Level 1 CFA® Exam:
Revaluation Model, Impairment & Derecognition of Assets
Accounting standards distinguish between 2 models used for determining the net book value of long-lived assets. These are:
- cost model, and
- revaluation model.
Remember: U.S. GAAP allow the cost model only, while according to IFRS both models can be used.
Revaluation to Fair Value
According to the revaluation model, a long-lived asset is reported at fair value at the date of revaluation less subsequent depreciation or amortization and impairment. So, any changes in the asset’s fair value are reflected in financial statements.
The effect of revaluation may or may not affect the company’s income statement. It depends on whether the revaluation decreased or increased the carrying amount of the asset.
- If initially, a decrease in the asset’s carrying amount occurs, it is included in the income statement. Then, if the asset’s fair value increases, the effect of revaluation will also be reported in the income statement up to the value of the historical cost less accumulated depreciation. If the fair value is bigger than this amount, the excess will be reported as other comprehensive income and included in accumulated other comprehensive income in equity under the heading of revaluation surplus.
- If initially there is an upward revaluation, it won’t be recognized in the income statement, but it will be recorded as other comprehensive income. Subsequent downward revaluations reduce equity, not more – however – than to the value of the previous revaluation.
Pipa Inc. decided to buy equipment for USD 50,000. After the first year, the fair value of the equipment amounted to USD 55,000, and after the second year to USD 44,000. The company uses the revaluation model to report long-lived assets. How do the changes in the equipment’s fair value affect the company’s balance sheet and income statement?
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Note that asset revaluation affects assets, equity, depreciation expense, and net income.
If the upward revaluation impacts other comprehensive income rather than net income, it leads to lower ROA and ROE ratios. However, if the upward revaluation affects net income because it is a reversal of the previous downward revaluation, such upward revaluation may even result in higher ROA and ROE ratios.
What is the effect of an increase in the revaluation surplus on the total assets-to-equity ratio?
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If you think about depreciation or amortization of assets on the one hand and impairment of assets, on the other hand, the difference between these concepts is that depreciation and amortization are planned reductions of an asset’s value, whereas impairment is all about the decline in an asset’s value, which cannot be anticipated.
We begin our analysis of assets' impairment with PP&E. Then, we take a look at intangible assets with finite lives, which are followed by intangible assets with indefinite lives.
PP&E
Under IFRS, companies are obliged to assess whether their long-lived tangible assets held for use are impaired or not every year. If a company considers that there have occurred indicators of impairment, the assets are tested for impairment.
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Three years ago, LinC, Inc. purchased a processing line for USD 100,000. The fair value of the line less costs to sell is USD 79,000 and the value in use amounts to USD 78,000. The company estimates undiscounted expected future cash flows from using the processing line to be USD 82,000. What is the value of the impairment loss under IFRS and under U.S. GAAP assuming that the carrying amount is USD 80,000?
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Intangible Assets
Impairment of an intangible asset depends on whether we are dealing with an intangible asset with a finite or indefinite life.
In the case of an asset with an indefinite life and goodwill, the asset should be tested for impairment at least annually.
In the case of an asset with a finite life, the impairment process is conducted in the same way as for PP&E. The asset will be tested for impairment only if there have occurred indicators of impairment.
Companies not only buy or manufacture assets but also dispose of them. If the asset is disposed of, it should be derecognized in the balance sheet. Examples of asset disposals include:
- sale,
- abandonment,
- exchange for other assets, and
- spin-off.
We talk of a spin-off when a new entity is separated from a parent company.
If a company decides to abandon or exchange assets or if it spins off its part into a separate company, the assets will be reclassified as long-lived assets held for use until disposal.
Now assume that a company sells a long-lived asset. If the asset is sold, the company will usually record a gain or loss, depending on the relation between sales proceeds and the carrying amount of the asset.
On 1 January 2018, a company purchased a machinery for USD 200,000. The useful life of the machinery and its salvage value were estimated at 10 years and USD 30,000, respectively. On 31 December 2022, the company sold the machinery for USD 120,000. Decide whether a company incurred a loss or made a gain?
Assume that:
- the company uses the straight-line depreciation method and reports assets at their historical cost less impairment less accumulated depreciation.
- between 1 January 2018 and 31 December 2022 there was no impairment loss.
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We distinguish among:
- long-lived assets held for use,
- long-lived assets held for use until disposal, and
- non-current assets held for sale.
You should know the differences and similarities between them. For example, the first two are depreciated and tested for impairment, while non-current assets held for sale are not. Also remember that under U.S. GAAP, impairment reversal is allowed only for non-current assets held for sale.
Level 1 CFA Exam Takeaways: Revaluation Model, Impairment & Derecognition of Assets
star content check off when done- Accounting standards distinguish between 2 models used for determining the net book value of long-lived assets: the cost model and the revaluation model.
- U.S. GAAP allow the cost model only, while according to IFRS cost model and revaluation model can be used.
- According to the revaluation model, a long-lived asset is reported at fair value at the date of revaluation less subsequent depreciation or amortization and impairment.
- Depreciation and amortization are planned reductions of an asset’s value.
- Impairment is about the decline in an asset’s value, which cannot be anticipated.
- Under IFRS, companies are obliged to assess whether their long-lived tangible assets held for use are impaired or not every year.
- Under IFRS the impairment reversal is allowed if the value of the asset increases in the future.
- U.S. GAAP do not allow impairment reversal.
- In the case of an asset with an indefinite life and goodwill, the asset should be tested for impairment at least annually.
- Examples of asset disposals include: sale, abandonment, exchange for other assets, and spin-off.
- We talk of a spin-off when a new entity is separated from a parent company.
- We distinguish among: long-lived assets held for use, long-lived assets held for use until disposal, and non-current assets held for sale.