Impairment, Revaluation and Derecognition

The impairment, revaluation, and derecognition of a company’s property, plant, and equipment, as well as its intangible assets, can significantly affect its financial statements and the financial ratios derived from them.

The Effect of Impairment, Revaluation, and Derecognition on Financial Statements and Ratios

Impairment

Impairment losses for property, plant, equipment, and intangible assets are recognized whenever the asset’s carrying amount is more than the recoverable amount. When this occurs, the asset is written down to the recoverable amount, and any loss is reported in the income statement. A new depreciation (or amortization) schedule based on the new carrying amount would need to be developed.

Impairment losses, therefore, result in a reduction in the carrying amount of assets on the balance sheet as well as the net income reported on the income statement. They do not, however, impact cash from operations.

Revaluation

Revaluation of a company’s long-lived assets changes their carrying amounts to fair value. This fair value is reflected on the company’s balance sheet. If revaluation results in an increase in the carrying amount, the increase in the asset’s value will appear in other comprehensive income and be accumulated in equity under the heading of revaluation surplus. If on the other hand, revaluation results in a decrease in the carrying amount, any previously accumulated amount in equity reflected as revaluation surplus will be reduced, and the difference will be shown as a loss on the income statement.

The use of the revaluation model instead of the cost model can therefore significantly impact the comparison of the financial statements and ratios of companies that use different models.

Derecognition

An asset is derecognized whenever it is disposed of or is expected to provide no future benefits emanating either from its use or disposal.

Gains or losses from the sale of assets are disclosed on the income statement, either as a component of other gains and losses or in a separate line item when the amount is material.

When an asset is retired, or abandoned, its value is reduced by the carrying amount as at the time of its retirement or abandonment. A loss equal to the asset’s carrying amount is then recorded.

When an asset is exchanged, its carrying amount is removed, the fair value of the acquired asset is added, and any difference between the carrying amount and the fair value is reported either as a gain or loss.

Question 1

Which of the following statements is the most accurate?

1. Impairment losses reduce the carrying amount of assets and increase the net income reported on the income statement.
2. If revaluation results in an increase in an asset’s carrying amount, the increase in the asset’s value will appear as a gain on the income statement.
3. When an asset is retired, its value is reduced by the carrying amount as at the time of its retirement, and a loss equal to its carrying amount is recorded.

Solution

The correct answer is C.

A is  incorrect because impairment losses reduce the carrying amount of assets aside from reducing, not increasing, the net income reported on the income statement.

B is incorrect because if revaluation results in the increase of an asset’s carrying amount, the increase in the asset’s value will appear in other comprehensive income and will be accumulated in equity under the heading of revaluation surplus.

Question 2

After the revaluation of a machine with a carrying value of $100,000, it was found that the fair value for that machine was $120,000. How would the revaluation surplus affect net income?

1. The revaluation surplus would not affect net income.
2. The revaluation surplus would increase net income by 20,000.
3. The revaluation surplus would decrease net income by 20,000.

Solution

The correct answer is A.

The revaluation surplus would not affect net income, since it should be added directly to equity.