Derecognition definition

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What is Derecognition in Accounting?

Derecognition is the removal of a previously recognized financial asset or financial liability from an entity's balance sheet. A financial asset should be derecognized if either the entity's contractual rights to the asset's cash flows have expired or the asset has been transferred to a third party (along with the risks and rewards of ownership). If the risks and rewards of ownership have not passed to the buyer, then the selling entity must still recognize the entire financial asset and treat any consideration received as a liability.

What Causes Derecognition to Occur?

Derecognition can occur in any of the following situations:

  • Sale or disposal of an asset. If an asset is sold or otherwise disposed of, it is derecognized from the balance sheet. For example, when a company sells a piece of machinery, it no longer controls the asset and should remove it from its books.

  • Loss of control over an asset. If an entity loses control over an asset, it must derecognize it. Loss of control means the company no longer has the rights to the benefits and risks associated with the asset, which can happen due to legal transfer, sale, or abandonment.

  • Expiration of rights to an asset. For assets with limited use terms (like patents or licenses), derecognition occurs when the rights expire. Once the legal term ends, the asset no longer has any value.

  • Full depreciation or amortization. When an asset is fully depreciated or amortized, its book value might become zero. Although it may still be used operationally, some companies choose to derecognize fully depreciated assets if they have no residual value, especially if they are no longer economically beneficial.

  • Asset impairment. When an asset’s value drops to zero due to impairment (for instance, due to damage or obsolescence), it may be derecognized. Impairment might not always lead to immediate derecognition but can be a precursor to it, particularly if the asset becomes unusable or unsellable.

  • Transfer to a third party. Assets transferred in a way that qualifies as a derecognition under accounting standards (such as a transfer of receivables or certain financial assets) are removed from the balance sheet. This is common in cases of securitization, factoring, or collateralization where rights and obligations are transferred to another party.

Derecognition of Fixed Assets

Part of the year-end closing procedure may include a step to review all fixed assets currently on the books to see if any should be derecognized. Otherwise, an excessive amount of accumulated depreciation may clutter the balance sheet. This is accomplished with a debit to the accumulated depreciation account for the full related amount of accumulated depreciation, as well as a credit to the carrying amount of the fixed asset in question.