Impairment

Impairment in accounting refers to the reduction in the recoverable amount of a fixed asset or goodwill below its carrying amount on the balance sheet. An impairment charge is a specific type of expense that reduces the value of an asset. Companies typically recognize impairment when the carrying amount of an asset exceeds its fair value or if there are events or changes in circumstances that suggest the book value may not be recoverable.

Understanding Impairment

Impairment can occur due to several factors, and understanding its implications is crucial for accurate financial reporting. When an asset becomes impaired, it often indicates that the asset’s market value has declined, or that future cash flows from the asset might not be as expected. This situation requires immediate recognition in the financial statements to ensure that the asset’s value is not overstated.

Key Concepts

1. Carrying Amount: This is the amount at which an asset is recognized in the balance sheet after deducting accumulated depreciation and impairment losses.
2. Recoverable Amount: It’s the higher of an asset’s fair value less costs of disposal and its value in use. The value in use is the present value of future cash flows expected to be derived from an asset.
3. Fair Value: The price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date.

Causes of Impairment

Several factors can lead to the impairment of an asset:

1. Market Conditions: A decline in market demand for the product or service relating to the asset.
2. Poor Management Decisions: Unwise acquisitions or investments.
3. Legal Changes: New regulations or laws that impact the usefulness of an asset.
4. Technological Advancements: Innovations that make an asset obsolete.
5. Environmental Factors: Natural disasters or other events that damage or destroy an asset.

Recognizing Impairment Loss

The process to recognize impairment loss involves several steps:

1. Identify Indicators of Impairment: Regularly review for any indicators that an asset may be impaired. This could be a change in technology, market, economy, etc.
2. Measure the Recoverable Amount: Determine the recoverable amount of the asset by comparing the fair value less costs of disposal and its value in use.
3. Compare Carrying Amount with Recoverable Amount: If the carrying amount is greater than the recoverable amount, the difference is the impairment loss.
4. Recognize the Impairment Loss: The loss should be recognized immediately in profit or loss.

Impairment Test

An impairment test compares the carrying amount of the asset to its recoverable amount. This is often performed annually for goodwill and other intangible assets with indefinite useful lives.

Steps of Impairment Testing:

1. Determination of Cash-Generating Units (CGUs): Assets are grouped into the smallest identifiable group of assets that generates cash inflows largely independent from other assets.
2. Estimate Future Cash Flows: Project the future cash flows that the asset/CGU is expected to generate.
3. Compute Present Value: Discount the future cash flows to their present value using an appropriate discount rate.
4. Determine Fair Value Less Costs to Sell: Estimate the price that would be received to sell the asset in an orderly transaction between market participants.
5. Compare Against Carrying Amount: The carrying amount of the asset is compared to its recoverable amount.

Example of an Impairment Test

If a company’s factory machinery (carrying amount $500,000) becomes technologically outdated due to new advancements, the recoverable amount might be calculated as follows:

• Fair Value: $350,000 (market value less costs to sell)
• Value in Use: $300,000 (discounted future cash flows)

Recoverable Amount (higher of Fair Value and Value in Use) = $350,000

Impairment Loss = Carrying Amount - Recoverable Amount Impairment Loss = $500,000 - $350,000 = $150,000

The $150,000 impairment loss would be recorded in the company’s income statement.

Implications of Impairment

Financial Statements

Impairment charges impact financial statements in several ways:

1. Income Statement: Impairment losses are recognized as an expense, reducing net income.
2. Balance Sheet: The carrying amount of the impaired asset is reduced, affecting total assets.
3. Cash Flows: Non-cash impairment charges do not directly impact current cash flows but indicate future potential cash flow reductions.

Management and Investors

• Management: Needs to manage assets efficiently to avoid future impairments.
• Investors: Should be aware of impairment charges as they can signal underlying issues in the company’s operations or market conditions.

International and U.S. Accounting Standards

IFRS (IAS 36)

Under International Financial Reporting Standards (IFRS), the key standard for impairment is IAS 36 “Impairment of Assets”. It outlines the procedures required to ensure that assets are carried at no more than their recoverable amount.

US GAAP

In the United States, impairment testing is governed by ASC 360 for long-lived assets and ASC 350 for goodwill and other intangibles.

Major Differences

• Frequency of Testing: IFRS requires annual testing for intangible assets with indefinite useful lives and certain goodwill, whereas US GAAP requires impairment tests only when there is an indication of impairment.
• Reversal of Impairment: IFRS allows reversing impairment losses for assets other than goodwill, whereas US GAAP does not permit the reversal of impairment losses.

Practical Applications

Corporate Examples

General Electric (GE)

In 2018, General Electric (GE) reported an impairment charge of approximately $22 billion on its Power segment’s goodwill. This charge followed the deterioration in the market conditions and revised cash flow projections.

Kraft Heinz

In February 2019, Kraft Heinz disclosed a $15.4 billion impairment charge related to goodwill impairment tied to several of its key brands, reflecting increased competition and changes in consumer preferences.

Industries Affected

• Technology: Rapid advancements render older technology obsolete, leading to frequent impairment charges.
• Retail: Shifts in consumer preferences and market competition can cause impairment of physical stores and trademarks.
• Oil & Gas: Fluctuations in oil prices can trigger impairments of exploratory and production assets.

Best Practices for Impairment Management

1. Regular Monitoring: Continually assess internal and external factors that could indicate potential impairments.
2. Clear Documentation: Maintain thorough records of impairment testing and the assumptions used.
3. Adopt Robust Valuation Models: Use appropriate discount rates and valuation techniques for accurate impairment assessments.
4. Transparent Communication: Clearly articulate the reasons and impacts of impairment charges to stakeholders.

Future Outlook

With increasing complexity in global markets and rapid technological changes, the frequency and significance of impairments are likely to rise. Companies need to enhance their impairment testing models and remain vigilant to market conditions to avoid large, unexpected write-downs.

Conclusion

Impairment is a critical aspect of financial reporting that ensures assets are not overvalued on the balance sheet. It impacts various areas of a company’s financial health, from income statements to investor perceptions. Understanding the causes, processes, and effects of impairment is crucial for accurate financial management and reporting.