Accounting follows the principle of conservatism. Concern always arises when any property or equipment is reported at an amount in excess of fair value. Because temporary swings in value can happen frequently and then rebound, they do not require accounting modification. Historical cost remains the reporting basis. Permanent declines in the worth of an asset, though, need to be noted in some appropriate manner. Consequently, two tests have been created by FASB to determine if the value of property or equipment has been impaired in such a serious fashion that disclosure of the damage is necessary.
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If possible impairment of property or equipment is suspected, the owner estimates the total amount of cash that will be generated by the asset during its remaining life. The resulting cash figure is then compared with the asset’s current book value to see if it is lower. This recoverability test indicates whether a problem exists that is so significant that immediate recognition is warranted. If expected future cash flows exceed the present book value of property or equipment, no reporting is necessary. The asset can still be used to recover its own book value; no permanent impairment has occurred according to the rules of U.S. Conversely, if an asset cannot even generate sufficient cash to cover its own book value, it has become a detriment to the owner. In that case, the accountant performs a second test (the fair value test) to determine the amount of loss to be reported. Book value is compared to present fair value, the amount for which the asset could be sold. For property and equipment, the lower of these two figures is then reported on the balance sheet. Any reduction in the reported asset balance creates a loss to be recognized on the income statement. [1]
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