Impaired Asset

Introduction to Impaired Assets

An impaired asset is a company asset that has a market value less than the value listed on the company’s balance sheet. Impairment occurs when one or more events cause the carrying amount (book value) of an asset to exceed its recoverable amount. Essentially, an impaired asset is worth less than it is officially represented to be in accounting records. This situation necessitates a write-down to reflect the asset’s decrease in value accurately.

Asset impairment can significantly affect a company’s financial statements and requires rigorous testing, evaluation, and record-keeping to ensure faithful representation of the company’s actual financial situation.

Causes of Asset Impairment

Several factors can lead to asset impairment. The main causes include:

Economic Downturns: During economic recessions, the market value of assets such as real estate, machinery, and equipment can significantly decrease.
Technological Obsolescence: Advances in technology can render existing equipment or software obsolete, leading to impairment.
Physical Damage: Assets that suffer physical damage, such as in a natural disaster, can see their value plummet.
Legal or Regulatory Changes: New laws or regulations might impair the utility or profitability of certain assets.
Poor Management or Operational Issues: Mismanagement can lead to underutilization or reduced efficiency of assets, thereby impairing them.
Market Changes: Shifts in market demand or supply can negatively impact the value of an asset. For example, a drop in demand for a product may reduce the value of the equipment used to produce it.

How to Test for Asset Impairment

Testing for impairment is a methodical process that comprises several steps. The primary international accounting standards guiding impairment tests are the International Accounting Standards (IAS) 36.

Step-by-Step Process for Testing Impairment:

1. Identify Scope for Testing

Initially, identify the assets to be tested for [impairment](../i/impairment.html). Not all assets need to be tested every reporting period.

2. Review Indicators of Impairment

Indicators could include a significant decline in market value, changes in the technological, market, economic, or legal environment, or internal evidence indicating an asset’s performance does not meet expectations.

3. Estimate Recoverable Amount

The recoverable amount is the higher of an asset’s fair value less costs of disposal (net selling price) and its value in use.

Fair Value Less Costs of Disposal: This is the amount obtainable from the sale of an asset minus the costs directly attributable to the sale.
Value in Use: This is the present value of future cash flows expected to be derived from an asset.

4. Compare Carrying Amount and Recoverable Amount

If the carrying amount exceeds the recoverable amount, the asset is considered impaired.

5. Calculate Impairment Loss

Calculate the impairment loss as the difference between the carrying amount and the recoverable amount.

6. Write Down to Recoverable Amount

The recognized impairment loss should be written down against the asset’s carrying amount on the company’s balance sheet.

7. Disclose Impairments in Financial Statements

Disclosures should include the amount of impairment loss recognized, the events leading to the recognition, and an explanation of how the recoverable amount was determined.

How To Record Impairment Loss

Proper recording of impairment loss in financial statements encompasses multiple steps, helping ensure compliance with accounting principles.

Journal Entries to Record Impairment:

Initial Recording:

The impairment loss is recorded by debiting an impairment loss account and crediting the asset account.
```
 [Impairment](../i/impairment.html) Loss    XXX
      [Accumulated Depreciation](../a/accumulated_depreciation.html)      XXX
```
This entry reduces the carrying amount of the asset.
Presentation in Financial Statements:

The impairment loss is presented in the income statement, typically under operating expenses.
Disclosure Details:

Financial statements should provide detailed disclosure about the impaired asset, including the amount of loss, reasons for impairment, and method of determining the recoverable amount.

Examples of Asset Impairment

Goodwill Impairment: Goodwill impairment occurs when the acquired business does not generate expected cash flows. Many companies in the retail sector, like J.C. Penney, have reported significant goodwill impairments during restructuring phases.
Inventory Impairment: A technology company holding inventory of electronics that quickly become obsolete may need to impair the inventory if its market value declines below its cost.
Investment Impairment: With fluctuating market conditions, companies like investment firms might need to impair investments if they suffer significant losses.
Real Estate Impairment: A commercial real estate company might face impairment tests regularly due to market volatility in property values.

Impairment under IFRS and GAAP

Both International Financial Reporting Standards (IFRS) and Generally Accepted Accounting Principles (GAAP) provide guidance on asset impairment, though there are differences.

Under IFRS (IAS 36):

Assets are tested for impairment when there is an indication of impairment.
Goodwill and intangible assets with indefinite lives are tested annually.
The recoverable amount is the higher of fair value less costs of disposal and value in use.

Under GAAP (ASC 360-10 and ASC 350):

Long-lived assets are reviewed for impairment when changes in circumstances indicate a possible impairment.
Goodwill is tested annually.
The recoverable amount is determined using the undiscounted cash flow method.

Differences Between IFRS and GAAP:

Testing Frequency: IFRS requires an annual test for certain assets, while GAAP primarily requires a test based on indications of impairment.
Measurement of Recoverable Amount: IFRS relies on the higher of the fair value or value in use, while GAAP uses undiscounted cash flows for initial recognition.

Real-World Implications

Impairment of assets has tangible consequences for businesses, affecting their financial health, stock prices, and stakeholder perception. Leading companies such as General Electric and Deutsche Bank have had significant impairments that impacted their financial performance.

General Electric: Faced a massive goodwill impairment charge in 2018, leading to a considerable reduction in their stock price.
Deutsche Bank: Reported substantial impairments on goodwill and other intangible assets due to operational restructuring.

General Electric has detailed on their official site how impairments have been handled historically in their financial statements. Similarly, Deutsche Bank provides insights into the methodology behind their impairment assessments.

Conclusion

Understanding the nuances of asset impairment is crucial for accurate financial reporting and maintaining the trust of investors and stakeholders. Companies must rigorously test for impairment, record any losses accurately, and disclose relevant details to present a transparent picture of their financial health. The guidelines provided by accounting standards ensure that such practices are standardized across different jurisdictions and industries.