What Does Asset Impairment Mean?
In the world of finance, impairment is the term used to imply a permanent decrease in the value of a company’s asset - be it a tangible asset or an intangible one. When compared, if an asset’s book value (also known as its total carrying value) proves to be more than the expected future profits from it, the asset is considered impaired.
What does Impairment Mean?
Detailed Explanation of Asset Impairment with Examples
What Causes Impairment of Assets?
Accounting Standards to Follow for Impairment of Assets
Asset Impairment vs. Asset Depreciation table
Detailed Explanation of Asset Impairment with Examples:
When testing an asset for impairment, its estimated future cash flow and total benefits from it are stacked against book value on the company’s balance sheet. If said book value is found to surpass the total projected profit of the asset, the asset is jotted down as an impaired one. Once an asset is declared impaired, the asset’s new decreased book value is recorded on the balance sheet, and simultaneously, an impairment loss is conceded on the company’s income statement.
A company is supposed to have accountants test its assets for impairment from time to time. If an impairment is found, it’s noted as the disparity between the carrying value and the fair value (the price a company projects to receive out of an asset when they sell it in the future) of the asset.
All tangible (e.g., property, fixed equipment, furniture, etc.) and intangible (e.g., patent, permits, etc.) assets of a company can be subjected to impairment, but receivable accounts, long-term assets, and fixed assets are usually the ones at the most risk of getting impaired due to the carrying value having a long stretch of time for the company’s projected profit amount to fall below it.
For example, say a company named XYZ acquired a building two years ago at the price of ₹2 crores. After depreciating the building, its carrying value was recorded as ₹1.25 crore on the company’s balance sheet. Now, the building has suffered some severe damage due to a flood recently, so XYZ decides to get it tested for impairments. The investigation of the damage concludes the building now has a total worth of ₹90 lakhs. So now, the building has been specified as an impaired asset, and the value has to be re-recorded on XYZ’s balance sheet to avoid an exaggeration. The impairment loss must reflect on its income statement as a notable decrease in the company’s net earnings.
Among real-world examples, consider Tata Steel Ltd.’s 2006 acquisition of the European steel company Corus Group Plc. (the venture is now known as Tata Steel Europe). Within one month of the acquisition (for which Tata Steel bid ₹1300 crores), the share price of the company fell by more than 20%. In the first quarter of 2020, the Tata Steel group announced a loss of ₹1,236.17 crores from the impairment of their acquired European assets.
What Causes Impairment of Assets?
An asset may become impaired owing to a number of reasons, such as:
- Damage to its condition over the years or because of a natural calamity,
- Change in the asset’s price due to market volatility
- variation in customer demand with changing times, and numerous more.
Rounded up here are only the most common few factors that might prompt companies to get their assets checked for impairment:
- An asset that’s quite old or has lacked proper maintenance
- An asset that has obtained serious physical damage
- Discontinued restructuring/plans of other operations involving the asset
- An asset that has been sitting idle for quite some time
- An asset initially planned to be disposed of
- Worse economic performance than assumed beforehand
- An asset that is incapable of providing the expected profits out of a joint venture or a financial association of any other kind.
- A change in technology heralding a significant decrease in the value of an asset
- Newer economic and/or legal rules and regulations that directly concern the function of an asset
- A drastic fall in the asset’s market price
- Swelled up market interest rates
- An asset’s carrying amount is higher than the holding company’s market capitalization.
It’s important to remember that an organization is obliged to evaluate all its assets at the end of each financial year to figure out if any of them need to be impaired. If an asset is showing any signs pointing at the need for impairment, that particular asset must be impaired.
Accounting Standards to Follow for Impairment of Assets:
According to IAS (International Accounting Standards) 36, once an asset is confirmed to be in need to be impaired, the following standards must be followed for the impairment of that asset:
- Working Out the Recoverable Amount:
According to IAS 36, “The recoverable amount of an asset or a cash-generating unit is the higher of its fair value less costs to sell and its value in use.” i.e., the recoverable value of an asset is equal to whichever amount is higher of the prospective amount obtainable from the sale of it (fair value less costs to sell) and the cash flow and/or other benefits from an asset (value in use). And in case the fair value less costs to sell can not be ascertained, the recoverable amount is the asset’s value in use.
Additionally, for assets that were planned to be disposed of, the recoverable amounts are almost always the same as the fair value less costs to sell, as their value in use usually does not exceed their fair value less costs to sell.
- Recognition and Measurement of an Impairment Loss:
Referring to IAS 36 again- “If the carrying amount exceeds the recoverable amount [of the asset], the asset is described as impaired. The entity must reduce the carrying amount of the asset to its recoverable amount and recognize it as an impairment loss.”
So, if the recoverable amount for an asset is more than its carrying amount, the disparity should be ignored, but if it's the other way around, the disparity has to be noted down as an impairment loss and must be counted as an expense.
- Cash Generating Units:
The best possible way to go is to determine the recoverable amount for an asset, no doubt. But in case that’s not possible, this is how you go about it: figure out the recoverable amount of the asset’s cash-generating unit (CGU). As defined by the IAS, a CGU is the tiniest group of assets generating cash inflows substantially unique and independent from the cash inflows from other individuals/groups of assets.
However, the book value of the CGU can not be below the higher of the selling price and the cash flow of the asset.
- Reversal of an Impairment Loss:
At the end of a financial year, a company should also review if any of the previously pointed out impairment losses have decreased or ceased to exist altogether. For this, it must once again determine the recoverable amount of the asset and compare it to the book value. If the former proves to be greater than the latter, the impairment loss needs to be reversed and put in as an income on the company’s income statement.
It’s important to note that the IAS prohibits the reversal of an impairment loss recognized for goodwill.
On to the last rule, the company’s financial statements must include the following disclosures:
- For each class of assets:
- Amount of impairment losses acknowledged in profit or loss**
- Amount of impairment losses reversed in profit or loss
- Amount of impairment losses on revalued assets acknowledged in other comprehensive income
- Amount of impairment losses on revalued assets reversed in other comprehensive income*
- For reportable segments:
- Impairment losses acknowledged
- Impairment losses reversed
- For each material impairment loss acknowledged or reversed:
- The events/circumstances preceding the acknowledgment/reversal of the impairment loss
- The total amount of the impairment loss acknowledged/reversed.
- For an individual asset: its nature and the segment to which it relates
- For a CGU: a description of the CGU and amount of the impairment loss acknowledged/reversed
- Which one is the recoverable amount: its fair value less costs to sell or its value in use?
- If it is the fair value less costs to sell then the method you followed to determine the amount
- If it is the value in use, then the discount rate used in all determinations of the value in use
- For the aggregate impairment losses or the aggregate reversals of impairment losses:
- The primary classes the affected assets belong to
- The primary events and circumstances from before
- Estimates to measure the recoverable amount of the CGU containing goodwill/intangible assets with indefinite useful lives
Asset Impairment vs. Asset Depreciation table
It’s a fairly common error to think the terms ‘asset impairment’ and ‘asset depreciation’ are one and the same. Let’s take a look at some differences between the two:
|Asset impairment is the permanent reduction in the value of both tangible and intangible assets.
|Asset depreciation is the method used to find out the cost of a tangible asset over its years of service.
|Impairment results when there’s a drastic decrease in the market value of an asset.
|A fixed asset is subjected to depreciation frequently to keep a tab of general, minor damages. Hence, depreciation counts for the gradual reduction in an asset’s value over its entire lifetime.
|The impairment of an asset always follows the same aforementioned procedures.
|Depreciation can follow the sum-of-the-year’s-digits (SYD) method, the double declining balance (DDB) method, or the straight-line method, according to preset arrangements.
|Impairment of an asset brings a change in the frequency of its depreciation, and the depreciation charges are decided based on the impaired asset’s new net book value.
|Depreciation on an asset does not directly affect anything about its impairment.
For an investor, impairment charges on a particular asset of a company can tell you a lot about the company’s management system and its track record, and its abilities to predict and plan for the future. With Deskera Books, small businesses can easily record disclosures and find assistance in their impairment reports for any and all assets, right at their fingertip!