Fixed assets can lose value over time due to depreciation, impairment, or revaluation. This reduction in value must be accounted for properly to ensure accurate financial reporting. Below is a detailed example of how a business records the reduction in value of fixed assets through depreciation, impairment loss, and revaluation.
1. Depreciation Example
Scenario:
A company purchases a machine for $50,000 on January 1, 2023. The estimated useful life is 10 years, and there is no residual value. The company uses the Straight-Line Method of depreciation.
Step-by-Step Calculation:
Annual Depreciation = Cost ÷ Useful Life
= $50,000 ÷ 10 = $5,000 per year
Journal Entry for Depreciation (End of Year 1):
Debit: Depreciation Expense $5,000
Credit: Accumulated Depreciation $5,000
Balance Sheet Impact:
| Year | Original Cost ($) | Accumulated Depreciation ($) | Net Book Value ($) |
|---|---|---|---|
| End of Year 1 | 50,000 | 5,000 | 45,000 |
| End of Year 2 | 50,000 | 10,000 | 40,000 |
2. Impairment Loss Example
Scenario:
At the end of Year 2, the machine suffers unexpected damage, reducing its recoverable value to $30,000. The book value before impairment is $40,000.
Step-by-Step Calculation:
Impairment Loss = Book Value – Recoverable Amount
= $40,000 – $30,000 = $10,000
Journal Entry for Impairment Loss:
Debit: Impairment Loss $10,000
Credit: Fixed Asset Account $10,000
Balance Sheet Impact After Impairment:
| Year | Original Cost ($) | Accumulated Depreciation ($) | Impairment Loss ($) | Net Book Value ($) |
|---|---|---|---|---|
| End of Year 2 (After Impairment) | 50,000 | 10,000 | 10,000 | 30,000 |
3. Revaluation Decrease Example
Scenario:
At the end of Year 3, a market reassessment reduces the machine’s fair value to $25,000. The book value before revaluation is $28,000 (after additional depreciation for Year 3).
Step-by-Step Calculation:
Revaluation Loss = Book Value – Fair Market Value
= $28,000 – $25,000 = $3,000
Journal Entry for Revaluation Loss:
Debit: Revaluation Loss $3,000
Credit: Fixed Asset Account $3,000
Balance Sheet Impact After Revaluation:
| Year | Original Cost ($) | Accumulated Depreciation ($) | Impairment & Revaluation Loss ($) | Net Book Value ($) |
|---|---|---|---|---|
| End of Year 3 (After Revaluation) | 50,000 | 15,000 | 13,000 | 25,000 |
4. Impact of Fixed Asset Value Reduction on Financial Statements
A. Balance Sheet
- Asset values decrease due to depreciation, impairment, or revaluation losses.
- Accumulated depreciation increases over time.
- Net book value is reduced to reflect the asset’s fair value.
B. Income Statement
- Depreciation expenses reduce net income annually.
- Impairment losses are recorded as an expense, reducing profitability.
- Revaluation losses impact the net earnings if no prior revaluation reserve exists.
C. Cash Flow Statement
- Depreciation and impairment are non-cash expenses added back in the operating activities section.
- Revaluation adjustments do not affect cash flow but may impact investor perceptions.
5. Preventing a Rapid Fall in Asset Value
- Regular maintenance and servicing.
- Upgrading technology to prevent obsolescence.
- Proper insurance coverage for asset protection.
- Revaluing assets periodically to reflect fair market value.
Managing Fixed Asset Value Reductions
A reduction in fixed asset value can occur due to depreciation, impairment, or revaluation losses. Businesses must record these changes accurately to maintain transparent financial statements. By properly accounting for these reductions, businesses ensure that their asset values reflect economic reality and comply with financial reporting standards.