What is the Impairment of Assets?
Impairment of assets is the reduction in the value of the assets in the books of accounts of the company when the value of the asset in the market is less than that of the value of the same asset in the company’s balance sheet at a particular point of time.
Impairment of assets is an accounting principle used to permanently reduce the value of a company’s asset. The assets of a company are tested for impairment annually and if impaired, an impairment loss is recognized in the income statement and the balance sheet is adjusted accordingly. The cash flow statement is not affected by the impairment as there is no cash transaction taking place at the time of the impairment.
As we note from the snapshot above, Tata Steel with its most expensive acquisition of Corus Group Plc has taken approximately $3 billion of impairment charges until now. Impairment charges have a negative impact on the financial statements as well as ratios.
Impairments of Assets under U.S. GAAP
Under U.S. GAAP, the test for impairment of Fixed Assets is done only when events and circumstances indicate that the recovery of the carrying value might not be possible through future use. Determining impairment and calculating the loss potentially involves two steps. In the first step, the asset is tested for impairment by applying the Recoverability Test. If the asset is impaired, the second step involves measuring the loss.
Recoverability Test: In this test, if the carrying value i.e. the original cost less accumulated depreciation is greater than the asset’s future cash flow stream (without discounting), then the asset is considered as impaired. As the recoverability test is based on estimates of future discounted cash flow, tests for impairment involve considerable management discretion.
Loss measurement: If impaired, the useful value of the asset is written down to its fair value on the balance sheet. Moreover, a loss is recognized in the income statement. This loss is taken to be equal to the excess of carrying value over the fair value of the asset.
Impairments of Assets under IFRS
Under IFRS, the firm needs to assess annually whether events or circumstances indicate an impairment of an asset’s value has occurred. For example, there may have been a considerable decline in the value of the asset or a major change in the asset’s physical condition. If so, the asset’s value must be tested for impairment.
When the carrying value of an asset exceeds the recoverable amount, the asset can be impaired. The recoverable amount is equal to its fair value minus any selling costs or its Value In Use, whichever is greater. The process of computation of value in use involves the following two steps:
- Estimation of the future cash flows that would be generated by the asset.
- Calculation of the present value of the future cash flows by applying an appropriate discount rate.
Reasonable assumptions must be taken in order to project future cash flows. The items that should be avoided while projecting the future cash flows include exaggerated revenue growth rates, significant anticipated cost reductions and unreasonable useful lives for plant assets. Avoiding these items will result in more meaningful results. Similarly, any extraordinary growth of recent times should be assumed to last only for the very near-term future and should not be projected to continue in the long-term.
If impaired, the asset’s value must be written down on the balance sheet to the recoverable amount. An impairment loss equal to the excess of carrying value over the recoverable amount is recognized in the income statement.
It is only under IFRS that the company is allowed to reverse its losses of the value of the impaired asset recovers in the future. However, the loss reversal is limited to the original impairment loss. Hence, the carrying value of the asset after reversal cannot exceed the carrying value before the impairment loss was recognized.
Note: Under U.S. GAAP, loss recoveries are not permitted unlike under IFRS where the company can recover its losses but cannot exceed the original carrying value as stated above.
Also, have a look at US GAAP vs IFRS
Impairments of Intangible Assets under U.S. GAAP and IFRS
Goodwill which is created in a purchase acquisition can be tested for impairment. Goodwill created internally should be expensed as incurred.
Impairment of Goodwill is similar to Tangible Assets under U.S. GAAP and IFRS both.
As we see from below, Toshiba Corp had to record a $2.3 billion goodwill impairment charge on the value of Westinghouse (Cranberry-based nuclear firm).
Asset Impairment Examples
Asset Impairment Example under IFRS
On April 1, 2005, Belfor Inc. bought a building for around $2 million. The estimated life of the building at the time of purchase was 20 years, the depreciation method used is the straight-line method. On March 31, 2009, the company came to know about a fly-over construction that would be adjacent to the building which would reduce the access to the building, decreasing its value. For 1 million, the company estimated to sell the building but would have to incur some costs of $50,000. Another option which the company considered was to use it which would help the company generate a present value of $1.2 million.
Now, if the carrying value exceeds the recoverable amount. We will impair the building by the difference between the carrying value and the recoverable amount.
Carrying amount– the building was originally bought at $2 million with its life estimated to be 20 years which is used for 5 years so far. This gives us an accumulated depreciation of $2/20*5= $0.5 million. To calculate the carrying amount of the building we need its formula which is carrying value = amount at which the asset was purchased minus accumulated depreciation. Therefore, $2 million minus $0.5 million = $1.5 million.
Now, Recoverable amount– the recoverable amount is the higher of fair value minus cost to sell or value in use as we discussed above. Therefore, in this case $1 million minus $0.05 million = $0.95 million. The value in use is equal to be the present value of the future cash flows, which, in the question, was given to be $1.2 million. As discussed above, the recoverable amount is higher of $0.95 million and $1.2 million.
The carrying amount is $1.5 million while the recoverable amount is $1.2 million. The company will have to book an impairment loss of $0.3 million.
Fixed Asset Impairment Example under U.S. GAAP
Lakme Ltd. purchased a building on 1st April 2008 worth $200,000. The building was recorded using the following journal entry: Building 200,000 Dr.; cash 200,000 Cr. The building has a useful life of 20 years and the company uses the straight-line method to depreciate it. Now, the yearly depreciation according to the method will be $10,000 and accumulated depreciation as of March 31, 2010, will be $10,000*3 = $30,000. Carrying amount is $200,000 minus $30,000 = $170,000.
The building remains at historical cost (cost of acquiring the asset plus any extra cost to make it ready to use) and is depreciated annually with no adjustment in value. In case the asset got impaired, the impairment loss would have been reported in the income statement subsequently valuing the asset downwards.
Impact of Impairment on Financial Statements
Income Statement: If Impaired, an impairment loss is recognized in the income statement in the same section where we report other operating income and expenses. With this loss, the profitability for the year is affected negatively.
Below is the income statement of Schlumberger Ltd. It reported a significant impairment charge of $3,172 million in its income statement resulting in a Net Loss of -$1,687 million
Balance Sheet: If impaired, the asset is written down to the amount equal to the impairment loss which is recognized in the income statement.
Cash Flow Statement: There is no impact on the Cash Flow Statement as no cash transaction took place.
Below is a snapshot of Schlumberger Ltd’s cash flow. We note that cash flow from operations is prepared using the Indirect method, wherein you start with the Net Income and add back all the noncash items included in the Income Statement.
We note that Impairment charges have been added back in the cash flow from operations in Schlumberger Ltd
Impact of Impairment of Intangible Assets on Financial Statements
- Income Statement: Impairment loss is recognized in the income statement just like in the case of Tangible Asset. This, again, negatively affects the Net Income for the year in which the loss has been recognized.
- Balance Sheet: The asset is written down to the amount equal to the impairment loss we reported on the income statement when impaired.
- Cash Flow Statement: The impairment will not affect the Cash Flow as no cash transaction took place.
Impact of Impairment of Assets on Financial Ratios
Profitability Ratios and Activity Ratios are majorly affected by the impairment losses reported on the Financial Statements of the company. For example, a lower Net Income means that the company would report a lower Net Profit Margin. A lower Net Profit Margin is not a good sign for any company. Similarly, a Higher Asset Turnover ratio is again a negative sign on the Asset side of the Balance Sheet would go down.
Shown below is the table of ratios showing effects of Impairment:
|Ratios||If the Asset is Impaired||If the Asset is not Impaired|
|Total Asset Turnover||High||Low|
|Fixed Asset Turnover||High||Low|
|Net Profit Margin||Low||High|
|Operating Profit Margin||Low||High|
|Return on Assets||Low||High|
|Operating Return on Assets||Low||High|
|Return on Total Capital||Low||High|
Also, have a look at Complete Guide to Ratio Analysis
Impairment of Assets Video
Impairment is an accounting principle used to permanently reduce the Asset. Under IFRS, an asset is tested for impairment annually unlike under U.S. GAAP where there are two stages from which the company decides whether they have to impair the asset or not. Generally, Fixed Assets are tested for impairment. Fixed Assets include both Tangible and Intangible Assets. There are two types of Intangible Assets- Identifiable and Unidentifiable Intangible Assets. Identifiable assets are amortized over the life of the asset and Unidentifiable Assets are tested for Impairment.
Under IFRS, Fixed Assets are reported at a depreciated cost (cost model). IFRS also provides Revaluation Method in which the asset is reported at Fair Value. If the carrying value is greater than the recoverable amount then the asset is said to be impaired and the impairment loss ( the difference between carrying value and recoverable amount) is recognized in the income statement.
Under U.S. GAAP, Fixed Assets are reported at depreciated cost (cost model). The asset is tested for impairment in two stages. First, there is a recoverability test that helps determine if the asset is impaired or not. Second, there is loss measurement i.e. if the asset is impaired then what amount of loss do we have to report on the income statement. An impairment loss can be recovered only under IFRS and not under U.S. GAAP.
Impairment losses negatively impact the Financial Statements of the company. In the income statement, it affects the profitability of the company and in the Balance Sheet, the assets get reduced. Impairment losses also negatively affect the Financial Ratios of the company. Mainly, Profitability and Activity Ratios are negatively affected. This can negatively impact the value of the company in the market and investor’s sentiments towards the company.
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