THE DIFFERENCES BETWEEN REVALUATION AND ASSETS IMPAIRMENT

THE DIFFERENCES BETWEEN REVALUATION AND ASSETS IMPAIRMENT NICOLAE BOBIȚAN, DIANA DUMITRESCU, CARMEN COSTULEANU WEST UNIVERSITY OF TIMISOARA nicubbitan@yah.cm, dianadumi@gmail.cm USAVM IASI ccstuleanu@yah.cm Abstract: Impairment and revaluatin are terms clsely related t ne anther, with subtle differences. Revaluatin and impairment bth require the cmpany t evaluate the assets fr their fair value, and then take apprpriate actin in updating the accunting bks. The majr difference between the tw is that a revaluatin can be made upwards (t increase the value f the asset t market value) r dwnwards (t decrease the value). An impairment, n the ther hand, nly refers t ne f the tw; a fall in the market value which is then written dwn. The purpse f the paper is t establish what are the differences between revaluatin and impairment f assets. Keywrds: revaluatin, impairment, fair value, carrying value, fixed assets JEL classificatin: M41 Intrductin Fixed assets such as machinery, tls, equipment are tangible lng term assets that are nt sld in the business, rather used in the prductin f gds and services. Fixed assets are recrded in the bks at their cst price and are then frequently updated t shw their true and fair market value. IAS/IFRS require fixed assets t be initially recrded at cst but they allw tw mdels fr subsequent accunting fr fixed assets, namely the cst mdel and the revaluatin mdel. Revaluatins and impairments are clsely related events in asset management, they relate directly t the 'measurement f asset carrying values after recgnitin', whether the cst mdel r the revaluatin mdel is adpted. Revaluatin f fixed assets is the prcess f increasing r decreasing their carrying value in case f majr changes in fair market value f the fixed asset. Revaluatin is a technique that helps determine the true and fair market value f a fixed asset. Impairment ccurs when the ecnmic value f an asset falls belw its carrying value r net bk value. This implies that the current carrying value f the asset may nt be ecnmically recvered in its current circumstances ver its remaining useful life. There may be instances in which a fixed asset lses its value and needs t be written dwn in the accunting bks f the firm. An asset can becme impaired fr a number f reasns, which include becming bslete, failing t meet regulatry standards, damages t the asset, changing market cnditins, etc. Other cmpany accunts such as a gdwill and accunts receivable can als becme impaired. Firms are required t cnduct regular tests n asset impairment (especially n gdwill) and any impairment then will be written ff. 64

Revaluatin IAS 16 prvides fr tw acceptable alternative appraches t accunting fr lng-lived tangible assets. The first ne is the histrical cst mdel, under which acquisitin r cnstructin cst is used fr initial recgnitin, subject t depreciatin ver the expected ecnmic life and t pssible write-dwn in the event f a permanent impairment in value, and the ther ne is the revaluatin mdel. Revaluatin helps t determine and accunt a fixed asset at the true and fair market value. When a revaluatin is dne, the asset s recrded value (histrical cst value in the ledger) will be adjusted t the market value. The histrical values recrded in the bks are nt accurate since the market value f the asset will fluctuate and may be higher r lwer ver time. A revaluatin will be dne t establish the mst accurate accunting infrmatin regarding the asset s value. In the revaluatin mdel, the fair value (defined as the amunt fr which the asset culd be exchanged between knwledgeable, willing parties in an arm s-length transactin), it is used in rder t make cmparisin and t determine the differences that will be registred like revaluatins adjustments. Usually, the fair value is determined by appraisers, using market-based evidence. Market values can als be used fr machinery and equipment, but since such items ften d nt have readily determinable market values, particularly if intended fr specialized applicatins, they may instead be valued at depreciated replacement cst. The revaluatin must be dne by licensed specialists wh will have t study markets carefully where such assets are sld in rder t determine the accurate market value. Besides determining the true market value f a fixed asset, revaluatin can be used t set funds aside fr the replacement f the asset, t negtiate prices in a merger r acquisitin, fr taking lans my mrtgaging fixed assets, fr regulatry reasns, etc. Under the revaluatin mdel, revaluatins shuld be carried ut regularly, s that the carrying amunt f an asset des nt differ materially frm its fair value at the balance sheet date. If an item is revalued, the entire class f assets t which that asset belngs shuld be revalued. Accunting fr revaluatin adjustments If a revaluatin results in an increase in value, it shuld be credited t ther cmprehensive incme and accumulated in equity under the heading "revaluatin surplus" unless it represents the reversal f a revaluatin decrease f the same asset previusly recgnised as an expense, in which case it shuld be recgnised as incme. A decrease arising as a result f a revaluatin shuld be recgnised as an expense t the extent that it exceeds any amunt previusly credited t the revaluatin surplus relating t the same asset. When a revalued asset is dispsed f, any revaluatin surplus may be transferred directly t retained earnings, r it may be left in equity under the heading revaluatin surplus. The transfer t retained earnings shuld nt be made thrugh the incme statement (that is, n "recycling" thrugh prfit r lss). S, generally, revaluatin adjustments are t be recgnized in ther cmprehensive incme and accumulated in equity under the heading f revaluatin surplus. If a revalued asset is subsequently fund t be impaired, the impairment prvisin is first ffset against the revaluatin surplus, and nly when that has been exhausted is it expensed. Equally, if an asset carried at histrical cst had been impaired, but was subsequently revalued abve histrical cst, because f sme dramatic change in ecnmic circumstances, the previus impairment prvisin wuld 65

flw back thrugh prfit, and nly the increase abve histrical cst wuld be recgnized in ther cmprehensive incme and accumulated in equity. Under the prvisins f IAS 16, the amunt credited t revaluatin surplus can either be transferred t retained earnings, but nt thrugh prfit r lss, as the asset is being used by an entity, r it can be held in the surplus accunt until such time as the asset is dispsed f r retired frm service. If sme f the surplus is transferred as the asset is used, the amunt f surplus transferred is limited t the difference between depreciatin based n the revalued carrying amunt f the asset and depreciatin based n the asset s histrical cst. Example fr revaluatin adjustments: At the beginning f the year a cmpany purchased a building with a carrying value f 400,000 and a useful life f 20 years and the cmpany uses straight line depreciatin. S, yearly depreciatin is hence 400,000/20 r 20,000. Accumulated depreciatin after 3 years is 20,000*3 r 60,000 and the carrying amunt is 400,000 minus 60,000 which equals 340,000. At this mment the cmpany use revaluatin mdel and carries ut a revaluatin exercise which estimates the fair value f the building t be $380,000 as at this date. The carrying amunt at the date is $340,000 and revalued amunt is $380,000 s result, an upward adjustment f $40,000 is required t building accunt. It is recrded thrugh the fllwing jurnal entry: Building 40,000 Revaluatin Surplus 40,000 Upward revaluatin is nt cnsidered a nrmal gain and is nt recrded in incme statement rather it is directly credited t an equity accunt called revaluatin surplus. Revaluatin surplus hlds all the upward revaluatins f a cmpany's assets until thse assets are dispsed f. The depreciatin in perids after revaluatin is based n the revalued amunt. In case f the same example depreciatin fr the next year shall be the new carrying amunt divided by the remaining useful life r 380,000/17 which equals 22,352. If a revalued asset is subsequently valued dwn due t impairment, the lss is first written ff against any balance available in the revaluatin surplus and if the lss exceeds the revaluatin surplus balance f the same asset the difference is charged t incme statement as impairment lss. Suppse after 2 years the cmpany revalues the building again t find ut that the fair value shuld be 320,000. Carrying amunt as at this mment is $380,000 minus 2 years depreciatin f 44,704 which amunts t 335,296. The carrying amunt exceeds the fair value by 15,296 s the accunt balance shuld be reduced by that amunt. Already, there is a balance f 20,000 in the revaluatin surplus accunt related t the same building, s n impairment lss shall g t incme statement. The jurnal entry wuld be: Revaluatin Surplus 15,296 Building Accunt 15,296 Otherwise, if the fair value been 280,000 the excess f carrying amunt ver fair value wuld have been 55,296. In that situatin the fllwing jurnal entry wuld have been required. Revaluatin Surplus 40,000 Impairment Lsses 15,296 Building 40,000 Accumulated 15,296 Impairment Lsses 66

Impairment On the ther side, impairment is the ther aspect f changing the value f an asset, there may be instances in which a fixed asset lses its value and needs t be written dwn in the accunting bks f the firm. In such an instance, the value will be written dwn t its true market price r will be sld. An asset that lses its value and needs t be written dwn is referred t as an impaired asset. Once an asset has been impaired, there is very little pssibility fr the asset t be written up; therefre, the asset must be carefully evaluated befre it is categrized as an impaired asset. IAS 36 defines impairment as the excess f carrying value ver recverable amunt, and defines recverable amunt as the greater f tw alternative measures: net selling price and value in use. At each balance sheet date, review all assets t lk fr any indicatin that an asset may be impaired, its carrying amunt may be in excess f the greater f its net selling price and its value in use. IAS 36 has a list f external and internal indicatrs f impairment. If there is an indicatin that an asset may be impaired, then yu must calculate the asset's recverable amunt. An asset can becme impaired fr a number f reasns, which include becming bslete, failing t meet regulatry standards, damages t the asset, changing market cnditins, etc. Other cmpany accunts such as a gdwill and accunts receivable can als becme impaired. Firms are required t cnduct regular tests n asset impairment (especially n gdwill) and any impairment then will be written ff. Indicatins f impairment culd be frm external surces (market value declines, negative changes in technlgy, markets, ecnmy, r laws, increases in market interest rates, cmpany stck price is belw bk value) r frm internal surces (bslescence r physical damage, asset is part f a restructuring r held fr dispsal, wrse ecnmic perfrmance than expected). The fllwing external and internal signs f pssible impairment are t be given cnsideratin: 1. Market value declines fr specific assets r cash generating units, beynd the declines expected as a functin f asset aging and use; 2. Significant changes in the technlgical, market, ecnmic, r legal envirnments in which the enterprise perates, r the specific market t which the asset is dedicated; 3. Increases in the market interest rate r ther market-riented rate f return such that increases in the discunt rate t be emplyed in determining value in use can be anticipated, with a resultant enhanced likelihd that impairments will emerge; 4. Declines in the (publicly wned) entity s market capitalizatin suggest that the aggregate carrying value f assets exceeds the perceived value f the enterprise taken as a whle; 5. There is specific evidence f bslescence r f physical damage t an asset r grup f assets; 6. There have been significant internal changes t the rganizatin r its peratins, such as prduct discntinuatin decisins r restructurings, s that the expected remaining useful life r utility f the asset has seemingly been reduced; and 7. Internal reprting data suggest that the ecnmic perfrmance f the asset r grup f assets is, r will becme, wrse than previusly anticipated. The mere fact that ne r mre f the freging indicatrs suggests that there might be cause fr cncern abut pssible asset impairment des nt necessarily mean that frmal impairment testing must prceed in every instance, althugh in the absence f a plausible explanatin why the signals f pssible impairment shuld nt be further cnsidered, the implicatin wuld be that sme fllw-up investigatin is needed. 67

These lists are nt intended t be exhaustive. Further, an indicatin that an asset may be impaired may indicate that the asset's useful life, depreciatin methd, r residual value may need t be reviewed and adjusted. The recverable amunt f an asset is the greater f its fair value less csts t sell and its value in use. T measure impairment, the asset s carrying amunt is cmpared with its recverable amunt. Recverable amunt is higher then fair value less csts t sell and value in use. Determining recverable amunt If fair value less csts t sell r value in use is mre than carrying amunt, it is nt necessary t calculate the ther amunt. The asset is nt impaired. If fair value less csts t sell cannt be determined, then recverable amunt is value in use. Fr assets t be dispsed f, recverable amunt is fair value less csts t sell. Fair value less csts t sell If there is a binding sale agreement, use the price under that agreement less csts f dispsal. If there is an active market fr that type f asset, use market price less csts f dispsal. Market price means current bid price if available, therwise the price in the mst recent transactin. If there is n active market, use the best estimate f the asset's selling price less csts f dispsal. Csts f dispsal are the direct added csts nly (nt existing csts r verhead). Value in use The calculatin f value in use shuld reflect the fllwing elements: an estimate f the future cash flws the entity expects t derive frm the asset expectatins abut pssible variatins in the amunt r timing f thse future cash flws the time value f mney, represented by the current market risk-free rate f interest the price fr bearing the uncertainty inherent in the asset ther factrs, such as illiquidity, that market participants wuld reflect in pricing the future cash flws the entity expects t derive frm the asset Cash flw prjectins shuld be based n reasnable and supprtable assumptins, the mst recent budgets and frecasts, and extraplatin fr perids beynd budgeted prjectins. IAS 36 presumes that budgets and frecasts shuld nt g beynd five years; fr perids after five years, extraplate frm the earlier budgets.management shuld assess the reasnableness f its assumptins by examining the causes f differences between past cash flw prjectins and actual cash flws. Cash flw prjectins shuld relate t the asset in its current cnditin future restructurings t which the entity is nt cmmitted and expenditures t imprve r enhance the asset's perfrmance shuld nt be anticipated. Estimates f future cash flws shuld nt include cash inflws r utflws frm financing activities, r incme tax receipts r payments. Discunt rate In measuring value in use, the discunt rate used shuld be the pre-tax rate that reflects current market assessments f the time value f mney and the risks specific t the asset. The discunt rate shuld nt reflect risks fr which future cash flws have been adjusted and shuld equal the rate f return that investrs wuld require if they were t 68

chse an investment that wuld generate cash flws equivalent t thse expected frm the asset. Fr impairment f an individual asset r prtfli f assets, the discunt rate is the rate the entity wuld pay in a current market transactin t brrw mney t buy that specific asset r prtfli. If a market-determined asset-specific rate is nt available, a surrgate must be used that reflects the time value f mney ver the asset's life as well as cuntry risk, currency risk, price risk, and cash flw risk. The fllwing wuld nrmally be cnsidered: the entity's wn weighted average cst f capital; the entity's incremental brrwing rate; and ther market brrwing rates. Cash-generating units Recverable amunt shuld be determined fr the individual asset, if pssible. If it is nt pssible t determine the recverable amunt (fair value less cst t sell and value in use) fr the individual asset, then determine recverable amunt fr the asset's cash-generating unit (CGU). The CGU is the smallest identifiable grup f assets that generates cash inflws that are largely independent f the cash inflws frm ther assets r grups f assets. When carried ut, the test is applied t the smallest grup f assets fr which the entity has identifiable cash flws, called a cash generating unit. The carrying amunt f the asset r assets in the cash generating unit (cash generating unit) is cmpared with the fair value and the present value f the cash flws expected t be generated by using the asset ( value in use ). If the higher f these future values is lwer than the carrying amunt, an impairment is recgnized fr the difference. The standard prvides a set f indicatrs f ptential impairment and suggests that these represent a minimum array f factrs t be given cnsideratin. Other mre industry-r entity-specific gauges culd be devised by the reprting enterprise. Recgnitin f an impairment lss An impairment lss shuld be recgnised whenever recverable amunt is belw carrying amunt. The impairment lss is an expense in the incme statement (unless it relates t a revalued asset where the value changes are recgnised directly in equity). Adjust depreciatin fr future perids. The bjective is t recgnize an impairment when the ecnmic value f an asset (r cash generating unit cmprised f a grup f assets) is truly belw its bk (carrying) value. In thery, and fr the mst part in practice als, an entity making ratinal chices wuld sell an asset if its net selling price (fair value less csts f dispsal) were greater than the asset s value in use, and wuld cntinue t emply the asset if value in use exceeded salvage value. Thus, the ecnmic value f an asset is mst meaningfully measured with reference t the greater f these tw amunts, since the entity will either retain r dispse f the asset, cnsistent with what appears t be its highest and best use. Once recverable amunt has been determined, this is t be cmpared t carrying value; if recverable amunt is lwer, the asset has been impaired, and this impairment must be given accunting recgnitin. It shuld be nted that value in use is an entity-specific value, in cntrast t fair value, which is based n market price. Value in use is thus a much mre subjective measurement than is fair value, since it takes accunt f factrs available nly t the individual business, which may be difficult t validate. The determinatin f the fair value less csts t sell (i.e., net selling price) and the value in use f the asset being evaluated will typically present sme difficulties. Fr actively traded assets, fair value can be ascertained by reference t 69

publicly available infrmatin (e.g., frm price lists r dealer qutatins), and csts f dispsal will either be implicitly factred int thse amunts (such as when a dealer qute includes pick-up, shipping, etc.) r else can be readily estimated. Mst cmmn prductive tangible assets, such as machinery and equipment, will nt easily be priced, hwever, since active markets fr used items will either nt exist r be relatively illiquid. It will ften be necessary t reasn by analgy (i.e., t draw inferences frm recent transactins in similar assets), making adjustments fr age, cnditin, prductive capacity, and ther variables. Accunting fr impairments If the recverable amunt f the cash generating unit is lwer than its carrying value, an impairment must be recgnized. The mechanism fr recrding an impairment lss depends upn whether the entity is accunting fr lng-lived assets n the amrtized histrical cst r revaluatin basis. Impairments cmputed fr assets carried at histrical cst will be recgnized as charges against current perid prfit, either included with depreciatin fr financial reprting, r identified separately in the statement f cmprehensive incme (r in the separate incme statement, reprting cmpnents f prfit r lss, if the presentatin f cmprehensive incme is achieved in tw statements). Fr assets gruped int cash generating units, it will nt be pssible t determine which specific assets have suffered impairment lsses when the unit as a whle has been fund t be impaired, and s IAS 36 prescribes a frmulaic apprach. If the cash generating unit in questin has been allcated any gdwill, any impairment shuld be allcated fully t gdwill, until its carrying value has been reduced t zer. Any further impairment wuld be allcated prprtinately t all the ther assets in that cash generating unit. The standard des nt specify whether the impairment shuld be credited t the asset accunt r t the accumulated depreciatin (cntra asset) accunt. Of curse, either apprach has the same effect: net bk value is reduced by the accumulated impairment recgnized. Eurpean practice has generally been t add impairment prvisins t the accumulated depreciatin accunt. This is cnsistent with the view that reducing the asset accunt directly wuld be a cntraventin f the general prhibitin n ffsetting. If the entity emplys the revaluatin methd f accunting fr lng-lived assets, the impairment adjustment will be treated as the partial reversal f a previus upward revaluatin. Hwever, if the entire revaluatin accunt is eliminated due t the recgnitin f an impairment, any excess impairment shuld be charged t expense (and thus be clsed ut t retained earnings). In ther wrds, the revaluatin accunt cannt cntain a net debit balance. Example fr impairments: At the beginning f a year a cmpany purchased a building fr 2 millin. Its estimated useful life at that date was 20 years and the cmpany uses straight line depreciatin methd. After 5 years the gvernment embarked n a plan t cnstruct a fly-ver adjacent t the building and the related installatin reduced the access t the building thereby decreasing the value f the building. The cmpany estimated that it can sell the cmpany fr 1 millin but it has t incur csts f 50,000. Alternatively, it if cntinues t use it the present value f the net cash flws the building will help in generating is 1.2 millin.the basic rule is t recgnize impairment if carrying amunt exceeds the recverable amunt. First, it is necessary t determine the carrying amunt. The building has a cst f 2 millin, useful life f 20 years and is used fr 5 years s far. This means that accumulated depreciatin is 2/20*5 r 0.5 millin. Carrying amunt is 2 millin minus 0.5 millin r 1.5 millin. 70

Secnd, it is necessary t determine the recverable amunt. Recverable amunt is the higher f fair value less csts t sell and value in use. Fair value less csts t sell in this scenari is 1 millin minus 0.05 millin r 0.95 millin. Value in use is the present value f future cash flws which amunts t 1.2 millin. Recverable amunt is the higher f 0.95 millin and 1.2 millin. Carrying amunt is 1.5 millin while recverable amunt is 1.2 millin. An impairment lss f 0.3 millin is t be recgnized. The jurnal entry wuld be: Impairment Lss 300,000 Accumulated Impairment Lsses 300,000 If due t any event the impaired asset regains its value the gain is recrded in incme statement t the extent f riginal impairment lss and any excess is cnsidered a revaluatin and is credited t revaluatin surplus. In the next year, the gvernment cnstructed a service rad parallel t the high way which imprved the recverable amunt t 1.4 millin. Depreciatin fr this year is 0.12 millin. Carrying amunt as at the end f the year is 1.2 millin minus 0.12 millin r 1.08 millin. The recverable amunt is 1.4 millin which shws that the building has t be appreciated by 0.32 millin. 0.3 f this amunt is t be credited t incme statement (because the riginal impairment lss ruted thrugh incme statement was 0.3 millin). The additinal 0.02 millin will be credited t revaluatin reserve. The jurnal entry wuld be: Accumulated Impairment Lsses 300,000 Building 20,000 Gain in Value f Building 300,000 Revaluatin Surplus 20,000 Cnclusin Revaluatin and impairment are terms clsely related t ne anther, with subtle differences. Revaluatin and impairment bth require the cmpany t evaluate the assets fr their true market value, and then take apprpriate actin in updating the accunting bks. The majr difference between the tw is that a revaluatin can be made upwards (t increase the value f the asset t market value) r dwnwards (t decrease the value). An impairment, n the ther hand, nly refers t ne f the tw; a fall in the market value which is then written dwn. Revaluatin and impairment is a special tpic that accunting deals with. It is very sensitive prblem, because the vlume f revaluatin surpluses / shrtages and the amunt f impairments accunted fr influences the ttal vlume f assets and liabilities disclsed in financial statements als with the final influence n prfit r lss. Fixed assets are initially recgnized at histrical cst. After initial recgnitin, cmpanies chse either the cst mdel r the revaluatin mdel fr each class f them. Under the cst mdel, assets are carried at cst after the deductin f any accumulated depreciatin and any accumulated impairmentlsses. Under the revaluatin mdel, assets are regularly updated at fair value and subsequentdepreciatin and impairment lsses are based n the revalued amunt at the date f revaluatin. Depreciatin and impairment lsses are required regardless f the methd chsen fr the subsequentvaluatin. Belw is a summary f accunting rules fr changes in the carrying amunt: A revaluatin increment is recgnized in ther cmprehensive incme and accumulated in equity under the heading f revaluatin surplus. Hwever, the increment is recgnized in earnings t the extent that it 71

reverses a revaluatin decrement f the same asset that was previusly recgnized in earnings. A revaluatin decrement is recgnized in earnings. Hwever, the decrement is recgnized in ther cmprehensive incme t the extent f any credit balance that exists in the revaluatin surplus with respect t the same asset. Because fixed assets are recrded in the bks at their cst price and are then frequently updated t shw their true and fair market value, the difference between revaluatin and impairment is: Revaluatin is a technique where an asset s recrded value (histrical cst value in the ledger) will be adjusted t the market value. An asset that lses its value and needs t be written dwn is referred t as an impaired asset. REFERENCES 1. Hussam Musa; Mirslav Škda Revaluatin and impairment f prperty, plant an equipment, Studia Universitatis "Vasile Gldiş" Arad Ecnmic Sciences (Studia Universitatis "Vasile Gldiş" Arad Seria Ştiinţe Ecnmice), issue: 11 / 2009, pages: 109123, n www.ceel.cm. 2. Erlend Kvaal - Tpics in accunting fr impairment f fixed assets, Series f Dissertatins 3/2005, BI Nrwegian Schl f Management, Department f Accunting, Auditing and Law, website www.bi.n 3. Ernest&Yung - Impairment accunting the basics f IAS 36 Impairment f Assets, http://www.ey.cm/publicatin/vwluassets/impairment_accunting_the_basics_f_ias_ 36_Impairment_f_Assets/$FILE/Impairment_accunting_IAS_36.pdf 4. Tae Hee Chi, Jinhan Pae*, Sunghwa Park, Yunghy Sng Asset Revaluatins: Mtives and Chice f Items t Revalue, http://aaahq.rg AM2010/abstract.cfm?submissinID=1929 5. Gvernment Financial Reprting Manual 2011-12 Impairments, http://www.hmtreasury.gv.uk/d/2011_12_frem_chap08_impairments.pdf 6. http://www.iasplus.cm - IAS 16 Prperty, Plant and Equipment and IAS 36 Impairment f Assets 72