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Chapter 9: Problem 8

When is a plant asset considered to be impaired? How is an impairment loss calculated?

Short Answer

Expert verified
An asset is impaired when its carrying amount exceeds its recoverable amount. The impairment loss is calculated as the carrying amount minus the recoverable amount.

Step by step solution

01

Understanding Asset Impairment

An asset is considered impaired when its carrying amount (the value of the asset on the balance sheet) is not recoverable and exceeds its fair value. This determination typically occurs when aspects such as market conditions, technological changes, or declining economic performance indicate that an asset's value has fallen.
02

Identifying Signs of Impairment

Management must regularly review plant assets for indications of impairment. Possible signs include a significant decrease in market value, changes in technology or market demand, and legal or economic changes affecting the business.
03

Determining the Recoverable Amount

The recoverable amount of the asset is the higher of its fair value less costs to sell and its value in use. Fair value less costs to sell is the amount that could be obtained from selling the asset in an orderly transaction, minus the costs of disposal. Value in use is the present value of future cash flows expected to be derived from the asset.
04

Calculating the Impairment Loss

An impairment loss is calculated as the amount by which the carrying amount of the asset exceeds its recoverable amount. The formula is: \[ ext{Impairment Loss} = ext{Carrying Amount} - ext{Recoverable Amount}.\]
05

Recording the Impairment Loss

The impairment loss is reported in the financial statements for the period in which the impairment is identified. It decreases the value of the asset on the balance sheet and is recognized as an expense on the income statement.

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Key Concepts

These are the key concepts you need to understand to accurately answer the question.

Carrying Amount
The carrying amount is a crucial accounting concept that refers to the value of an asset as recorded on a company's balance sheet. Essentially, it represents the cost of the asset minus any accumulated depreciation or amortization. This is the book value of the asset, and it is used to assess whether an asset might be impaired.
  • Example: If a machine was initially purchased for $100,000 and has accumulated depreciation of $30,000, the carrying amount would be $70,000.
  • Significance: Comparing the carrying amount with the recoverable or fair value helps determine if an asset is impaired.
It is important to note that the carrying amount does not always represent the fair market value, as it primarily reflects historical cost and the allocation of that cost over the asset's useful life.
Fair Value
Fair value is an estimate of the price at which an asset would sell in an orderly, arm's-length transaction between market participants. This concept reflects current market conditions rather than historical cost and aims to provide a realistic value of an asset based on present circumstances.
  • Determination: Fair value is often assessed by looking at comparable market transactions or using valuation techniques, such as discounted cash flow analysis.
  • Market Influences: Economic changes, shifts in consumer demand, or technological advancements can affect the fair value of an asset.
Understanding the fair value is essential when determining an asset's impairment status since it represents the market's perception of the asset's worth.
Recoverable Amount
The recoverable amount is a key figure in determining if an asset is impaired. It represents the maximum amount that can be recovered from an asset through its use or sale. In impairment testing, it is the figure against which the carrying amount is compared.
  • Components: The recoverable amount is the higher of an asset's "fair value less costs to sell" and its "value in use."
  • Fair Value Less Costs to Sell: This is the potential sale price in an orderly transaction minus selling expenses.
  • Value in Use: This involves calculating the present value of future cash flows expected from the asset.
The concept ensures that an asset is carried in the financial statements at no more than what could potentially be recovered from its use or disposal.
Impairment Loss Calculation
Impairment loss calculation is an essential process that involves determining by how much an asset's carrying amount exceeds its recoverable amount. This calculation identifies the loss in value the asset has undergone, which needs to be recognized in financial statements.
  • Formula: The impairment loss is computed with the formula: \( \text{Impairment Loss} = \text{Carrying Amount} - \text{Recoverable Amount} \).
  • Recording: Once calculated, this loss decreases the asset's value on the balance sheet and is treated as an expense on the income statement.
  • Importance: This ensures financial records accurately reflect the true value of the company's assets.
This process helps maintain transparency and accuracy in financial reporting, ensuring all stakeholders have a clear picture of the company's financial health.

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Most popular questions from this chapter

Accounting for Plant Assets Ethan Corporation had the following transactions related to its delivery truck: Year 1 Jan. 5 Purchased for \(\$ 28,000\) cash a new truck with an estimated useful life of four years and a salvage value of \(\$ 4,000\). Feb. \(\quad 20\) Installed a new set of side-view mirrors at a cost of \(\$ 80\) cash. June \(\quad 9\) Paid \(\$ 325\) for an engine tune-up, wheel balancing, and a periodic chassis lubrication. Aug. 2 Paid a \(\$ 410\) repair bill for the uninsured portion of damages to the truck caused by Ethan's own driver. Dec. 31 Recorded depreciation on the truck for the year. Year 2 May 1 Installed a set of parts bins in the truck at a cost of \(\$ 950 \mathrm{cash}\). This expenditure was not expected to increase the salvage value of the truck. Dec. 31 Recorded depreciation on the truck for the year. Year 3 Dec. 31 Recorded depreciation on the truck for the year. Ethan's depreciation policies include (1) using straight-line depreciation, (2) recording depreciation to the nearest whole month, and (3) expensing all truck expenditures of \(\$ 100\) or less. Required Prepare journal entries to record these transactions and adjustments.

Acquisition Cost of Long-Lived Asset Derrick Construction purchased a used front-end loader for \(\$ 32,000\), terms \(2 / 10, n / 30\), F.O.B. shipping point, freight collect. Derrick paid the freight charges of \(\$ 330\) and sent the seller a check for \(\$ 31,360\) one week after the machine was delivered. The loader required a new battery, which cost Fischer \(\$ 180\). Derrick also spent \(\$ 240\) to have the company name printed on the loader and \(\$ 375\) for one year's insurance coverage on it. Derrick hired a new employee to operate it at a wage of \(\$ 20\) per hour; the employee spent one morning (eight hours) practicing with the machine and went to work at a construction site that afternoon. Calculate the amount at which the front-end loader should be reported on the company's balance sheet.

Return on Assets The Queen Company reported net income of \(\$ 80,000\) and average total assets of \(\$ 450,000\). Calculate the company's return on assets.

Amortization Expense For each of the following unrelated situations, calculate the annual amortization expense and prepare a journal entry to record the expense: a. A patent with a 15 -year remaining legal life was purchased for \(\$ 756,000\). The patent will be commercially exploitable for another six years. b. A patent was acquired on a device designed by a production worker. Although the cost of the patent to date consisted of \(\$ 88,200\) in legal fees for handling the patent application, the patent should be commercially valuable during its entire remaining legal life of 15 years and is currently worth \(\$ 720,000\). c. A franchise granting exclusive distribution rights for a new wind turbine within a three-state area for four years was obtained at a cost of \(\$ 72,000\). Satisfactory sales performance over the four years permits renewal of the franchise for another four years (at an additional cost determined at renewal).

Disposal of Plant Asset Ben Company has a used executive charter plane that originally cost \(\$ 1,000,000\). Straight-line depreciation on the plane has been recorded for six years, with a \(\$ 100,000\) expected salvage value at the end of its estimated eight-year useful life. The last depreciation entry was made at the end of the sixth year. Eight months into the seventh year, Ben disposes of the plane. Required Prepare journal entries to record: a. Depreciation expense to the date of disposal. b. Sale of the plane for cash at its book value. c. Sale of the plane for \(\$ 300,000\) cash. d. Sale of the plane for \(\$ 220,000\) cash. e. Destruction of the plane in a fire. Ben expects a \(\$ 210,000\) insurance settlement.
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