairment indicators" exist. This approach does not rely on net undiscounted future cash flows and subsequent comparison to asset carrying value as required in the GAAP methodology. In addition, the impairment loss is calculated as the amount by which the carrying amount of the asset exceeds it recoverable amount. The recoverable amount is the higher of the following: 1) fair value less cost to sell; or 2) value in use (i.e., the present value of future cash flows including disposal value).

The carrying value of the long-lived assets should be written down to fair value (less cost of disposal if intended for sale). The impairment loss is reported pretax as a component of income from continuing operations. Once recognized, the impairment loss cannot be restored.

Some impacts on current financial statements:

  • Lower fixed assets and total assets.
  • Both net income and tax expense are reduced due to the impairment loss.
  • Tax payable: the impairment loss is not recognized for tax purposes until the property is disposed of. It leads to a deferred tax asset (a future tax benefits), not a current refund.
  • Stockholders' equity is reduced, and thus debt-to-equity ratio is increased.
  • Impairment write-down has no effect on cash flows since it is a non-cash charge.
  • Asset turnover ratios tend to increase due to the lower asset base.
  • Return on assets and return on equity are reduced because of the impairment loss.

The write-down affects future financial statements and ratios in the same way as it affects the current period, except in the following aspects:

  • Future depreciation expenses are reduced due to the reduced book value of the asset.
  • As a result, future net income and profit margin increases. Note that impairment loss is a one-time loss, and does not affect the income statements of future periods.
  • Future return on assets and return on equity will both increase because of higher future profitability and lower asset and equity base.

Revaluation of Long-Lived Assets

Under U.S. accounting standards, it is compulsory to account for impairment in long-lived assets (downward revaluation). However, upward revaluation of long-lived assets to reflect fair market values is not allowed.

The balance sheet is more informative when assets and liabilities are stated at market value rather than historical cost. IASB and some other non-U.S. GAAP do permit upward revaluations. The purpose of a revaluation is to bring into the books the fair market value of long-lived assets.

  • If an asset revaluation initially decreases the asset's carrying value, the decrease is recognized as a loss. Later if there is an increase in the carrying value, the increase is recognized as a profit (up to the amount of original decrease).
  • If an asset revaluation initially increases its carrying value, the increase bypasses the income statement and goes to equity (revaluation surplus). Later if there is a decrease then it first decreases the revaluation surplus then goes to income.

Financial Statement Analysis Considerations

  • The leverage motivation. An upward revaluation may improve a firm's leverage.
  • Income manipulation. Revaluations are subjective by their nature. For example, a downward revaluation will reduce ROE in the current period but make the firm more profitable in future years since the total assets and shareholders' equity will be lower.
  • Revaluation has no impact on cash flows.
  • What is the true value of the firm's long-lived assets? Why is the revaluation necessary? Who does the appraisal? How often is it done?

Practice Question 1

Under U.S. GAAP, if the fair value of an impaired long-term asset is not readily determinable, it should be shown on the balance sheet at historical cost less accumulated depreciation. True or False?
Correct Answer: False

If fair value of an impaired asset is not readily determinable, its value should be estimated by discounting expected future net operating cash flows. This is not equal to cost less accumulated depreciation.

Practice Question 2

Which of the following is compared with a long-lived asset's carrying value to determine whether a potential impairment exists (U.S. GAAP)?

A. The asset's estimated future discounted net cash flows.
B. The asset's estimated future undiscounted net cash flows
C. The asset's fair market value
Correct Answer: B

After this amount is estimated, the manager compares this amount with the carrying amount of the asset. If the carrying amount is greater than the cash flows, the impaired asset is written down. The write-down is the difference between the asset's fair value and its carrying amount.

Practice Question 3

A firm had an asset with a carrying value of $300,000. Its fair value is $180,000, and the future discounted cash flows from the use of the asset are estimated to be $200,000. Under U.S. GAAP, the firm should:

A. recognize an extraordinary loss of $20,000
B. recognize an extraordinary loss of $100,000
C. recognize an impairment loss of $120,000
Correct Answer: C

When the market value of an asset has significantly decreased or there is a significant decrease in the future cash flows from the asset, the loss on the asset impairment should be recognized, for the excess of the carrying value over the market value, if available.

Practice Question 4

Which of the following is evidence that a loss due to value impairment must be recognized?

I. There is a forecast of a significant decline in the profitability of the asset.
II. There are adverse changes in the legal or business climate.
III. There are significant cost overruns.
Correct Answer: I, II and III

All are evidence of a decrease in the value of the asset--that the carrying amount of the asset cannot be recovered and a loss on impairment should be recognized.

Practice Question 5

Foxburg Company purchased a new piece of machinery for $ 600,000 in January 2008. Foxburg depreciated this asset over 6 years using straight-line depreciation with no expected salvage value. They conclude near the end of year 2010 (third year of use) that the machine's operational value has been impaired to the point that its expected future cash flows are reasonably estimated to be $ 150,000 over the remaining three years. At the end of 2010, the machine's fair market value is approximately $125,000. Under U.S. GAAP, what amount should the machinery be reported at on the 12/31/10 balance sheet?

A. 150,000
B. 125,000
C. 175,000
Correct Answer: B

Per SFAS No. 121, once impairment has been established (expected future cash flows of $150,000 < $300,000 carrying value), the actual amount of the loss is determined by comparing the FMV of the asset ($125,000) with the carrying value ($ 300,000 or $ 600,000 - 3[600,000/6]). Thus, the loss would be $ 175,000 and the machinery would be written down to its fair value of $ 125,000.

Practice Question 6

The amount of the loss required to be recognized for an impairment in value of a long-lived asset should be the excess of the asset's carrying value over the:

A. undiscounted estimated future cash flows
B. acquisition cost
C. fair value
D. acquisition cost less the estimated future cash flows
Correct Answer: C

When the fair value is available, the loss on impairment is the difference between the carrying value and the fair value.

Practice Question 7

When a long-term asset is written down due to an impairment of value, which of the following is true?

I. Fixed assets will decrease.
II. Stockholders' equity will decrease.
III. Net income will decrease.
Correct Answer: I, II and III

The impairment will cause a loss to be recognized, which will decrease income and then stockholders' equity. The loss will also cause a write down the value of the assets.

Practice Question 8

Under U.S. GAAP, impairment losses are recognized for long-lived tangible assets held for use when:

I. The asset's carrying amount is not recoverable.
II. The asset's carrying value exceeds its undiscounted future cash flows.
III. The asset's fair value exceeds its carrying value.
IV. The asset's carrying value exceeds its fair value.
Correct Answer: I and II

Practice Question 9

Here is the info about a manufacturing equipment held for use:

Carrying value: $200k; Undiscounted future cash flows: $220k; Discounted future cash flows: $180k; Fair value: $170k.

Under U.S. GAAP, how much should the impairment loss be?


Correct Answer: None

Since the carrying value is less than the undiscounted future cash flows, no impairment loss should be recognized.

Practice Question 10

Under IFRS, recoverability is based on the comparison between:

I. carrying value.
II. fair value.
III. undiscounted future cash flows.
IV. discounted future cash flows.
Correct Answer: I and higher of II and IV

III is used under U.S. GAAP.

Practice Question 11

The impairment loss:

I. reduces long-term assets.
II. reduces income.
III. reduces cash flows from operating activities.
IV. is typically considered non-recurring.
Correct Answer: I, II and IV

It is a non-cash item and needs to be added back to the net income to get cash flows from operating activities (when using the indirect method).

Practice Question 12

Under U.S. GAAP, if the fair value of a long-lived, tangible asset increases after an impairment loss,

A. the loss cannot be reversed.
B. the loss can be reversed.
C. the accounting treatment depends on whether the asset is classified as held for use or held for sale.
Correct Answer: C

If it is held for use, then the loss cannot be reversed, otherwise it can. However, the IFRS allows impairment losses to be reversed.

Practice Question 13

Which of the following statements is (are) true with respect to the effects a write-down will have on financial statements and corresponding financial ratios?

I. The years after the write-down will see a higher return on equity will than would be the case if there were no asset write-downs.
II. Asset turnover ratios will increase after the write-down.
III. Following a write-down, future depreciation expenses will become higher.
IV. The debt-to-equity ratio will decrease once a company has written down its impaired assets.
Correct Answer: I and II

I is true and III is incorrect because the year after the write-down, the resulting depreciation expense will be lowered and the corresponding income figures would have increased. Also, with a write-down, asset values and consequently, equity values will have dropped. Hence, an improved income and a lowered equity will result in a higher ROE.

IV is incorrect because once an asset is written down, the value of both assets and equity will drop. Consequently, ratios such as debt-to-equity will increase.

Practice Question 14

Which statement(s) is (are) true?

I. U.S. GAAP allows the historical cost method to value long-lived assets.
II. IFRS standards allow for the accounting of long-lived assets either through the "cost" or the "revaluation" model.
Correct Answer: I and II

Practice Question 15

Under IFRS, if the revaluation initially increases the asset's carrying value by $5,000, and in a subsequent period the asset's carrying value is decreased by $2,000:

A. The $5,000 is recognized as a profit and the $2,000 is recognized as a loss.
B. The $5,000 increase goes directly to the equity and the $2,000 decrease is recognized as a loss.
C. Both $5,000 and $2,000 go to the equity directly.
Correct Answer: C

This is because the initial revaluation increases the carrying value.

Practice Question 16

Under IFRS, if the revaluation initially increases the asset's carrying value by $2,000, and in a subsequent period the asset's carrying value is decreased by $5,000:

A. The $2,000 increase goes to the equity first. In the subsequent period the $2,000 decrease goes to the equity and the remaining $3,000 is recognized as a loss.
B. The $2,000 is recognized as a profit and the $3,000 is recognized as a loss.
C. Both $2,000 and $5,000 go to the equity directly.
Correct Answer: A

The subsequent decrease first decreases the revaluation surplus of $2,000 and the remaining $3,000 loss is recognized in the income statement.

Practice Question 17

Asset revaluation:

I. always reduces reported leverage.
II. can be used by management to manage earnings.
III. affects depreciation, total assets and shareholders' equity.
Correct Answer: II and III

I is false: Only an upward revaluation can be used to reduce reported leverage.

Practice Question 18

Under IFRS, an asset revaluation:

A. always affects earnings.
B. affects earnings if the revaluation initially increases the asset's carrying value.
C. affects earnings if the revaluation initially decreases the asset's carrying value.
Correct Answer: C

If the revaluation initially increases the asset's carrying value then the increase bypasses the income statement and goes directly to equity.

Practice Question 19

Asset revaluation can improve:

I. leverage such as asset/debt ratio.
II. profitability such as ROE.
III. cash flows such as CFO.

A. I and II
B. I, II and III
C. II only
Correct Answer: A

It does not affect cash flows.

Practice Question 20

The revaluation model is:

I. An alternative to the cost model.
II. Not permitted under IFRS.
III. Not permitted under U.S. GAAP.

A. I and II
B. I and III
C. III only
Correct Answer: B

IFRS permits the use of either the revaluation model or the cost model.

Practice Question 21

Which of the following would be a circumstance that would lead to the impairment of a long-term asset?

A. any change in the legal or business environment
B. significant decreases in the market value of the asset
C. current period operating or cash flows that are smaller than the previous periods
Correct Answer: B

Significant decreases in the market value of the asset will lead to an impairment of that asset and must be written down.

Practice Question 22

A loss on impairment should be recognized when:

A. the carrying value of the specific asset is too low
B. the market value of the specific asset has fallen significantly below the book value.
C. replacement cost of the asset has risen
Correct Answer: B

When the market value of the asset has decreased significantly, then an impairment loss should be recognized.

Practice Question 23

A firm had an asset with a carrying value of $600,000. The estimated future undiscounted cash flows from the use of the asset have decreased to $300,000. Under U.S. GAAP, the firm should:

I. write down the asset
II. recognize an impairment loss
III. determine the fair value of the asset, if possible

A. I, II and III
B. II and III
C. I and II
Correct Answer: A

When the undiscounted estimated cash flows expected from use of the asset are decreased significantly, there exists one of the conditions for recognizing an impairment of value.

Practice Question 24

Taylor Corporation has determined that a printing press that it purchased in 2008 for $400,000 has become partially obsolete due to newer equipment purchased in 2010. The press had a book value of $160,000 at December 31, 2010. At the end of the press' life, the estimated value is $40,000, and the net future cash flows from using the machine are estimated to be $90,000. These cash flows have a present value of $73,800 and $32,200, from the future cash flows and residual value, respectively. What amount should Taylor record as "loss due to asset impairment" (Under U.S. GAAP)?

A. $30,000
B. $32,000
C. $54,000
Correct Answer: C

When a fair market is not available, the discounted future cash flows can be used as the cost basis. The present value of the future cash flows is $106,000 ($73,800 + $32,200). The loss is $54,000 ($160,000 book value less $106,000).

Practice Question 25

The effect of the recognition of loss due to impairment in the years after the recognition would be to:

A. have no effect on return on assets or return on equity
B. decrease the return on equity
C. increase the return on assets
Correct Answer: C

The assets will be decreased in the years following the recognition, while the income will increase due to the fact that less depreciation is recognized.

Practice Question 26

A firm had an asset with a carrying value of $600,000. The estimated future discounted cash flows from the use of the asset have decreased to $300,000. If the fair value of the asset is $350,000, an impairment loss should be recognized in the amount of (Under U.S. GAAP):

A. $50,000
B. $250,000
C. $300,000
Correct Answer: B

The loss on impairment should be recognized for the excess of the fair value of the asset over the carrying value of the asset, if the fair value is available. If the fair value is not available, the discounted future cash flows can be used.

Practice Question 27

Under U.S. GAAP, impairment of an asset must be recognized in a firm's accounts when:

A. there has been a decrease in the market value of the asset.
B. the carrying value of the asset is higher than the expected future cash flows from the use of the asset plus its disposal value.
C. the carrying value of the asset is higher than the present value of expected future cash flows from the use of the asset plus its discounted disposal value.
Correct Answer: B

A does not automatically lead to a write down if the value of the asset can be recovered through future cash flows.

C is not correct; this is one of the calculations that can be done to work out the size of the loss on an impaired asset.

Practice Question 28

Which of the following statements is (are) true with respect to valuation impairments under the U.S. GAAP?

I. An asset is deemed as impaired if its book value exceeds its expected discounted cash flows.
II. The amount of the write-down is equal to the difference between the asset's book value and the present value of its expected cash flows even if the fair market value is available.
III. The amount of the write-down must appear on the income statement as part of continuing operations.
IV. Once the impairment has been eliminated, the asset's book value may be written back up again to better reflect economic reality.

A. I and II
B. III only
C. III and IV
Correct Answer: B

I is incorrect because the rule stipulates that the book value of the asset must exceed its undiscounted cash flows.

II is incorrect because the amount of the write-down is equal to the difference between the asset's book value and its fair market value (if it is available).

IV is incorrect because once an asset is written down, it may not be written back up again, even as the circumstances turn favorable again.

Practice Question 29

The net carrying value of a plant is $3 million. The plant is categorized as assets held for use. Based on the firm's estimate the undiscounted future cash flows from the plant will total $650k a year for the next 5 years. The fair value of the plant is estimated to be $2.5 million. Under U.S. GAAP, the impairment loss should be:

A. $0.
B. $250k.
C. $500k.
Correct Answer: A

Since the carrying value ($3 million) is less than the undiscounted future cash flows $650,000 x 5 = $3.25 million), no impairment loss should be recognized.

Practice Question 30

Regarding the reversals of impairments of long-lived assets,

A. The U.S. GAAP allows the loss to be reversed if the asset is categorized as held for use.
B. The U.S. GAAP disallows the loss to be reversed if the asset is categorized as held for sale.
C. The IFRS allows the loss to be reversed regardless of whether the asset is held for use or sale.
Correct Answer: C

The U.S. GAAP disallows the loss to be reversed if the asset is categorized as held for use, and allows if the asset is categorized as held for sale.