Welcome to Impairment of Assets (IAS 36)!
Hello there! Today we are diving into one of the most important "sanity checks" in accounting: Impairment. Don't let the name intimidate you. At its heart, impairment is simply making sure that we don't show our assets at a value higher than what they are actually worth to the business. Think of it as a "reality check" for your Balance Sheet.
In this chapter, we will learn how to spot when an asset might be losing value, how to calculate that loss, what to do with the numbers, and how to account for reversals. Let’s get started!
1. What is Impairment?
In simple terms, an asset is impaired when its Carrying Amount (CA) is higher than its Recoverable Amount (RA).
• Carrying Amount: This is the value currently sitting in your accounts (Cost minus Accumulated Depreciation or Amortisation).
• Recoverable Amount: This is the maximum value the company can get back out of the asset, either by using it or selling it.
The Golden Rule: An asset must never be recorded at more than its recoverable amount. If it is, we must "write it down" (reduce its value) and recognize an impairment loss.
Analogy: Imagine you bought a smartphone for \$800 a year ago. It’s now recorded in your "personal books" at \$600 after some use. However, you drop it and crack the screen. Now, the most someone would pay you for it is \$200, and it’s not very useful to you anymore. That \$400 gap (\$600 - \$200) is the impairment!
2. When to Test for Impairment
You don’t have to check every single asset for impairment every single day—that would be exhausting! Instead, IAS 36 says you should perform an impairment review only when there is an indication that an impairment may have occurred. These indicators are split into two categories:
External Sources of Information
• A significant fall in the asset's market value (more than expected).
• Negative changes in the technology, market, economy, or laws in which the company operates.
• An increase in market interest rates (this reduces the "Value in Use" calculation).
• The company’s stock market value is lower than the book value of its net assets.
Internal Sources of Information
• Evidence of physical damage or obsolescence (e.g., a machine breaks).
• Plans to discontinue or restructure the operation the asset belongs to.
• Evidence that the economic performance of an asset is worse than expected (e.g., it's producing fewer units than planned).
Quick Review Box
Important! Most assets are only tested when there is an indicator. However, Goodwill and Intangible assets with indefinite useful lives (or not yet available for use) must be tested for impairment annually, regardless of whether there are indicators or not.
3. Calculating the Recoverable Amount
This is where students sometimes get confused, but there is a simple trick to remember it. The Recoverable Amount is the HIGHER of two figures:
1. Fair Value Less Costs of Disposal (FVLCD): How much cash you would get if you sold the asset today, minus direct disposal costs (like legal fees or removal costs).
2. Value in Use (VIU): The "internal" value. This is the present value of the future cash flows the asset is expected to generate by continuing to be used in the business and from its ultimate disposal.
Formula:
\( \text{Recoverable Amount} = \max(\text{FVLCD}, \text{VIU}) \)
Why the higher of the two? Because as a rational business owner, if your asset is worth more to sell than to use, you would sell it! If it's worth more to keep and use, you'd keep it. You will always choose the option that gives you the most value.
4. Calculating and Recording the Impairment Loss
Once you have your Recoverable Amount (RA), compare it to your Carrying Amount (CA).
If CA > RA: You have an impairment loss.
Formula:
\( \text{Impairment Loss} = \text{Carrying Amount} - \text{Recoverable Amount} \)
If RA > CA: No new impairment has occurred at this reporting date. However, if an impairment loss was recorded in previous years, check whether that prior loss should now be reversed.
Accounting Treatment
Where does the loss go? It depends on whether the asset has been revalued before:
• For assets held at historical cost: Charge the loss immediately as an expense in the Statement of Profit or Loss (P&L).
• For revalued assets: First, charge the loss against any existing Revaluation Surplus in other comprehensive income for that specific asset (reducing equity). Any remaining loss exceeding that surplus is recognized in profit or loss.
Key Takeaway
Always check if there is a Revaluation Surplus first! It acts like a "buffer" that protects the Profit or Loss account from the impact of the impairment.
5. Cash Generating Units (CGUs)
Sometimes, it’s impossible to calculate the recoverable amount for a single asset because it doesn't generate cash on its own. Think of a single machine in a massive assembly line—it doesn't produce cash unless the whole line is working. In this case, we group assets into a Cash Generating Unit (CGU).
Definition: A CGU is the smallest identifiable group of assets that generates cash inflows that are largely independent of the cash inflows from other assets.
Allocating an Impairment Loss to a CGU
If a CGU is impaired, we have to spread the loss across all the assets in that unit. Follow this priority list:
1. Specific Assets: If you know one specific asset is damaged or destroyed, write it down first.
2. Goodwill: Next, allocate the remaining loss to reduce any Goodwill allocated to that CGU to zero.
3. Other Assets (Pro-rata): Any remaining loss is spread across the other non-current assets in the CGU based on their relative carrying amounts.
Critical Rule: When spreading the loss, you cannot reduce the carrying amount of an asset below the highest of:
• Its individual Fair Value Less Costs of Disposal (if measurable);
• Its individual Value in Use (if determinable); and
• Zero.
Any unallocated loss from this restriction is reallocated pro-rata to the other assets in the CGU.
6. Reversal of an Impairment Loss on an Individual Asset
At each reporting date, an entity must assess whether there is any indication that an impairment loss recognized in prior periods may no longer exist or may have decreased (e.g. favorable economic conditions or technological improvements).
If such an indicator exists, the recoverable amount must be recalculated:
• General Rule: The prior impairment loss on an individual asset is reversed and recognized immediately in the Statement of Profit or Loss (or treated as a revaluation increase in OCI if the asset is carried at revalued amount).
• Upper Ceiling Limit: The reversal is strictly capped. The increased carrying amount cannot exceed the carrying amount that would have been determined (net of depreciation or amortisation) had no impairment loss been recognized in prior years.
• Goodwill Rule: Goodwill impairment can NEVER be reversed. Under IAS 36, any impairment loss recognized for goodwill is permanent.
7. Common Mistakes to Avoid
• Don't use the lower of FVLCD and VIU: Always use the higher one for Recoverable Amount. Remember, businesses want to maximize their returns!
• Don't ignore costs to sell: If the exam gives you "Fair Value" and "Selling Costs," you must subtract the costs before comparing it to Value in Use.
• Watch the Revaluation Surplus: If you have a loss of \$10,000 and a Revaluation Surplus of \$4,000, only \$6,000 goes to the P&L. The first \$4,000 clears out the surplus.
• Depreciation after impairment: After an impairment (or reversal), you must calculate future depreciation based on the new revised carrying amount over the remaining useful life.
• Never reverse goodwill: An impairment on goodwill cannot be written back, even if circumstances improve drastically.
8. Summary Checklist
• Step 1: Look for indicators (Internal/External) or perform mandatory annual testing for goodwill and indefinite life intangibles.
• Step 2: Calculate Recoverable Amount (Higher of FVLCD and VIU).
• Step 3: Compare RA to Carrying Amount. If CA > RA, recognize an impairment loss.
• Step 4: Recognize the loss in P&L (unless offsetting an existing revaluation surplus in OCI).
• Step 5: For CGUs, follow the allocation order (Specific assets → Goodwill → Other assets pro-rata).
• Step 6: Assess for reversals on individual assets (subject to the depreciated historical cost ceiling, never reversing goodwill).
Final Encouragement: Impairment is just a way to keep accounts honest. Master the "Higher of" rule, the CGU allocation sequence, and the limits on reversal, and you will be well on your way to success in your FR exam!