IMPAIRMENT LOSS

Impairment occurs when a business asset suffers a depreciation in fair market value in excess of the book value of the asset on the company’s financial statements.

• The technical definition of the impairment loss is a decrease in the net carrying value of an asset greater than the future undisclosed cash flow of the same asset.

Business assets should be tested for impairment when a situation occurs that causes the asset to lose value. An impairment loss is recognized and accrued to record the asset’s revaluation. Once an asset has been revalued, fluctuations in market value are calculated periodically. Certain intangible assets, such as goodwill, are tested for impairment on an annual basis. Impairment losses can occur for a variety of reasons:

• when an asset is badly damaged (negative change in physical condition)
• the asset’s market price has been significantly reduced
• legal issues have had a negative impact on the asset
• the asset is set for disposal before the end of its useful life A loss on impairment is recognized as a debit to Loss on Impairment (the difference between the new fair market value and a current book value of the asset) and a credit to the asset. The loss will reduce income in the income statement and reduce total assets on the balance sheet.

A loss on impairment is recognized as a debit to Loss on Impairment (the difference between the new fair market value and current book value of the asset) and a credit to the asset. The loss will reduce income in the income statement and reduce total assets on the balance sheet.

For example, take a retail store that is recorded on the owner’s balance sheet as a non-current asset worth Rs. 20,000 (book value or carrying value is Rs. 20,000). Based on the asset’s book value, assume the store has a historical cost of Rs. 25,000 and accumulated depreciation of Rs 5,000.

A hurricane sweeps through the town and damages the store’s building. After assessing the amount of the damage, the owner calculates that the building’s market value has fallen to Rs. 12,000.

The Loss on Impairment is calculated to be Rs. 8,000 (20,000 book value – 12,000 market value)

The journal entry to recognize the Loss on Impairment:

• Debit Loss on Impairment for Rs. 8,000
• Debit Store Building-Accumulated Depreciation for Rs. 5,000
• Credit Store Building for Rs. 13,000

The Loss on Impairment for Rs. 8,000 is recognized on the income statement as a reduction to the period’s income and the asset Store Building is recognized at its reduced value of Rs. 12,000 on the balance sheet (25,000 historical cost – 8,000 impairment loss – 5,000 accumulated depreciation). After the impairment, depreciation expense is calculated using the asset’s new value.

The measurement of the amount of loss involved in impairment involves the following steps:

• Perform the recoverability test: It involves evaluating whether the future value of an asset’s undiscounted cash flows is less than the book value of the asset. If the cash flow is less then, the impairment loss is calculated.
• Measurement of impairment loss: It is calculated by finding the difference between book value and market value of the asset.
• The use of undiscounted cash flows in this process assumes that the cash flows are definite and risk-free and the timing of the cash flow is not taken into account.

KEY POINTS:

• Two tests are performed to determine the amount of an impairment loss: recoverability and measurement.
• The recoverability test evaluates if an asset‘s undiscounted future cash flows are less than the asset’s book value. When cash flows are less, the loss is measured.
• The measurement test uses the difference between the asset’s market value and book value to calculate the amount of the impairment loss.

Key Terms

• Recoverability: The property of being able to recover.
• Cash flows: cash received or paid by a company for its business activities.
• Intangible asset: Any valuable property of a business that does not appear on the balance sheet, including intellectual property, customer lists, and goodwill.

SIX TIPS FOR IMPAIRMENT TEST

1. Cash flows in the impairment calculations should be reasonable. Forecasted statements in the prior periods may need to be revisited. It must be based on the latest management reports or budgets or estimates. It must be backed by reasonable assumptions that should represent management’s best estimate of economic situations that will remain over the remaining lives of the asset. Greater weight should be given to external evidence.
2. Value in use should comply with the standard: Future cash flows should be estimated for assets in the present situation. The major problems that might occur in making assumptions about the value in use relate to future restructuring and capital expenditures on investment. Where management has approved the restructuring plans, the approved budget is likely to include the costs and benefits of the restructuring.
3. Focus on market capitalization: Market capitalization below net asset value is an indicator of the impairment test. If the market capitalization is less than the value in use then the impairment test is carried out. The fall in the market value of an asset is the indicator of impairment. A lower market value acts as a trigger but it doesn’t necessarily mean so. However, when management determines the recoverable value above the market value then the assumptions of market conditions should be checked in the light of available external evidence.
4. Check the discount rate: Many companies follow the capital asset pricing method to determine the discount rate. The factors like cost of capital, corporate loan rates, and risks associated with the cash flows are to be taken into account since these may result in an increase in the discount rate.
5. Reconcile the conclusion with the external market data: The current economic assumptions made a year ago might not be reasonable in the current scenario. Consumer expenditure is falling due to the economic situation hence cash flow growth assumptions must be reviewed carefully. The analyst reports should be obtained to support growth assumptions.
6. Compare the assets being tested for impairment with the cash flows coming from that asset: It is to be ascertained that the cash flows being tested are consistent with the assets being tested. IAS 36 states that cash flows related to assets that generate cash flow independently should not be included in the cash flow forecasts. Cash flows should exclude cash related to financing.