Impairment of Assets Formula: Accounting Explained

Understanding asset impairment is crucial for accurate financial reporting. Most accountants would agree that improperly measuring asset values can significantly misrepresent a company's financial health.

This article explains the impairment of assets formula to calculate declining asset values. You'll learn the key procedures for recording impairment losses and reversals under IFRS and GAAP standards.

We cover identification cues for impaired assets, walk through the formula calculations and journal entries, examine goodwill impairment testing, and compare IAS 36 and ASC 350. You'll also learn about the tax benefits of reporting asset write-downs.

Introduction to Asset Impairment

Asset impairment refers to when an asset on a company's balance sheet decreases in value. This can happen for various reasons, such as:

A decline in the asset's market value
Changes that impact the asset's ability to generate future cash flows
Damage or obsolescence that decreases the asset's functionality

When impairment occurs, the carrying value of the asset on the financial statements exceeds its current fair market value. Carrying value refers to what the asset is recorded as, based on its historical cost less accumulated depreciation to date.

To ensure assets are not overvalued on financial statements, companies are required to test certain assets for impairment periodically. If impairment exists, an impairment loss must be recognized on the income statement to write down the asset to its current fair value.

Testing and recording impairment losses is an important accounting requirement under both U.S. GAAP and IFRS. Key standards include ASC 360 and IAS 36.

This introduction summarizes the essential concepts related to asset impairment. The sections below will explore the technical details of impairment testing and accounting in further depth.

What is the formula for the impairment of an asset?

The formula to calculate impairment of an asset is:

Impairment Loss = Carrying Amount of Asset - Recoverable Amount

Where:

Carrying Amount: The value of the asset on the company's balance sheet, which is typically the asset's original cost less accumulated depreciation to date
Recoverable Amount: The higher of the asset's 1) fair value less costs to sell and 2) value in use

Essentially, if the carrying amount exceeds the recoverable amount, there is impairment that needs to be recognized.

For example:

A piece of equipment was purchased 5 years ago for $100,000
It has been depreciated over 5 years down to a carrying value of $60,000
Due to decreased demand, the fair value of the equipment is now determined to be $30,000

In this case:

Carrying Amount = $60,000 Recoverable Amount = $30,000 (fair value)

Since the carrying amount exceeds the recoverable amount, there is an impairment loss of $30,000 that must be recorded.

The journal entry would be:

Impairment Expense = $30,000
Accumulated Depreciation = $30,000

Recording this impairment loss reduces the carrying amount to equal the recoverable fair value at the measurement date.

How do you calculate the impairment of assets value in use?

To calculate the impairment of an asset's value in use, companies follow these key steps:

Estimate future cash flows from the asset over its remaining useful life. This involves making assumptions about revenue, costs, capital expenditures etc. related to using the asset.
Determine an appropriate discount rate to calculate the present value of those estimated future cash flows. The discount rate should reflect current market rates and the risks associated with realizing the projected cash flows.
Calculate the present value of the future cash flows by applying the discount rate. This gives the value in use of the asset.
Compare the value in use to the asset's current carrying value on the balance sheet. If the value in use is less than the carrying value, an impairment charge must be recognized for the difference.

The value in use calculation requires management to make estimates and assumptions about the future cash flows and discount rates. Changes in these assumptions can significantly impact the resulting valuation. Companies are required to disclose key assumptions and sensitivities used in impairment testing.

What is an example of asset impairment in accounting?

Understanding asset impairment is an important concept in accounting. Here is a practical example to illustrate:

A construction company may face extensive damage to its heavy machinery and equipment due to a natural disaster or severe weather event. This type of sudden and significant decline in the fair value of assets below their carrying value on the books is an indicator of potential impairment.

Specifically, if the damaged assets' market value has dropped well below what the company originally paid for them (their historical acquisition cost), impairment may need to be recognized. The company would compare the assets' current fair value to their carrying value on the financial statements. If the fair value is less, this suggests impairment.

For instance, say a bulldozer originally cost $100,000. Due to the natural disaster, it now has extensive damage that significantly impacts its functionality and reduces its market value to only $30,000. This $70,000 decline triggers an impairment test under accounting rules.

If impairment is confirmed, the company would write down the bulldozer's book value by $70,000, recording this as an impairment loss expense on their income statement. This reduces the asset's value on the balance sheet to its new fair market value of $30,000.

In summary, sudden damage or functionality issues reducing market value can lead to recognizing impairment losses under accounting standards like IAS 36 and ASC 360. This ensures assets are not overvalued on financial statements.

How does the impairment of financial assets work?

Impairment of assets occurs when an asset's carrying value on the balance sheet exceeds its fair value. Here is an overview of how asset impairment works under US GAAP:

When Asset Impairment Testing is Required

Companies are required to test assets for impairment when events or changes in circumstances indicate that the carrying amount may not be recoverable. Some examples that may trigger impairment testing include:

A significant decrease in the market value of an asset
A significant change in the extent or manner an asset is used
A significant physical change in the asset
A significant adverse change in legal factors or business climate affecting the asset
Current-period operating or cash flow losses combined with a history of losses or projected losses

Steps for Testing and Measuring Impairment

If impairment indicators are present, companies follow a two-step process:

Compare asset's carrying value to the undiscounted future cash flows expected from the asset. If the carrying value exceeds the undiscounted cash flows, proceed to step 2.
Calculate the asset's fair value. Recognize an impairment loss for the excess of the carrying value over the fair value.

The impairment loss is recorded as an expense on the income statement, which reduces net income for the period.

Companies can use various valuation methodologies to estimate an asset's fair value, such as market comparables, discounted cash flows, or replacement costs. Judgment is involved in determining fair value.

After Impairment

Once an asset is impaired, its new cost basis becomes the impaired carrying value. Future depreciation or amortization is adjusted based on the new carrying amount and remaining useful life.

Companies must assess at each reporting date whether indicators exist that impairment may no longer exist or may have decreased. If so, they must recalculate the asset's recoverable amount. A previously recognized impairment can be reversed up to the amount of original impairment.

In summary, asset impairment reduces the carrying value of assets on the balance sheet when fair value declines below book value. Following US GAAP impairment guidelines is key for accurate financial reporting.

Identifying Signs of Impairment

Impairment of assets can be indicated by several events or changes in circumstances. Careful monitoring and analysis of assets is important to determine if impairment exists.

Assessing Decreased Asset Functionality

A decline in an asset's functionality or utility can signal the need for impairment testing. Situations that may indicate decreased functionality include:

A significant change in how the asset is used or a reduction in its output capacity
Physical damage or obsolescence that impacts the asset's ability to generate future economic benefits
Changes in technology or the business environment that diminish the usefulness of the asset

If functionality and output have notably declined, it can directly reduce the discounted cash flows used to determine the asset's recoverable amount for impairment testing.

Market Value Declines and Impairment

Markets continuously evaluate the worth of assets. A substantial and prolonged decline in the market value of an asset below its carrying value on the balance sheet may signify impairment.

Factors to analyze when considering the market value impact include:

The magnitude and duration of the value decline
Volatility in the market and whether changes are temporary
The reason for the decrease and if they relate to adverse economic or company-specific events

Significant and sustained market value reductions frequently foreshadow asset impairment due to diminished expectations of future cash inflows.

Future Cash Flow Projections and Impairment

Projected cash flows are a key assumption used in estimating recoverable value. Revisions to cash flow forecasts can indicate impairment triggers, such as:

Worse-than-expected economic conditions and unfavorable industry changes
Increased costs of raw materials, labor, or other expenses
Loss of major customers or new competitive threats affecting revenue
Higher assumed discount rates due to rising capital costs and investment risks

Downward adjustments to expected future cash flows directly reduce an asset's calculated recoverable amount, making impairment more likely. Careful monitoring of cash flow assumption changes allows for timely impairment testing.

The Impairment of Assets Formula Explained

The impairment of assets formula is used to calculate and record impairment losses in financial statements. Impairment occurs when an asset's carrying value on the balance sheet exceeds its recoverable amount.

Calculating the Recoverable Amount

To test for impairment, first the asset's recoverable amount must be determined. This is the higher of:

Fair value less costs to sell - The amount obtainable from selling the asset in an orderly transaction between market participants, minus disposal costs
Value in use - The present value of estimated future cash flows expected from continuing use of the asset and its eventual disposal

If the asset's carrying value exceeds its recoverable amount, there is an impairment loss that must be recognized.

For example, if equipment with an original cost of $100,000 and accumulated depreciation of $20,000 (carrying value of $80,000) has a fair value less costs to sell of $60,000 and a value in use of $70,000, it is impaired since its carrying value exceeds its recoverable amount of $70,000. There is an impairment loss of $10,000.

Recording Impairment Loss on the Income Statement

The impairment loss is recorded as follows:

Debit Impairment Loss Expense on the income statement
Credit Accumulated Depreciation (for the impaired asset's specific account)

This reduces net income in the current period by the amount of the impairment loss. It also decreases the asset's carrying value on the balance sheet to its new recoverable value.

For the above example, the journal entry would be:

Debit:  Impairment Loss Expense     $10,000
         Credit: Accumulated Depreciation—Equipment $10,000

Reversal of Impairment Losses: When and How

Under IFRS, impairment losses can be reversed in future periods if conditions improve such that the recoverable amount increases. This is not permitted under US GAAP.

To record a reversal of an impairment loss under IFRS:

Debit Accumulated Depreciation
Credit Impairment Loss Reversal on the income statement

This increases net income and restores some or all of the previously recognized impairment loss. The asset's carrying value is increased accordingly.

Reversals are limited to the amount needed to restore the pre-impairment carrying value. Goodwill impairment can never be reversed.

Impairment Testing Approaches

This section provides an overview of common methods used to test assets for impairment, such as discounted cash flow models and fair value assessments.

Applying Discounted Cash Flow for Impairment Testing

Discounted cash flow (DCF) analysis can be used to determine if an asset's carrying value is recoverable. The steps include:

Estimate future cash flows the asset is expected to generate over its remaining useful life
Determine an appropriate discount rate to calculate the present value of those estimated future cash flows
Compare the present value to the asset's current carrying value on the balance sheet
If the present value is less than the carrying value, an impairment charge may be required

Key inputs into the DCF model include revenue growth rates, profit margins, capital expenditures, and the discount rate. Cash flow projections should be based on reasonable assumptions about the asset's highest and best use.

Fair Value Measurement under IFRS 13

IFRS 13 provides guidance around measuring fair value for financial reporting purposes. Key principles include:

Fair value aims to represent a hypothetical exit price for an asset as of the measurement date
Entities should maximize the use of relevant observable inputs and minimize unobservable inputs
The fair value hierarchy prioritizes inputs used in valuation techniques:
- Level 1: Unadjusted quoted prices in active markets for identical assets
- Level 2: Inputs other than quoted prices that are observable either directly or indirectly
- Level 3: Unobservable inputs for the asset

When testing assets like property, plant and equipment for impairment, IFRS 13 can provide a framework for deriving comparable fair market values.

Revaluation and Impairment: A Dual Approach

In some cases, assets are measured at revalued amounts rather than historical cost on the balance sheet. Upward revaluations can increase the carrying amount. However, a subsequent downward revaluation may be an indicator of impairment. Key points:

If an asset's fair value declines below its carrying amount, this may trigger an impairment test
Impairment charges reduce the revalued amount rather than being based on original cost
Future upward revaluations can reverse impairment losses from prior periods

So, revaluation and impairment provide complementary approaches to ensuring assets are not overstated on the balance sheet.

Performing Goodwill Impairment Tests

Goodwill impairment testing is an important process for companies to periodically evaluate the fair value of goodwill assets on their balance sheets. This section provides an overview of techniques for testing and recording goodwill impairment under US GAAP and IFRS accounting standards.

Goodwill Impairment Accounting Procedures

The key steps involved in accounting for goodwill impairment are:

Determine the carrying value of the reporting unit that contains the goodwill. This includes assets, liabilities, and goodwill.
Establish the fair value of the reporting unit. This is generally done using valuation models like discounted cash flow analysis.
Compare the fair value to the carrying value. If the carrying value exceeds the fair value, there is a potential goodwill impairment.
Calculate the implied fair value of goodwill by deducting the fair values of all other net assets from the reporting unit's fair value. Compare this to the carrying amount of goodwill.
If the carrying amount of goodwill is higher than the implied fair value, record an impairment charge for the difference. This charge reduces the goodwill asset on the balance sheet and is recorded as an operating expense on the income statement.

Companies need to exercise judgment, especially with future cash flow projections, when testing for goodwill impairment. The frequency of testing differs between US GAAP and IFRS.

The Role of ASC 350 in Goodwill Impairment

The FASB's ASC 350 provides guidance to companies on accounting for goodwill after an acquisition and testing for impairment. Key aspects include:

Companies are required to test goodwill for impairment annually or when a triggering event occurs indicating possible impairment.
A qualitative initial assessment can first be performed to evaluate if quantitative testing is necessary.
The quantitative impairment test involves comparing implied goodwill value to carrying value as outlined above.
Goodwill should be assigned and tested at the reporting unit level, not the consolidated company level.
Detailed guidance is provided on testing procedures, valuation methodologies, frequency, and disclosures.

Under ASC 350, the impairment charge is not tax deductible and reduces future earnings capacity. However, testing goodwill regularly for impairment provides a more accurate financial picture for investors and analysts.

Impairment Accounting Differences: IFRS vs. US GAAP

This section will highlight key differences and similarities in impairment guidance between IFRS and US GAAP.

Contrasting the Impairment Models of IFRS and US GAAP

The main differences between IFRS and US GAAP in impairment accounting include:

Measurement of Impairment: IFRS uses a one-step model to determine asset impairment based on the higher of fair value less costs of disposal and value in use. US GAAP uses a two-step model, first testing for impairment by comparing carrying value to undiscounted future cash flows, then measuring impairment as the difference between carrying value and fair value.
Timing of Testing: IFRS requires testing whenever there is an indication of impairment. US GAAP sets specific events that automatically require impairment testing, such as a significant decrease in share price.
Reversals of Impairment: IFRS allows impairment losses to be reversed in future periods if conditions improve. US GAAP prohibits reversal of impairment losses for most assets.
Goodwill Impairment: Under IFRS, goodwill must be allocated to cash generating units and tested annually for impairment. US GAAP allows testing at the reporting unit level first and impairment is recognized only if fair value is less than carrying value.

The two frameworks align in requiring assets to be carried at no more than their recoverable amount and recognizing impairment charges on the income statement. But key differences lead to timing variations and greater impairment charges under IFRS.

IAS 36 – Impairment of Assets and Its US Counterpart

The IASB's IAS 36 outlines detailed methodology for identifying impaired assets, measuring recoverable amounts, recognizing and reversing impairment losses, and disclosures. The FASB's ASC 360-10 provides the US GAAP equivalent on accounting for impaired long-lived assets like property, plant and equipment.

Key aspects of IAS 36 not present in ASC 360-10 include:

Annual goodwill impairment testing requirements
Reversing impairment losses when conditions improve
More prescriptive fair value measurement guidance

So while ASC 360-10 covers impaired asset measurement concepts, IAS 36 provides more comprehensive guidance on applying impairment across all asset types.

Tax Implications of Asset Impairment and Disposal

Asset impairment can have tax consequences that are important to consider when making write-down decisions. Understanding the potential tax benefits can influence the approach.

Navigating the Tax Benefit of Impairment Losses

Impairment losses are generally tax deductible in the year the loss is recognized. This can provide a tax benefit by reducing taxable income. However, the tax rules differ across jurisdictions.

It's important to consult with a tax advisor to determine the specific tax implications in your situation. Key factors to evaluate:

Whether the tax deduction can be carried forward if it exceeds taxable income in the current year
Any limitations on using the impairment loss to offset taxable income
The reinvestment plans for the impaired asset and impact on future deductions

Weighing the tax impact alongside accounting and strategic factors allows for fully-informed decision making.

Strategic Reinvestment Following Asset Write-downs

After recognizing impairment on an asset, next steps may include:

Repurposing or selling the asset
Investing capital into upgrading the asset
Shifting capital to new assets aligned with strategic goals

Careful planning can optimize reinvestment decisions to support business objectives.

For example, using an impairment loss tax deduction to fund new asset purchases that drive strategic growth priorities. Or selling the impaired asset and directing freed up capital to expand production capacity.

Reinvestment plans are a key input when deciding on asset impairment testing approaches. The outcomes influence follow-on decisions.

In summary, evaluating tax consequences and mapping strategic reinvestment options are vital steps when assessing asset impairment scenarios. This ensures fully-optimized decisions aligned to financial, tax and business goals.

Concluding Summary

The article has covered key aspects related to asset impairment under generally accepted accounting principles. When the carrying value of an asset exceeds its fair value, an impairment charge may need to be recognized. This can impact net income and equity on the financial statements.

It is important for businesses to have robust policies and procedures around asset valuation, particularly for fixed assets and goodwill. Assets should be evaluated regularly to determine if impairment testing is required. Factors like decreased functionality, changes in market conditions, or lower cash flows can be triggers.

If an impairment charge occurs, companies should ensure proper disclosure in the financial statements and notes. They may also consider tax implications, potential reinvestment options, and longer-term strategic plans.

Adhering to accounting standards around asset impairment can help provide more accurate financial reporting. It also supports better operational and investment decisions aligned to actual asset values. Understanding these concepts is key for controllers, CFOs, auditors and other financial professionals.