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2020-11-10 01:27:29ExpensesEnglishhttps://quickbooks.intuit.com/global/resources/row_qrc/uploads/2020/11/impairment-loss-in-busines.pnghttps://quickbooks.intuit.com/global/resources/expenses/impairment-loss-business/Recording an Impairment Loss in Your Business

Recording an Impairment Loss in Your Business

10 min read

The International Accounting Standards Board (IASB) has set out detailed guidelines for the impairment accounting in International Accounting Standard (IAS) 36. Yet, it becomes quite challenging for your business to put these guidelines into practice. This is because you are required to estimate the fair value of assets, for which observable prices are often not available.

Also, you need to put a great degree of professional judgment while calculating such estimates.

So, stakeholders like financial statement users, regulators, and accounting bodies raise concerns about the lack of precision in following the guidelines and making disclosures in the financial statements.

This article explains what is the impairment of assets, the difference between depreciation and impairment, various requirements for impairment accounting, and how impairment loss is calculated.

What is Impairment?

Impairment refers to the amount by which the carrying amount of an asset or a Cash Generating Unit (CGU) exceeds its recoverable amount.

You must ensure that your business entity’s assets are disclosed at no more than their recoverable amount. Recoverable amount refers to the amount that your business could recover through the use or sale of an asset.

Now, IAS 36 requires a business entity to recognize an impairment loss if an asset’s recoverable amount is less than its carrying value. IAS 36 details the guidelines and procedures to ensure that this principle is applied to all the major non-financial assets.

In addition to this, you need to test for the impairment of an asset only when there is an indication that the fair value of such an asset is less than its carrying amount.

Impairment vs. Depreciation

S. No.ParticularsImpairmentDepreciation
DefinitionImpairment of an asset occurs when the asset’s fair value unexpectedly falls below its carrying amount.Depreciation is the gradual decrease in the value of an asset over a period of time.
Application on AssetsImpairment can take place for a broad range of asset classes. For example, goodwill, receivables, plant and equipment, and investments.Depreciation is allocated only for plant ad equipment.
ConditionsImpairment is undertaken when there is:

  • a change in the physical condition of the asset
  • significant reduction in the asset’s market value
  • a change in the technology, environment, economic, and legal aspects
Depreciation is allocated due to the deterioration or obsolescence of an asset. This is because the assets wear out with usage over a period of time. Due to such wear and tear, the asset’s value decreases relative to the new technology that has been developed over a period of time. Moreover, depreciation is charged in order to match expenses to the revenue as per the matching concept of accounting.

Requirements for Impairment

In order to recognize asset impairment, the following points need to be considered:

  • Assets are impaired when their fair value falls below their book value
  • Assessment of assets in order to test for impairment needs to be carried out periodically. This is because an impairment loss can have a negative impact on your financial statements. Assessment of certain assets like goodwill needs to be undertaken periodically. This is because assets like goodwill need to be mandatorily assessed for impairment annually. This is irrespective of whether or not there is any indication of impairment or not.
  • Both external and internal sources indicating asset impairment must be taken into consideration.
  • Impairment loss should be determined for an individual asset if possible. However, if it is not possible to determine impairment loss for an individual asset, then impairment loss must be determined for the asset’s CGU. The CGU is nothing but the smallest identifiable group of assets generating cash inflows. Such cash inflows are independent of the cash inflows generated from other assets or groups of assets.

Example of Impairment

Hightech Express carries out an impairment assessment for its Cash Generating Unit (CGU). The economy witnessed a pandemic as a result of which the equipment of Hightech Express remained idle for almost two years, qualifying the asset for impairment testing. The total carrying value for the CGU is $2,600,000 and the total estimated recoverable amount is $1,350,000. Thus, the total impairment loss amounts to $1,250,000 ($2,600,000 – $1,350,000).

This impairment loss needs to be written off so that the asset’s value is not overstated on the balance sheet of Hightech Express.

In order to write off the asset, the impairment loss of $1,250,000 must be disclosed on the debit side of the income statement. This will reduce net income by the same amount.

Also, the asset’s balance on the balance of Hightech Express gets reduced by $1,250,000. Thus, a credit entry of $1,250,000 is made to the asset’s account or another balance sheet account by the name of the provision of impairment losses.

Understanding Impairment Loss

Impairment is a term that is used to explain a sudden reduction in the value of an asset. Such a reduction in the value of the asset is due to a change in technology, economy, or legal aspects surrounding your business. It may also be due to an unforeseen event that leads to physical damage to the asset.

For instance, a manufacturing unit may have to impair its plant and machinery as a result of an earthquake hitting its city. Such an uncertain event leads to a decrease in the fair value of the asset well below its carrying amount. The carrying value of an asset refers to the amount at which the asset is recorded in the balance sheet after deducting accumulated depreciation and accumulated impairment losses.

The impairment of an asset has an adverse impact on the financial statements of your business. Therefore, it is important for you to test the assets for impairment periodically. In case an asset indicates impairment, you need to write off the difference between the fair value and the carrying value of the asset.

In addition to this, the impairment of assets applies to fixed assets including plant and equipment, land and building, goodwill, and other intangible assets.

However, assets like inventories, deferred tax assets, financial assets, or non-current assets held for sale do not come under the purview of impairment of assets.

How To Calculate Impairment Loss?

Following is procedure on how to calculate impairment loss:

  1. Identify an Asset To Be Impaired

The first step Your business is required to assess whether there is an indication of an asset impairment at the end of each accounting period. That is, you need to assess whether the carrying amount of an asset is higher than its recoverable amount.

Now, in order to help you make such an assessment, IAS 36 details a list of internal and external indicators of impairment. Therefore, you need to calculate an asset’s recoverable amount in case there is an indication that an asset may be impaired as per these indicators.

Furthermore, there are certain types of intangible assets for which you need to measure the recoverable amounts annually. This is irrespective of whether or not there is any indication that such an asset may be impaired. These assets include:

  • An intangible asset having an indefinite useful life
  • An intangible asset not yet available for use
  • Goodwill

As per IAS 36, the following are the external indicators of impairment:

  • A decline in market value
  • Unfavorable changes in technology, economy, markets, or laws
  • Increase in market interest rates
  • Value of net assets greater than market capitalization

Besides the external sources, there are also internal sources that indicate asset impairment. These include:

  • Physical damage or obsolescence
  • An asset remaining idle is held for disposal or is a part of a restructuring
  • Poor economic performance

It is important to note that these indicators do not form an exhaustive list. Furthermore, when an asset indicates that it needs to be impaired, it may also indicate that you need to review and adjust the following:

  • Asset’s useful life
  • Depreciation method
  • Residual value
  1. Calculate Recoverable Amount

The recoverable amount of an asset refers to the higher of:

  • the face value less the costs of disposal and
  • value in use.

Here the fair value refers to the price that you would receive on selling an asset or the price you would pay to transfer a liability in an orderly transaction between you and the seller.

And value in use refers to the present value of future cash flows expected to be received from an asset or a Cash Generating Unit (CGU).

Now, there would be no asset impairment if the fair value less the costs of disposal or value in use is more than the carrying amount. Then, the recoverable amount is considered as the value in use in case the fair value less the costs of disposal cannot be determined. But, the recoverable amount is fair value less the costs of disposal for those assets that can be disposed of.

  1. Calculate Fair Value

Fair value is the price that you would receive after selling an asset or the price that you would pay to transfer the liability in an orderly transaction between you and the buyer.

Thus, in order to calculate the impairment loss, you need to determine the fair value of the asset to be impaired and subtract the costs of disposal from it.

The cost of disposal refers to the direct costs only and not the existing or overhead costs.

  1. Determine Value in Use

As mentioned above, the value in use refers to the present value of the expected future cash flows derived from an asset or a CGU. So, while calculating the value in use the following items must be determined or considered:

  • Estimated future cash flows that your entity expects to generate from the asset
  • Timing of those future cash flows and its variations
  • Time value of money reflected in the current market risk-free rate of interest
  • Other factors including asset illiquidity that market participants would consider while pricing the expected future cash flows of your entity

It is important to note that you must use reasonable assumptions, and recent budgets and forecasts. Also, the estimated cash flow projections should also consider extrapolation for periods beyond budgeted projections.

As per IAS 36 guidelines, you should prepare budgets and forecasts for not more than 5 years. However, you need to extrapolate the forecasts based on earlier budgets for periods after 5 years. Also, you should evaluate the reasonableness of the assumptions. This can be done by considering the differences between the past cash flow projections and the actual cash flows.

There is one more point that you need to keep in mind. The cash flow projections must relate to the asset in its current state. That is, any enhancements or expenditures to improve the asset in the future should not be considered. Also, the estimated cash flows should not include cash inflows and outflows from financial activities, income tax receipts, or payments.

  1. Determine Discount Rate

The discount rate is the pretax rate that indicates the time value of money based on the market judgment. It also reflects any risks that are associated with a specific asset. But, such a rate does not indicate any risks for which future cash flows have been adjusted. Furthermore, it should be equal to the rate of return that investors demand. This rate is nothing but the one that investors earn in case they choose to make an investment generating cash flows equivalent to those expected from the asset.

Now, in case of impairment of a single asset or portfolio of assets the discount rate is the rate at which you would pay to borrow funds in order to buy that specific asset or portfolio.

Furthermore, you need to use a proxy rate in case a market-determined rate for the specific asset is not available. Such a rate must reflect the time value of money over the asset’s life as well as currency risk, price risk, country risk, and cash flow risk.

So, the following can be considered as proxy discount rates:

  • Your business entity’s average cost of capital
  • Your entity’s incremental borrowing rate
  • Other market borrowing rates
  1. Recognition of an Impairment Loss

As mentioned above, an impairment loss is recognized in books of accounts when the recoverable amount is less than the carrying amount of an asset.

Further, the impairment is recognized as an expense in the profit and loss statement. However, if the impairment loss pertains to a revalued asset, the impairment loss is treated as a revaluation decrease. In addition to this, depreciation relating to future periods is also adjusted.

What is Impairment Loss in Accounting?

An impairment loss in accounting refers to the amount by which the carrying amount of the asset or a CGU exceeds its recoverable amount. The carrying amount is nothing but the amount at which an asset or a CGU is recorded in the company’s balance sheet after deducting accumulated depreciation and accumulated impairment losses.

Whereas, the recoverable amount is the higher of:

  • an asset’s fair value less the cost of disposal and
  • value in use of an asset
Information may be abridged and therefore incomplete. This document/information does not constitute, and should not be considered a substitute for, legal or financial advice. Each financial situation is different, the advice provided is intended to be general. Please contact your financial or legal advisors for information specific to your situation.

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