Impairment

What Is Impairment?

Impairment refers to a sudden, permanent loss of value in the organization's asset, fixed or intangible, below the carrying value of the asset on the balance sheet.

This sudden decline in the value of asset (s) can be because of various reasons, internal and external.

Ranging from market conditions and technological factors to legal issues or physical damage.

An asset is said to be Impaired under IAS 36 an asset cannot be listed in the financial statements at a value higher than the maximum that can be obtained from its sale or use. When the recoverable amount is less than the carrying amount.

Under GAAP, general guidelines for the appropriate timing of asset (or asset group) impairment testing are provided by ASC 360. ASC 360 specifically states that anytime events or circumstances arise that suggest the asset's carrying value could not be recoverable, impairment testing should be carried out.

The accounting process of depreciation (a reduction in the value of an asset throughout its useful life) may seem similar. Depreciation/amortization diminishes the asset’s value over time. 

Depreciation and amortization are commonly employed for ordinary wear and tear, whereas impairment losses account for exceptional declines in an asset’s value. 

Understanding IAS 36

IAS 36 was reissued in March 2004 and applies prospectively from the beginning of the first annual period commencing on or after March 31, 2004, to goodwill and intangible assets acquired in business combinations with an agreement date on or after that date. 

IAS 36 applies to all except:

• Inventories 
• Assets arising from construction contracts 
• Deferred tax assets
• Assets arising from employee benefits 
• Financial assets 
• Investment property carried at fair value 
• Agricultural assets carried at fair value 
• Insurance contract assets 
• Non-current assets held for sale 

Therefore, IAS 36 applies to (among other assets):

• Land
• Buildings 
• Machinery and equipment
• Investment property carried at cost
• Intangible assets
• Goodwill
• Investments in subsidiaries, associates, and joint ventures carried at cost
• Assets carried at revalued amounts under IAS 16 and IAS 38

An organization must analyze whether there is any indication that an asset may be impaired after the conclusion of each reporting period (i.e., its carrying amount may be higher than its recoverable amount). 

IAS 36 includes a set of external and internal indicators. If there is a possibility that an asset is impaired, the asset’s recoverable value must be determined.

Whether or not there is any indication that they may be impaired, the recoverable amounts of the following types of intangible assets are measured periodically. 

In some situations, the most recent thorough computation of the recoverable amount from a previous period can be used in the current period’s impairment test for that asset.

Calculating the amount that can be recovered:

• It is not essential to determine the recoverable amount if fair value minus disposal expenses or value in use is more than the carrying amount. The asset is not in any way impaired.
• The recoverable amount is the value in use if fair value minus disposal costs cannot be calculated.
• The recoverable amount for assets to be disposed of is fair value minus disposal charges.

Impairment And Tangible assets

The standard also offers guidelines on how to recognize impairment losses for certain assets, how to calculate recoverable amounts, and what signs of impairment to look for.

It also describes how to assess and identify impairment losses for assets with a lengthy lifespan, like property, plant, and equipment.

Under Impairment, IAS 36, the assets that are subjected to impairment testing include the following assets:

• Tangible assets, including land, buildings, and machinery & equipment
• Intangible assets such as goodwill, intangible assets not available for use, and indefinite-lived intangible assets
• Investments in subsidiaries, joint ventures, and associates carried at cost
• Assets carried at revalued amounts under IAS 16 and 38.

Fair Value Minus Costs Of Disposal

IFRS 13 Fair Value Measurement is used to determine fair value. Disposal expenses are only the direct additional expenditures (not existing costs or overheads).

Value In Use

The following elements should be considered when calculating the value in use:

• A forecast of future financial flows
• The entity anticipates gaining from the asset
• Assumptions regarding potential changes in the quantity or timing of future cash flows
• The current market risk-free rate of interest, which represents the time value of money
• The cost of bearing the asset’s inherent uncertainty
• Other factors that market players might consider when pricing future cash flows, such as illiquidity

Cash flow projections should be based on acceptable and supported assumptions, the most recent budgets and forecasts, and extrapolation for periods beyond the budgeted projections. 

Budgets and predictions should not exceed five years, according to IAS 36; for periods exceeding five years, extrapolate from previous budgets. 

Management should examine the causes of variations between prior cash flow estimates and actual cash flows to determine the appropriateness of its assumptions.

Future restructurings to which the business is not committed, as well as expenditures to improve or enhance the asset’s performance, should not be expected in cash flow predictions.

Cash inflows and outflows from financing operations, as well as income tax collections and payments, should not be included in future cash flow estimates.

Discount Rate

The pre-tax rate should be used to calculate the value in use since it reflects current market estimates of the time worth of money and the risks associated with the asset.

The discount rate should not reflect risks for which future cash flows have been adjusted, and it should be equal to the rate of return required by investors if they were to choose an investment that would provide cash flows equivalent to those expected from the asset.

The discount rate is the rate an entity would pay in a current market transaction to borrow money to buy that specific asset or portfolio of assets if it were impaired.

If a market-determined asset-specific rate is unavailable, a proxy must be employed that takes into account the time value of money during the asset's lifetime, as well as country risk, currency risk, price risk, and cash flow risk. 

Normally, the following would be taken into account:

• The weighted average cost of capital of the entity

• The entity's rate of incremental borrowing

• Other borrowing rates on the open market

Recognition Of An Impairment Loss

The loss is recognized when the recoverable amount is less than the carrying amount. It is recorded as a cost unless it relates to a revalued asset, where it is treated as a revaluation decrease. 

Depreciation should be adjusted for future periods.

Cash Generating Units

If possible, the recoverable amount should be determined for each particular asset.

Determining the recoverable amount for an individual asset (i.e., the higher fair value, fewer costs of disposal, and value in use) is not achievable; establish the recoverable amount for the asset's cash-generating unit (CGU). 

The smallest identifiable group of assets that generates cash inflows that are mostly independent of cash inflows from other assets or groups of assets is referred to as the CGU.

Impairment And Goodwill

Goodwill is an intangible asset that results from the organization's acquiring activities. As a result of the acquisition, goodwill can be said to be the excess of the purchase price over the sum of all the fair values of intangible and tangible assets.

Goodwill impairment occurs when the fair value of the asset declines below the carrying value on financial statements. Goodwill should be tested for impairment annually.

The events that led to the goodwill impairment include: 

• Economic downturns
• Heightened competition
• Loss of key employees
• Regulatory actions
• Unfavorable changes in market, technology, or law.

Testing requirement of goodwill under US GAAP requires the company to conduct an annual impairment test. The company must compare the fair value of the reporting unit with its carrying value.

If the fair value is lower, the impairment loss is recognized.

Testing requirement for goodwill under IFRS allows the company to conduct an impairment test whenever events indicate any possible impairment, instead of requiring annual tests.

The impairment loss detected the loss allocated between the parent and the subsidiary company based on their interest in the holding.

Once the goodwill is written off, followed by the proportional reductions in the carrying value of the asset. Consequently, any remaining part of the impairment is assigned to the parent company's equity.

An asset’s carrying value shall not be decreased below the highest of:

• Its fair market worth minus costs of disposal (if measurable)
• Its value in use (if measurable)
• Zero.

If the previous criterion is followed, it is then allocated pro-rata to the unit’s other assets (group of units).

How is an Impairment loss treated in the books of accounting?

As an example, consider a transaction between Dairy Queen and Nestle worth about $50 million. Dairy Queen’s tangible assets, which include a production factory, delivery vans, and other equipment, were appraised at $25 million at the time of purchase. 

Copyrights and patents worth $7 million are among its intangible assets. On Nestle Inc.’s balance sheet, the difference between the value of Dairy Queen’s assets and the amount paid, i.e., $18 million, will be recorded as goodwill. 

Dairy Queen’s brand awareness, customer loyalty, and strong social media presence were deemed valuable by the corporation.

However, after three long years of declining sales, the corporation discovers that the value of the patents and copyrights obtained in the purchase of Dairy Queen is less than projected, so a $5 million impairment charge is recorded.

Depreciation and amortization have lowered the value of long-term assets by another $5 million over that time. As a result, the current book value stands at $40 million.

Due to uneven marketing and a lack of inventive new items, Dairy Queen has also lost numerous big distributors. As a result, the corporation incurs an extra $15 million charge as well.

Types of Triggering Events, Reversal of Impairment Losses & Disclosures

To determine if an asset's or cash-generating unit's (CGU) carrying amount is more than its recoverable amount, impairment testing is done. Impairment evaluations can be triggered by a variety of circumstances.

Accounting standards such as IAS 36 require specific disclosures to be made at the time of recognition or reversal of an impairment loss.

Let us understand these events in detail below.

Triggering Events

According to experts, reviewing each asset regularly is futile. A more effective strategy is to respond rapidly to triggering events that indicate potentially negative effects on assets.

Of course, a company's capacity to identify such triggering events and mobilize a quick response is key to the strategy's success.

Hurricanes and other natural or man-made calamities are clear triggering events. Other triggers are less obvious, such as: 

1. Obscure clauses in new or amended regulations, 
2. Legal ramifications from lawsuits and other legal actions, 
3. Rapidly deteriorating or long-term economic conditions, 
4. Industry disruptors and technological obsolescence, 
5. A brand-damaging scandal, 
6. A major customer’s bankruptcy or 
7. Other correlative effects on operating cash flows or company profits.

Companies with good crisis management processes might add “evaluation of impaired assets” to their response plans as an action item.

Reversal Of Loss

• Assess whether there is any indication that a loss has lessened at each balance sheet date in the same way as impaired assets are identified. Calculate the amount that can be recovered if this is the case.
• For the unwinding of the discount, there is no reversal.
• If the loss had not been recognized, the higher carrying amount owing to reversal should not be more than the depreciated historical cost.
• Unless it relates to a revalued asset, the reversal of a loss is recorded in profit or loss.
• Depreciation should be adjusted for future periods. 
• It is illegal to reverse a loss for goodwill.

Disclosure By Class Of Assets

The impairment losses

• are recorded in the profit or loss statement.
• are reversed in profit or loss
• which line item(s) of the statement of comprehensive income 
• on revalued assets recognized in other comprehensive income
• on revalued assets reversed in other comprehensive income

Segment-By-Segment Disclosure

• Losses due to impairment recognized.
• Losses on impairment reversed.

Other Disclosures

If an individual impairment loss (reversal) is significant, the following information must be disclosed:

• Events and conditions that resulted in the loss
• The extent of the loss or reversal
• Individual asset: the type of asset and the market segment to which it belongs
• Description of cash-generating units, amount of the loss (reversal) by asset class, and segment
• If the recoverable amount is fair value with fewer costs of disposal, then
  a) the level of the fair value hierarchy,
  b) the valuation techniques used, and
  c) the key assumptions used in the measurement of fair value are all categorized within ‘Level 2’ and ‘Level 3’ of the fair value hierarchy.

If the total amount of the losses recognized (reversed) is significant to the financial statements as a whole, disclose:

• Main asset groups that are impacted
• Important events and situations

Free Resources

To continue learning and advancing your career, check out these additional helpful WSO resources:

• Amortization of Intangible Assets

• Asset Disposal

• Fully Depreciated Asset

• Impaired Asset

• Stranded Assets