Impairment, Revaluation, and Derecognition: Mastering Asset Value Adjustments | CFA Level I FSA

Asset values can fluctuate unexpectedly, and impairment, revaluation, and derecognition methods allow firms to adjust an asset’s carrying value based on market changes. We’ll discuss the IFRS and US GAAP treatments and the impact these transactions have on financial statements and ratios.

Impairment and Revaluation

When asset values get impaired, firms need to write them down. The treatment varies based on the type of asset and the reporting standard. Let’s break it down for Property, Plant, and Equipment (PP&E) under IFRS and US GAAP:

IFRS Treatment for PP&E

• Cost Model: PP&E (excluding land) is reported at amortized cost, which is historical cost minus accumulated depreciation. Assets must be tested for impairment at least annually.
  • Impairment Calculation: If an asset’s carrying value exceeds the recoverable amount (the greater of fair value less selling costs or value in use), the asset is written down to its recoverable amount, and a loss is recognized in the income statement.
  • Loss Reversal: If the impaired asset’s value recovers, loss reversal up to the original loss is allowed under IFRS.
• Revaluation Model: PP&E is reported at fair value, less any accumulated depreciation.
  • Revaluation: At each revaluation date, the balance sheet value is adjusted to fair value, and depreciation is recorded between revaluation dates.
  • Loss Recognition and Reversal: If an asset is revalued below its historical cost, a loss is taken to the income statement. Subsequent reversals are recognized in the income statement up to the original loss. Any increase in value above the historical cost is taken to shareholders’ equity.

US GAAP Treatment for PP&E

• Cost Model Only: Under US GAAP, only the cost model is allowed, and the revaluation model is prohibited.
  • Impairment Calculation: An asset is considered impaired if the carrying value is greater than the asset’s future undiscounted cash flow stream. If impaired, the asset is written down to its fair value or the discounted value of its future cash flows, and a loss is recognized in the income statement.
  • Loss Recovery: Loss recoveries are not permitted under US GAAP.

Derecognition of Assets

Derecognition occurs when assets are sold, exchanged, or abandoned. Here’s how it works:

• Sold Assets: The difference between the sale proceeds and the carrying value of the asset is reported as a gain or loss in the income statement. The cash flow statement treats the proceeds from selling a long-lived asset as an investing cash inflow, not operating cash flow.
• Abandoned Assets: The carrying value of the asset is removed from the balance sheet, and a loss of that amount is recognized in the income statement.
• Exchanged Assets: A gain or loss is computed by comparing the carrying value of the old asset with the fair value of the new asset. The carrying value of the old asset is removed from the balance sheet, and the new asset is recorded at its fair value.

Intangible Assets

Finite-life intangible assets are amortized over their useful lives and tested for impairment similarly to PP&E. Under IFRS, the revaluation method is also permitted if an active market for the intangible asset exists.

Intangible assets with indefinite lives, like goodwill, are not amortized but are tested for impairment at least annually. An impairment loss is recognized when the carrying value exceeds fair value.

Assets Held for Sale

When a long-lived asset is reclassified as held for sale, it is no longer depreciated or amortized. If impaired, the asset is written down to the net realizable value, and the loss is recognized in the income statement. Loss reversals are allowed under both IFRS and US GAAP, limited to the original impairment loss.

Impairments, Revaluations, and Derecognition Impact on Financial Statements and Ratios

When long-lived assets’ circumstances differ from expectations, impairments and revaluations are used to adjust the balance sheet. These adjustments have various impacts on financial statements and ratios:

Impairment of Assets

• Reduces carrying value on the balance sheet and recognizes an impairment loss in the income statement.
• Decreases ROA and ROE due to reduced net income and both assets and equity being reduced.
• Increases asset turnover as total assets are reduced.
• In subsequent periods, net income, ROA, and ROE will be higher due to lower depreciation and reduced assets and equity.
• Impairment has no impact on cash flow as it is an unrealized loss until the asset is disposed of.
• Impairment decisions can be used by management to manipulate earnings.

Revaluation of Assets (under IFRS)

• Upward revaluation increases total assets and shareholders’ equity.
• Net income is not affected, as upward revaluation above historical cost is taken to stockholders’ equity as comprehensive income.
• Leverage ratios decrease due to higher assets and equity.
• In subsequent periods, higher depreciation expense leads to lower net income, ROA, and ROE. However, higher operating capacity can result in higher revenues and earnings.

Disclosure Requirements

Proper disclosures of accounting decisions for long-lived assets are crucial under IFRS and US GAAP:

IFRS Disclosures

For property, plant, and equipment (PP&E), intangible assets, and investment property, disclosures include:

• Basis for measurement, useful life, gross carrying value, and reconciliation of beginning to ending values.
• If revaluation model is used, disclose revaluation date, fair value determination method, and carrying value using the historical cost model.
• Disclose title restrictions, assets pledged as collateral, and agreements to acquire PP&E in the future.
• For impaired assets, disclose impairment losses and reversals, where losses and reversals are recognized in the income statement, and circumstances causing impairment or reversal.
• For intangible assets, disclose whether useful lives are finite or indefinite.
• For investment property, disclose the chosen reporting model (cost or fair value).

US GAAP Disclosures

For PP&E and intangible assets, disclosures include:

• Accumulated depreciation, depreciation methods, depreciation expense, and balances of major asset classes.
• For impaired assets, disclose a description of the impaired asset, circumstances causing impairment, fair value determination method, amount of loss, and where the loss is recognized in the income statement.
• For intangible assets, provide an estimate of amortization expense for the next five years.

And there you have it! While this topic can be a bit dry and requires some memorization, revisiting it before the exam will help ensure it stays fresh in your mind.