Impairment of long-lived assets is one of the key accounting decisions taken by a company. This decision has an impact on the company’s profitability, classification of the cash flows, financial ratios and various trends. International Financial Reporting Standards (IFRS) and U.S. Generally Accepted Accounting Principles (GAAP) provide guidance on impairment of assets. It is important to understand when an asset is to be impaired and how to treat the impairment.
Definition of Impairment
An asset is impaired when its value in the market is less than its value recorded on the balance sheet of the company. Such a difference, if found to exist for sure, is accounted for in the books. The value of the asset is written down to its current market price. Long-lived assets are generally categorized into three categories. A tangible asset includes property, plant, equipment, etc. An identifiable intangible asset may be a patent, trademark or license. A non-identifiable intangible asset is mostly the goodwill of the company. All these assets are prone to impairments.
Indicators of Impairment Test
The companies need to assess their external environment to figure out whether an asset needs to be impaired. There are several indicators that may lead to an impairment of the asset. Some of the indicators are:
- The physical condition of the asset may have changed significantly.
- Economic or legal factors may have changed significantly.
- The market price may have decreased significantly.
An impairment under IFRS
Under IFRS, IAS 36 is the primary source of guidance on the impairment of tangible assets. The major points covered under this regulation are:
- Impairment losses need to be recognized when the asset’s Book Value > asset’s Recoverable amount.
Where Asset’s Recoverable Amount = higher of (Fair value – Selling costs) OR value in use.
The value in use is calculated by discounting future cash flows expected from the continued use of the asset.
- IFRS requires the companies to assess the indications of the impairment annually by keeping an eye on the several indicators mentioned above.
- For identifiable intangible assets that cannot be amortized and goodwill, the companies are required to test these for impairment at least annually.
- The impairment loss is allowed to be reversed if the asset’s value recovers later.
An impairment under U.S. GAAP
Under U.S. GAAP, the most important source is ASC 360-10, which regulates the impairment of tangible assets. The impairment of assets is treated as follows:
- U.S. GAAP has a two-step test to determine if the asset is impaired or not.
- The first step is defined as the recoverability test in which the book value of the asset is tested. The book value of the asset is not recoverable when it is higher than the undiscounted cash flows expected from the continuous use of the asset.
- The second step is defined as the measurement of impairment loss. If the asset’s value is proven to be unrecoverable in the first step, then the impairment loss is calculated. Impairment loss = asset’s book value – asset’s fair value (or the present value of the future cash flows expected).
- Companies are advised to carry out the impairment test only when they are sure that the asset’s carrying/book value cannot be recovered permanently.
- U.S. GAAP also requires goodwill and other identifiable intangible assets to be tested at least annually for impairment.
- No reversal of loss is allowed.
Effect of Impairment Loss
Impairment loss indicates that the company has overstated its earnings by not recognizing enough depreciation/amortization expense in past. The impairment loss has the following effect on various financial statements and ratios:
- Book value/carrying amount of the asset is reduced on the balance sheet.
- Net income is reduced on the income statement.
Since it reduces the book value of the fixed assets, the fixed asset turnover ratio and the debt-to-total assets ratio will improve.
Conclusion: The impairment of long-lived assets needs to be determined correctly as it affects the financial statements and the ratios of the companies. It is advised to figure out the right indicators of the impairment and subsequently, account for the impairments in a regulated way.