Impairment test is an accounting procedure carried out to find out if an asset is impaired, i.e. whether the economic benefits that the asset embodies have dropped drastically. Under US GAAP, if the carrying value of an asset exceeds the sum of undiscounted expected cash flows of an asset, the asset is impaired.
An asset’s carrying value reflects its worth. Conceptually, the value should equal its fair value and whenever the carrying value is different from its fair value, the carrying value must be reduced by the amount of difference by recognizing an expense called impairment expense in the income statement. The impairment expense is different from depreciation and amortization. It represents a non-continuous adjustment made as and when required.
Indicators of Impairment
Impairment review is required each year to assess whether there are indications that impairment might have occurred. These include:
- obsolescence due to new technological changes,
- decline in performance i.e. net cash flows of the asset or CGU,
- decline in market value of the asset,
- changes in economy such as an increase in labor cost, raw materials, etc. that would shrink the net cash flows of the asset
- physical damage to the asset such as fire or other accident
- major restructuring i.e. reshuffling of products, segments, acquisition of new assets, etc.
Steps in Impairment Test
Under US GAAP, ASC 360-10 offers accounting guidance related to impairment testing. US GAAP impairment test has two steps:
- Step 1: compare the sum of all undiscounted net cash flows that the asset is expected to generate with the carrying value of the asset. If the carrying value is lower than the sum of cash flow, it indicates impairment and vice versa.
- Step 2: once it is established that impairment has occurred, the amount of impairment expense is determined as the difference between the carrying value of the asset and its fair value.
Under IFRS, IAS 36 offers impairment guidance. IFRS impairment test is more comprehensive. It involves comparing carrying value of the asset with its recoverable amount, which is the higher of the asset or cash-generating unit’s fair value less cost and value in use. Value in use is the present value of net incremental cash flows that a company generates by using the asset in its operations.
Your company owns a fleet of 200 articulated diesel buses. Environmentalists are pressing the government to require public transit companies to switch to hybrid buses. You expect to earn $12 million from the buses each year for next 5 years. There is a 50% chance that the new laws will be passed which will reduce your revenues from the fleet by 30%. The carrying value of your fleet is $55 million and your company’s cost of capital is 12%. Find out if there is any impairment loss, if you company follows US GAAP.
In the first step of the impairment test, you need to compare the sum of expected undiscounted cash flows with the carrying value of the fleet. Expected cash flows per year is $10.2 million (=0.5 × $12 million + 0.5 × 12 million × (1 – 0.3)). Total expected undiscounted cash flows over the remaining useful life of the asset are $51 million ($10.2 million × 5). Because the carrying value is higher than the sum of cash flows, the asset is impairment.
In the second step, you need to find out the actual amount of the impairment expense which equals the difference between the fair value of the asset and its carrying value. The present value of expected cash flows, which in this case works out to $36.77 million, is a good indicator of fair value. Impairment loss that must be recognized equals $18.33 million (=$55 million - $36.77 million).