“Can impairment have any real worth?” by Aaron C. Escartin (November 30, 2009)

SUITS THE C-SUITE By Aaron C. Escartin
Business World (11/30/2009)

The only constant thing in the world is change. As time passes, things wither, deteriorate, or become obsolete. They lose their value and become impaired.

This also applies to company assets. But how and when would you know that an asset has become impaired? Does an asset become totally worthless? Is the loss on impairment tax-deductible? What are its income tax implications?

For accounting purposes, impairment loss is recognized when the recoverable amount of an asset is less than its carrying amount, in accordance with Philippine Accounting Standard (PAS) 36. In this case, the company records an impairment loss in its income statement equivalent to the difference between its recoverable amount and its carrying amount. Consequently, this will reduce the company’s net income.

In testing an asset for impairment, one has to know the meaning of carrying amount and recoverable amount.

The carrying amount is simply the acquisition cost less any accumulated depreciation or amortization and any impairment loss.

On the other hand, the recoverable amount of an asset is the higher value between its fair value less cost to sell and its value in use.

Fair value less cost to sell refers to the amount obtainable from the sale of an asset at an arm’s length transaction, less costs of disposal. This usually refers to the selling price in the sales agreement less the disposal costs. If unavailable, the fair value is equivalent to its market price.

Disposal costs include legal costs, stamp duties and transaction taxes.

On the other hand, value in use of an asset is the present value of future cash flow expected to be derived from the asset.

Cash flow encompasses cash that can be generated from the continuing use of the asset. This includes cash generated from selling the products produced using the asset, rentals collected, and proceeds from its disposal. These cash flows should be computed based on their present values since these will be received in the future.

Impairment loss is not an allowable tax deduction, since such loss is not actually sustained during the taxable year. The Bureau of Internal Revenue (BIR) has already held that fluctuations in market value are never to be considered in the computation of income until the gain or loss is realized.

Generally, only losses actually sustained during the taxable year and not compensated for by insurance or other forms of indemnity are allowable as deduction under Section 34(D)(1) of the Tax Code. Hence, in calculating taxable income, impairment loss should be added back to financial income before income tax in the income statement.

After recognizing impairment loss for financial accounting purposes, the depreciation expense on impaired asset should be computed based on the carrying amount after impairment loss, which is in effect equivalent to the recoverable amount.

Taxwise, depreciation expense should still be computed based on the original acquisition cost. This leads to higher depreciation expense for income tax purposes.

Hence, in computing taxable income, additional depreciation expense representing the difference between tax and accounting depreciation should be deducted from financial income before income tax.

To illustrate, assume that an asset has an acquisition cost of P100,000 and useful life of five years. Its depreciation expense is P20,000 annually, using the straight-line method. After a year, its carrying amount becomes P80,000. At that time, the fair value of the asset is P70,000 after deducting related disposal costs and its value in use is P60,000. Hence, its recoverable amount is P70,000, which is its fair value less cost to sell since it is higher than the value in use. Since the recoverable amount of P70,000 is lower than the carrying amount of P80,000, the asset is considered impaired.

The impairment loss of P10,000 is treated as an expense in computing financial income, but not for tax purposes. The company will therefore show a higher taxable income compared to financial income. Hence, impairment loss will be added to financial income to arrive at the taxable income.

The subsequent tax depreciation expense will still be P20,000, while for accounting purposes, it is computed based on the recoverable amount of P70,000.

Consequently, accounting depreciation for the second year until the fifth year is now at P17,500 annually.

This will then lead to lower taxable income compared to financial income.

Thus, the difference in tax and accounting depreciation of P2,500 (P20,000 and P17,500) should be deducted from financial income to determine the taxable income.

These rules apply to tangible assets like buildings, machinery and equipment.

Like everything else in life, change affects accounting. In addition, accounting and tax rules differ. Being familiar with tax rules and accounting standards is necessary for a more accurate tax and financial statements reporting.

(Aaron C. Escartin is a tax partner of SGV & Co.)

This article was originally published in the BusinessWorld newspaper. It is for general information only and is not a substitute for professional advice where the facts and circumstances warrant. The views and opinion expressed above are those of the author and do not necessarily represent the views of SGV & Co.