Impairment by definition:
“Impairment is a factor which hampers the ability of an asset to yield future economic benefits.”
Didn’t get it? Ok, let me simplify it for you. Impairment makes assets less usable. This means, after the impairment, the asset will not be as useful as it was before the impairment happened.
For example, if a car gets damaged in an accident, it’s market value may decrease. Also, its ability to generate future cash flows may also decrease. Both these factors result in a decrease in the ability of the car to generate economic benefits and is thus impairment of the car.
In accounting terms, an asset is impaired if its net book value exceeds the present value of its future cash flows. (this will be explained further in the calculation of impairment)
Key Features of Impairment:
- Impairment is not a necessary happening with every asset. Some assets may complete their useful life without any impairment.
- Impairment is a very subjective term and would require special examination or detailed analysis to find out the value of impairment. Different experts may determine a different amount of impairment depending on what assumptions have been keyed in the analysis.
- Impairment may result either in a loss in the market value of the assets OR the reduction in the flow of economic benefits from that asset OR both.
- There may be different causes of impairment like physical damage or decrease in the market value or decision of the management or loss of reputation or some regulatory or government directives.
- Both tangible and intangible non-current assets may get affected by impairment
- Charging impairment (where appropriate) ensures that assets are not overstated in the statement of financial position of the entity.
- What’s best about an asset whose net book value is zero? There won’t be any impairment on it
Impairment is an expense which results in a credit entry in the asset’s account and debit in the impairment expense account. This area is dealt in detail with IAS 37 “Impairment of Assets.”
Debit: Impairment expense account (P&L)
Credit: Asset cost account (B/S)
This accounting treatment is in contrast to the depreciation where there is no accounting entry passed in the asset account directly.
Indicators of impairment
Sometimes the impairment may be quite visible, i.e., physical damage to the asset due to some accident or natural calamity. However, in some cases, impairment is not entirely visible. Below are some of the indicators which may suggest that an impairment has occurred.
- In-house or external development of an alternative process/machine
- A decrease in the market demand of the product(s) produced by the asset
- A release of an updated model of the product by the vendor
- Decrease in the useful life of the asset due to an external factor
- A partial or full ban by regulators on the products manufactured through the asset
- Physical damage to the asset
- Leakage of the secret product formula which created a competitive edge
- Attack of infectious viruses which lead to malfunctioning of the software
- Obsolescence of the technology which was used to develop the asset
- Development of a better software by the vendor or the competitor
- Theft of the base code by hackers
Last 4 points in the above list are related to software/intangible assets.
Calculation of impairment
In order to calculate impairment, first, check if the net book value of the asset is higher than its recoverable value. The recoverable value is calculated by taking higher of
- the value in use, and;
- fair value less cost of disposal.
Calculation of value in use of the asset may not be simple always and may require several complex calculations.
On a general note, adopt the following step-wise-approach:
- Estimate future cash flows specifically attributable to the asset/CGU (Cash Generating Unit)
- Use appropriate discount rate to calculate the net present value of the asset/CGU
- Ensure that all irrelevant and non-incremental costs/revenues are not included in this calculation
Fair value less cost of disposal is rather easy to calculate in the sense that a market rate of the similar asset/similar deal is taken and any selling expenses (i.e., commission, advertisement, necessary repair, loading/unloading, etc.) are deducted from the sale proceeds.
Let’s take the following example to understand the above concepts:
A company has purchased a machine for $100,000 which has a useful life of 4 years. The company uses straight-line depreciation method. At the beginning of year 4, this machine started malfunctioning due to electric shock, and now it is estimated that its production ability is reduced to half.
If the machine is used in business, it’ll generate an annual profit of $20,000 in the fourth year with nil residual value. If the machine is sold immediately, it will be purchased by a scrapyard for $16,000 after paying a commission of $500.
What will be the impairment charge at the beginning of year 4?
Let’s take a step-wise approach:
Steps 1: Calculate net book value of the asset: i.e., After 3 years of depreciation $75,000 ($25,000 x 3 years) the net book value will be $25,000 ($100,000 – $75,000) at the beginning of year 4.
Step 2: Calculate recoverable value which is higher of:
- The value in use: Value in use, in this case, is $20,000
- Immediate disposal proceeds less cost to sell: in this case is $15,500 ($16,000 – $500)
Thus the recoverable value of the machine is $20,000.
Step 3: Compare answers to step 1 and 2 and see if net book value is higher or low than the value in use. As net book value is $25,000 and the recoverable value is $20,000, there is an impairment charge of $5,000.
Reversal of impairment
It some rare cases, it is allowed to reverse the impairment charged on an asset/CGU. Reversal of impairment may result due to any of the following factors:
- Revised estimates of the remaining useful life of the asset indicating improved useful life
- Improvement in the production capacity of the asset due to better operations or maintenance
- Increase in the market value of the product which is being produced/manufacturing using the asset under review
- Other factors which may logically depict reversal of the impairment
It is worth mentioning that the reversal of the impairment can be up to a maximum extent of the impairment charged earlier. Let’s say if impairment was charged on an asset of $5,000, then the maximum reversal of this entry can be only up to $5,000 and not more than that (however, less than $5,000 reversal of impairment is allowed).