Difficulty: Intermediate | Prerequisites: PPE Acquisition notes, Depreciation and Disposal notes. You need to be comfortable with book value, accumulated depreciation, and the disposal journal entry before tackling impairment.
This topic covers what happens when a PPE asset loses value unexpectedly (impairment), when management decides to sell rather than use an asset (held for sale), and how to account for money spent on an asset after it is already in service (subsequent expenditures). These are the "life events" that happen between acquisition and final disposal. They determine whether costs hit the balance sheet or the income statement, which directly affects reported profit.
Impairment uses a two-step test: first check whether expected cash flows are below book value (recoverability), then write the asset down to fair value. Held-for-sale assets are reported at the lower of carrying value or fair value less costs to sell, and can be written back up (but never above the original carrying value). Subsequent expenditures are either capitalised (if they extend life or improve the asset) or expensed (if they just maintain it).
Impairment
A permanent write-down of an asset's carrying value when that value is no longer recoverable. Similar in concept to lower of cost or market for inventory.
Impairment indicator
An event or change that suggests the carrying value of an asset may not be recoverable, such as a significant decline in market value, a change in how the asset is used, or adverse legal or business developments.
Recoverability test (Step 1)
Compare the asset's carrying value to the sum of its expected undiscounted future cash flows. If carrying value exceeds those cash flows, the asset fails the test and you proceed to Step 2.
Think of it as a screening question: "Will this asset at least pay for itself?"
Impairment loss (Step 2)
The amount by which carrying value exceeds fair value. Recorded as a loss on the income statement, with a corresponding reduction in the asset's carrying value on the balance sheet.
Fair value (for impairment)
The price at which the asset could be bought or sold in an active market, or the present value of expected future cash flows (discounted cash flows) if no active market exists.
Held for sale
An asset that management has committed to sell in the near future. It is transferred out of PPE to "Other Assets," depreciation stops, and it is reported at the lower of carrying value or fair value less costs to sell.
Fair value less costs to sell
The net amount the company expects to receive after selling the asset and paying any selling costs (commissions, legal fees, etc.).
Maintenance and ordinary repairs
Costs to keep an asset in normal operating condition without extending its useful life. Expensed immediately.
Improvements (replacements)
Major component replacements or upgrades that increase the useful life or productivity of an asset. Capitalised using one of three treatments: substitution, capitalisation, or reduction of accumulated depreciation.
Additions
New components or extensions physically attached to an existing asset. Capitalised as a new asset or added to the existing asset's cost.
Rearrangements
Reinstallation, rerouting, or reorganising an asset's configuration. Capitalised if they benefit future periods; expensed if the benefit is only to the current period.
Impairment testing under US GAAP follows a two-step process.
First, determine whether impairment indicators are present (decline in demand, adverse regulation, technological obsolescence, etc.). If so, compare the asset's carrying value (book value) to the sum of expected undiscounted future net cash flows from the asset.
If carrying value > undiscounted cash flows: the asset fails the test. Proceed to Step 2.
If carrying value <= undiscounted cash flows: no impairment. Stop here.
Compare the carrying value to the asset's fair value.
Impairment loss = carrying value minus fair value
Fair value can be the market price (if one exists) or the present value of expected future cash flows (discounted)
The loss is recognised on the income statement and the asset's carrying value is written down on the balance sheet. Under US GAAP, an impairment loss on PPE held for use cannot be reversed in later periods.
Equipment: original cost $2,000,000, carrying value $1,100,000
A competitor's new product caused demand to drop 40%
Expected undiscounted future cash flows: $550,000
Fair value of the equipment: $400,000
Step 1: Carrying value ($1,100,000) > undiscounted cash flows ($550,000). The asset fails the recoverability test.
Step 2: Impairment loss = $1,100,000 - $400,000 = $700,000.
Journal entry:
Dr. Loss on Impairment $700,000
Cr. Accumulated Depreciation $700,000 (or write down the asset directly)
The equipment's new carrying value is $400,000.
When management decides to sell a PPE asset rather than continue using it:
Assess the asset for impairment
Transfer the asset to "Other Assets" on the balance sheet
Stop depreciating it
Report at the lower of carrying value or (fair value less costs to sell)
To qualify as held for sale, management must be actively trying to sell the asset at a reasonable price.
Held-for-sale assets are unique because they can be written both down and back up (though never above the original carrying value at the date of reclassification).
Initial reclassification (31 December 2020):
Carrying value: $40,000
Fair value: $32,000; costs to sell: $2,000
Fair value less costs to sell: $30,000
Write-down needed: $40,000 - $30,000 = $10,000
Entry: Dr. Loss on Held-for-Sale Asset $10,000; Cr. Held-for-Sale Asset (or contra) $10,000. New carrying value: $30,000.
Scenario A: Fair value rises to $36,000 at 31 December 2021 (costs to sell still $2,000)
Fair value less costs to sell: $34,000
Current carrying value: $30,000
Write-up: $34,000 - $30,000 = $4,000
Entry: Dr. Held-for-Sale Asset $4,000; Cr. Recovery of Loss on Held-for-Sale Asset $4,000. New carrying value: $34,000.
Scenario B: Fair value rises to $46,000 at 31 December 2021 (costs to sell $2,000)
Fair value less costs to sell: $44,000
But the original carrying value at reclassification was $40,000
You cannot write up above $40,000
Write-up capped at: $40,000 - $30,000 = $10,000
Entry: Dr. Held-for-Sale Asset $10,000; Cr. Recovery of Loss on Held-for-Sale Asset $10,000. New carrying value: $40,000.
Once an asset is in service, every dollar spent on it falls into one of two buckets: capitalise it (add to the balance sheet) or expense it (hit the income statement now). The general rule: if the spending extends the useful life or improves productivity, capitalise. If it just keeps things running, expense.
Costs to keep the asset in operating condition without extending its life
Examples: oil changes, replacing small parts, routine cleaning
Accounting treatment: expense immediately
Entry: Dr. Repairs Expense; Cr. Cash
Replacement of a major component that increases useful life or productivity
Three possible accounting treatments:
Treatment 1: Substitution (old component's book value is known)
Remove the old component (debit Accumulated Depreciation for its depreciation, credit the asset for its original cost, recognise any loss)
Capitalise the new component (debit Building/Equipment, credit Cash)
Example: replacing a shingle roof (original cost $60,000, 80% depreciated) with a tile roof ($100,000). Remove the old roof (Dr. Accumulated Depreciation $48,000, Dr. Loss $12,000, Cr. Building $60,000). Record the new roof (Dr. Building $100,000, Cr. Cash $100,000).
Treatment 2: Capitalisation (old component is fully depreciated or its cost is irrelevant)
Simply add the new component's cost to the asset
Example: old shingle roof fully depreciated, new roof costs $100,000. Entry: Dr. Building $100,000; Cr. Cash $100,000.
Treatment 3: Reduction of Accumulated Depreciation (extends life but does not improve quality, and the original cost is unknown)
Debit Accumulated Depreciation instead of the asset
Example: new electrical panel installed for $10,000, original panel cost unknown. Entry: Dr. Accumulated Depreciation $10,000; Cr. Cash $10,000.
New physical extensions to an existing asset
Capitalised as a new asset (if it has its own useful life) or added to the existing asset
Depreciated over the shorter of its own life or the remaining life of the asset it is attached to
Example: Arthur builds a storage facility (15-year life, $90,000) attached to an existing building with a 20-year remaining life. Entry: Dr. Building $90,000; Cr. Cash $90,000. Depreciate over 15 years (the addition's own life, since it is shorter).
Reinstallation, rerouting, or reorganising equipment or facilities
Capitalise and depreciate if the rearrangement adds benefit to future periods (e.g. Frito-Lay relocates machinery to be closer to customers)
Expense if there is no clear benefit to the future
Capitalising puts the cost on the balance sheet, spreading it over future periods through depreciation. Expensing puts the full cost on the income statement immediately. Capitalising increases assets and net income in the current period; expensing decreases both.
Students confuse the recoverability test (Step 1, undiscounted cash flows) with the impairment loss measurement (Step 2, fair value). Step 1 uses undiscounted cash flows as a screen. Step 2 uses fair value (or discounted cash flows) to measure the loss.
Students sometimes think impairment losses on PPE held for use can be reversed if the asset's value recovers. Under US GAAP, they cannot.
With held-for-sale assets, students write the asset back up above its original carrying value. The write-up is capped at the carrying value on the date of reclassification.
Students treat all subsequent expenditures the same. You need to distinguish maintenance (expense) from improvements (capitalise) from additions (capitalise) and know the three treatments for improvements.
⚠️ The two-step impairment test is a high-frequency exam topic. Know which step uses undiscounted cash flows and which uses fair value.
⚠️ For held-for-sale assets, expect a problem testing whether you can write an asset back up and, if so, by how much.
⚠️ Subsequent expenditure problems will give you a scenario and ask whether to capitalise or expense, and if capitalising, which of the three treatments to use. The key signal is whether the old component's cost is known, unknown, or fully depreciated.
⚠️ Know the journal entries for substitution (two entries: remove old, add new) vs. straight capitalisation (one entry) vs. reduction of accumulated depreciation.
True or false: The recoverability test uses discounted cash flows. (False. It uses undiscounted cash flows. The impairment loss measurement may use discounted cash flows as a proxy for fair value.)
Fill in the blank: Impairment loss = carrying value minus ______. (fair value)
True or false: A held-for-sale asset can be written up above its original carrying value. (False. Write-ups are capped at the carrying value on the reclassification date.)
Fill in the blank: Oil changes and small-part replacements are classified as ______ and should be ______. (maintenance / ordinary repairs; expensed)
True or false: When a major component is replaced and the old component's book value is known, you should use the substitution method. (True.)
Q: Equipment has a carrying value of $1,100,000. Expected undiscounted future cash flows are $550,000 and fair value is $400,000. Is the asset impaired, and if so, what is the loss?
A: Step 1: carrying value ($1,100,000) > undiscounted cash flows ($550,000), so the asset fails the recoverability test. Step 2: impairment loss = $1,100,000 - $400,000 = $700,000.
Q: A held-for-sale asset was reclassified at a carrying value of $40,000. It was written down to $30,000 (fair value $32,000 less costs to sell $2,000). A year later, fair value is $46,000 and costs to sell are $2,000. What is the new carrying value?
A: Fair value less costs to sell = $44,000. But the maximum is the original carrying value of $40,000. So the asset is written up from $30,000 to $40,000 (a recovery of $10,000).
Q: A shingle roof with an original cost of $60,000 (80% depreciated) is replaced with a tile roof costing $100,000. What journal entries are needed?
A: Remove old roof: Dr. Accumulated Depreciation $48,000; Dr. Loss on Disposal $12,000; Cr. Building $60,000. Record new roof: Dr. Building $100,000; Cr. Cash $100,000.
Q: A new electrical panel is installed in a building for $10,000. The original cost of the panel is unknown, and the improvement extends the building's life but does not improve quality. Which treatment is used?
A: Reduction of accumulated depreciation. Entry: Dr. Accumulated Depreciation $10,000; Cr. Cash $10,000.
Impairment testing relies on the book value established through acquisition and depreciation. The held-for-sale rules connect to disposal (when the asset is eventually sold, you remove it using the same disposal steps). Subsequent expenditure decisions affect future depreciation: capitalising a replacement resets or extends the depreciable base, while expensing it does not.
impairment, impairment test, recoverability test, undiscounted cash flows, fair value write-down, impairment loss, held for sale, held-for-sale asset, fair value less costs to sell, write-up cap, subsequent expenditures, capitalise vs expense, maintenance, ordinary repairs, improvements, replacements, substitution method, capitalisation treatment, reduction of accumulated depreciation, additions, rearrangements, ACCT MIS 3200, Chapter 11, LO 11-8, LO 11-9