Permanent Diminution in Value

Permanet Diminution in Value: A Comprehensive Guide

Definition

Permanent diminution in value refers to a significant fall in the value of an asset that is not expected to recover. When this occurs, the fixed asset must be reported on the balance sheet at the reduced amount, which is essentially the estimated recoverable amount. Any decrease or provision for this must go through the profit and loss account. If it is later determined that the provision for diminution is no longer necessary, it should be reversed and written back into the profit and loss account.

Examples

Impairment Loss of Equipment: If a company’s machinery becomes obsolete due to technological advancements, and its value drops significantly and irreversibly, this would be classified as a permanent diminution in value.
Write-Down of Real Estate: If a natural disaster damages a building owned by a business and the damage is so severe that the property’s value plummets and is unlikely to recover fully, this would also constitute a permanent diminution in value.

Frequently Asked Questions (FAQs)

Q1: What necessitates a permanent diminution in value adjustment? A1: When an asset’s value suffers a permanent and significant drop that cannot be reasonably expected to recover, accounting standards require that this change be reflected in the financial statements.

Q2: How is a permanent diminution in value different from depreciation? A2: Although both account for a decline in asset value, permanent diminution in value reflects an unexpected and irreversible drop, while depreciation is a systematic allocation of an asset’s cost over its useful life.

Q3: Where is the reduced value of an asset shown after a permanent diminution in value? A3: The reduced value is shown on the balance sheet at the estimated recoverable amount.

Q4: How should the provision for diminished value be recorded? A4: The provision should be recorded through the profit and loss account as an expense.

Q5: Can a permanent diminution in value be reversed? A5: Yes, if it is subsequently found that the diminution in value is no longer required, the provision can be written back to the profit and loss account.

Fixed Asset: Long-term tangible pieces of property that a company owns and uses in its operations to generate income.
Balance Sheet: A financial statement that summarizes a company’s assets, liabilities, and shareholders’ equity at a specific point in time.
Recoverable Amount: The higher of an asset’s fair value less costs to sell and its value in use.
Profit and Loss Account: A financial statement that summarizes the revenues, costs, and expenses incurred during a specific period.

Online Resources

Suggested Books for Further Studies

“Financial Accounting” by Walter T. Harrison Jr. and Charles T. Horngren
“Intermediate Accounting” by Donald E. Kieso, Jerry J. Weygandt, and Terry D. Warfield
“Accounting for Non-Accountants” by Wayne A. Label

Accounting Basics: Permanent Diminution in Value Fundamentals Quiz

### When does a permanent diminution in value occur? - [ ] When an asset temporarily decreases in value. - [x] When an asset's value decreases permanently and significantly. - [ ] When depreciation is calculated annually. - [ ] When an asset's value increases marginally. > **Explanation:** A permanent diminution in value occurs when an asset's value decreases permanently and significantly, and it is not expected to recover. ### How should a permanent diminution in an asset's value be recorded? - [x] As an expense through the profit and loss account. - [ ] Directly to the retained earnings. - [ ] Only in notes to the financial statements. - [ ] As a deferred tax asset. > **Explanation:** When an asset value is permanently diminished, the provision for the diminution must be recorded as an expense through the profit and loss account. ### Where should a permanently diminished asset value reflect in the financial statements? - [ ] In the cash flow statement. - [ ] In the income statement. - [ x ] In the balance sheet. - [ ] In the statement of shareholders' equity. > **Explanation:** The reduced value of an asset due to permanent diminution must be reflected in the balance sheet at the estimated recoverable amount. ### Can permanent diminution in value be reversed? - [x] Yes, if it is later found to be no longer required. - [ ] No, it is always permanent. - [ ] Only with board approval. - [ ] Only through depreciation. > **Explanation:** If it is subsequently determined that the provision for diminution is no longer required, it can be reversed and written back to the profit and loss account. ### What distinguishes permanent diminution in value from temporary diminution in value? - [ ] The frequency of asset appraisals. - [ ] The method of calculation. - [ ] Compliance with local tax laws. - [x] The expectation of value recovery. > **Explanation:** Permanent diminution in value is distinguished by the expectation that the asset's diminished value will not recover, whereas temporary diminution expects recovery. ### Which accounting principle governs the reporting of permanent diminution? - [ ] Consistency principle - [x] Conservatism principle - [ ] Matching principle - [ ] Full Disclosure principle > **Explanation:** The conservatism principle governs the reporting of permanent diminution to ensure that losses are recognized as soon as they are identified. ### How does permanent diminution impact a company’s financial health? - [ ] It increases asset value. - [x] It decreases total asset value. - [ ] It boosts revenue. - [ ] It reduces liabilities. > **Explanation:** Permanent diminution in value leads to a decrease in the total value of the assets on the balance sheet, which can negatively impact the company's financial health. ### In which account should the provision for permanent diminution be recorded initially? - [ ] Loan account - [ ] Shareholder’s equity account - [x] Profit and loss account - [ ] Depreciation account > **Explanation:** The provision for permanent diminution should initially be recorded as an expense in the profit and loss account. ### What happens to the balance sheet if the diminution provision is revised? - [ ] No effect; balance sheet remains unchanged. - [x] The reduced amount is adjusted to reflect the revised provision. - [ ] Only the income statement is impacted. - [ ] Asset depreciation increases. > **Explanation:** If the diminution provision is revised, the reduced amount on the balance sheet is adjusted to reflect the new provision amount. ### Which term best describes the value at which an asset is shown post-diminution? - [ ] Book Value - [x] Recoverable Amount - [ ] Net Present Value - [ ] Market Value > **Explanation:** Post-diminution, an asset is shown at its recoverable amount, which is the greater of its fair value minus costs to sell or its value in use.

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