Impairment in Accounting Explained for Dummies

What is impairment?

In accounting, impairment is the term used to describe a situation when a sudden and unforeseen decrease occurs in the fair value, also known as the current market price, of an asset.

Impairment is occasionally called writing down.

When an asset’s fair value drops below its carrying value (book value) as reported on a company’s balance sheet, a company is required to follow International Accounting Standard 36 (Impairment of Assets).

The aim of IAS 36 is ‘to ensure that an entity’s assets are not carried at more than their recoverable amount and to describe how the recoverable amount is determined. Standard 36 defines recoverable amount as ‘the higher of fair value less costs of disposal and value in use.’ (All the accentuations in citations from International Accounting Standards are by the article writer.)

Aspects regarding impairment attended to in IAS 36

Definitions

• Impairment loss: ‘The amount by which the carrying amount of an asset or cash-generating unit exceeds its recoverable amount.’ (A cash-generating unit (CGU) is described by IAS 36 as ‘the smallest identifiable group of assets that are largely independent of the cash flows from other assets of groups of assets.’
• Carrying amount: ‘The amount at which an asset is recognised in the balance sheet after deducting accumulated depreciation and accumulated impairment losses.
• Recoverable amount: ‘The higher of an asset’s fair value less costs of disposal (sometimes called net selling price) and its value in use.’
• 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.’
• Value in use: ‘The present value of the future cash flows expected to be derived from an asset or cash-generating unit.’

Impairment requirements

Timing of impairment

• An annual impairment test for goodwill and intangible assets which are not yet available for use.
• Regarding a qualifying asset, where there is an indication of impairment.

Assets included and excluded

• Included

IAS 36 applies to, inter alia, the following assets:

• Land
• Buildings
• Machinery and equipment
• Intangible assets
• Goodwill
• Investment property carried at cost
• Investments in subsidiaries, associates, and joint ventures at cost

An asset is called an ‘impaired asset’ when its carrying amount exceeds its fair value.

• Excluded

The following assets are not subjected to impairment:

• Inventories
• Deferred tax assets
• Assets arising from employee benefits
• Assets obtained from construction contracts
• Financial assets
• Agricultural assets carried at fair value (refer IAS 41)
• Insurance contract assets
• Non-current assets held for sale
• Investment property carried at fair value

Reasons for the impairment of an asset

Impairment can be ascribed to numerous factors, external and internal. The following lists are examples of factors that can compel a company to record the impairment of an asset in its accounting system.

External factors

• A significant decline in the market value of an asset
• Drastic changes in the economy, laws, technology, and markets, negatively affecting the company or some of its assets
• The net assets of the company exceed its market capitalisation
• Escalating costs, implying running costs to maintain an asset are much higher than expected with the acquisition of the asset, or running costs have considerably escalated over time, causing a reduction in the value of the asset

Internal factors

• Obsolescence or physical damage to an asset
• The asset is not operating or being used
• Worse economic performance than expected
• The asset is part of a restructuring or held for disposal

How an impaired asset is recorded in a company’s accounting system

If an impairment test indicates that an asset is impaired, an impairment loss should be recorded.

An impairment loss is recorded as an expense and is reported on the income statement. Simultaneously, the value of the impaired asset is reduced with the amount of the impairment loss and reported as such on the balance sheet.

Advantages of impairment

• Recording the impairment of an asset, provides analysts and investors with valuable information, enabling them to evaluate how efficiently the management of a company governs and directs the operations of a company.
• The impairment in the value of assets can serve as an early warning to creditors and investors of imminent failures in the company.

Disadvantages of impairment

• Generally, it is difficult to determine the value that must be used for the impairment of an asset.
• There are no detailed guidelines on how to treat impaired assets, for instance when to recognise impairment, how to measure impairment, and how to disclose impairment.

Impairment versus depreciation and amortisation

Although all three accounting methods record the reduction in the value of an asset, the differences between them are described below:

• Depreciation:

In accounting, depreciation refers to the method used by businesses to allocate the cost of a tangible or physical asset over its useful life, also referred to as its life expectancy.

International Accounting Standard 16 defines depreciation as the allocation of an asset’s depreciable amount on a systematic basis over the useful life of the asset.

Useful life refers to the period the asset is in use, based on, inter alia, the following criteria: usage, expected output, the number of production units expected to be obtained from the use of the asset, legal limits, and expected wear and tear.

In South Africa, the South African Revenue Service (SARS) allows ‘depreciation allowances’, also referred to as ‘wear-and-tear allowances’, for certain ‘qualifying assets, such as ’machinery, plant, implements, utensils, vehicles, and other qualifying assets.

SARS allows the following two methods of depreciation:

The straight-line method

The formula to calculate the annual depreciation of an asset is the cost price of the asset x depreciation rate. The depreciation rate is based on the useful life of the asset. For instance, if the useful life of an asset is 4 years, the depreciation rate will be 25% (100%/4) per year.

The diminishing-value method

According to SARS, this method calculates the depreciation for a year of assessment on the remaining value of the asset (book value), that is, the cost of the qualifying asset less an allowance for the previous years of assessment.’

The formula is as follows: Book value x Depreciation rate

• Amortisation (also known as amortization)

Basically, the meanings of depreciation and amortisation are the same. The main difference between the two terms is that amortisation is applied to intangible assets, such as goodwill, patents, trademarks, and trading licences, to name a few.

• Impairment

As with depreciation and amortisation, impairment also deals with the reduction in the value of an asset.

However, impairment of an asset in accounting is required when a sudden and irreversible decrease in the value of an asset occurs. For example, when equipment is damaged due to an explosion.