Question

The management of Petro Garcia Inc. was discussing whether certain equipment should be written off as a charge to current operations because of obsolescence. This equipment has a cost of $900,000 with depreciation to date of $400,000 as of December 31, 2014. On December 31, 2014, management projected its future net cash flows from this equipment to be $300,000 and its fair value to be $230,000. The company intends to use this equipment in the future.
(a) Prepare the journal entry (if any) to record the impairment at December 31, 2014.

(b) Where should the gain or loss (if any) on the write-down be reported in the income statement?

(c) At December 31, 2015, the equipment’s fair value increased to $260,000. Prepare the journal entry (if any) to record this increase in fair value.

(d) What accounting issues did management face in accounting for this impairment?

Answer 1

Answer:

Petro Garcia Inc.

a) There is no impairment in the accounting sense at December 31, 2014.  The book value of the equipment is $500,000 $(900,000 - 400,000).  The future net cash flows are $300,000 with a fair value of $230,000.  This means that the benefits from the equipment exceed the book value and not vice versa.  No journal entry is required, therefore.

b) The loss on write-down should have been reported as an expense (loss) in the income statement under Impairment Loss on Equipment.  The gain is not recognizable in this case because there is no permanent damage to the equipment.  Management still intends to continue the use of the equipment.  And the asset is generating future benefits.  Finally, the combined value of benefits and estimated resale value exceed the book value.  Conditions for impairment have not been met.

c) At December 31, 2015, when the equipment's fair value increased to $260,000, no impairment loss or gain is recognized since there is no permanent damage to the equipment and the company is still using it to generate revenue.  Impairment gain or loss is only recognized when there is a permanent reduction in value of the asset.

d) Issues faced in accounting for impairment include the assessment of the fair value and the period to test for impairment.  Fair value is determined as the total of an asset's undiscounted expected future cash flows and its expected salvage value, which is what the company expects to receive from selling or disposing of the asset at the end of its useful life.  It is not so easy to determine the fair value of an equipment in use.

The other issue is the requirement by GAAP that impairment should be tested periodically.  There is no clear definition of a good period for which impairment of a tangible asset should be tested, unlike an intangible asset, e.g. goodwill.  This later is tested annually, according to GAAP.

Explanation:

a) Impairment is a permanent reduction in the value of an asset when the total benefits expected from the asset is less than the book value.

b) The book value of an asset is the asset's value less accumulated depreciation.

c) A company checks for impairment when there is a legal or economic condition affecting the asset, or there is a change in consumer demand for the product produced by the asset, or there is a damage to the asset, or there is a change in the asset's value.