Impaired asset: meaning, causes, how to test, and how to record: Meaning & Applications

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What Is Impaired Asset?

An impaired asset is an asset whose carrying amount on a company's balance sheet exceeds its recoverable amount, meaning its fair value less costs to sell or its value in use. This concept falls under the broader financial category of financial reporting. When an asset becomes impaired, its economic benefits are no longer expected to justify its recorded value, necessitating an adjustment to reflect its true worth. The objective is to prevent assets from being overstated in a company's financial statements and ensure they are carried at no more than their recoverable amount.²⁷, ²⁸

History and Origin

The concept of asset impairment gained significant traction with the development of international and national accounting standards. A key standard is IAS 36, "Impairment of Assets," which was originally issued by the International Accounting Standards Committee in June 1998 and later adopted and revised by the International Accounting Standards Board (IASB) in April 2001.²⁵, ²⁶ This standard consolidated requirements on how to assess the recoverability of an asset, drawing from earlier standards like IAS 16 (Property, Plant and Equipment) and IAS 22 (Business Combinations).²⁴ In the United States, the Financial Accounting Standards Board (FASB) provides guidance under ASC 360, "Property, Plant, and Equipment," which addresses the impairment of long-lived assets.²², ²³ These frameworks were developed to ensure that financial statements accurately reflect the true value of a company's assets, particularly in cases where their value has diminished due to various factors.²¹

Key Takeaways

An impaired asset's carrying amount on the balance sheet is greater than its recoverable amount.
Impairment testing ensures that assets are not overstated in financial statements.
The recoverable amount is the higher of an asset's fair value less costs of disposal or its value in use.
An impairment loss is recognized as an expense, reducing the asset's carrying amount.
Goodwill and intangible assets with indefinite useful lives are subject to annual impairment tests.

Formula and Calculation

The core calculation in determining an impairment loss involves comparing an asset's carrying amount to its recoverable amount. An impairment loss occurs when the carrying amount exceeds the recoverable amount.²⁰

The recoverable amount is defined as the higher of:

Fair Value less Costs of Disposal: The price that would be received to sell an asset in an orderly transaction, less the costs of selling that asset.¹⁹
Value in Use: The present value of the future cash flow expected to be derived from the asset's continued use and eventual disposal.¹⁸

The formula for the impairment loss is:

\text{Impairment Loss} = \text{Carrying Amount} - \text{Recoverable Amount}

If the recoverable amount is greater than or equal to the carrying amount, no impairment loss is recognized.

Interpreting the Impaired Asset

Interpreting an impaired asset means understanding the implications of its reduced value on a company's financial health and future prospects. When an asset is identified as impaired, it signals that the initial investment in that asset is unlikely to generate the expected profitability or economic benefits. This can impact various financial metrics, such as return on assets and asset turnover, as the asset's value is written down.

The identification of impaired assets can also indicate underlying issues within a company, such as technological obsolescence, changes in market conditions, or poor asset management decisions. For investors, a significant impairment charge can raise concerns about the accuracy of prior financial reporting and the company's future earnings stability.

Hypothetical Example

Consider a manufacturing company, "Alpha Corp," that owns a specialized machine with a carrying amount of $500,000 on its balance sheet. Due to a sudden technological breakthrough by a competitor, the demand for products manufactured by this machine has significantly decreased, indicating a potential impairment.

Alpha Corp performs an impairment test:

Fair Value Less Costs of Disposal: An independent appraisal determines that if Alpha Corp were to sell the machine today, it would fetch $300,000, and the selling costs would be $20,000. So, the fair value less costs of disposal is $300,000 - $20,000 = $280,000.
Value in Use: Alpha Corp estimates the future cash flows from using the machine to be $70,000 per year for the next five years. Using an appropriate discount rate, the present value of these future cash flows is calculated to be $290,000.

The recoverable amount is the higher of $280,000 (fair value less costs of disposal) and $290,000 (value in use), which is $290,000.

Since the carrying amount ($500,000) exceeds the recoverable amount ($290,000), the machine is impaired.

The impairment loss is:
$500,000 (Carrying Amount) - $290,000 (Recoverable Amount) = $210,000.

Alpha Corp would record an impairment loss of $210,000, reducing the machine's carrying amount to $290,000. This adjustment would also impact the company's [depreciation] (https://diversification.com/term/depreciation) calculations in future periods.

Practical Applications

Impaired assets appear in various contexts across industries, impacting a company's financial health and reporting. Here are some practical applications:

Corporate Financial Reporting: Publicly traded companies are mandated to assess and report asset impairments in their financial statements. This is particularly relevant for significant long-lived assets like property, plant, and equipment and intangible assets such as goodwill acquired through mergers and acquisitions.¹⁶, ¹⁷ For instance, General Electric (GE) faced substantial impairment charges related to its power and insurance businesses in 2017 and 2018, leading to a significant drop in its stock price and regulatory scrutiny for disclosure failures.¹³, ¹⁴, ¹⁵
Mergers and Acquisitions (M&A): After an acquisition, the acquired company's assets, including goodwill, are often subject to impairment testing. If the acquired assets do not perform as expected, or if market conditions change unfavorably, a substantial impairment charge can result, reflecting a decrease in the acquired business's value.
Real Estate Investment: In the real estate sector, properties can become impaired due to declining market value, economic downturns, or changes in local regulations that reduce their income-generating potential.
Technological Industries: Companies in rapidly evolving technological fields often face the risk of their equipment or proprietary technology becoming obsolete, leading to impairment. This can involve writing down the value of specialized machinery or capitalized software.
Natural Resources: In industries like mining and oil and gas, asset impairment can occur if commodity prices fall significantly, making extraction economically unfeasible, or if reserves are re-estimated downward. This can affect the value of their fixed assets and future capital expenditures.

Limitations and Criticisms

While the concept of asset impairment is crucial for accurate financial reporting, it comes with certain limitations and criticisms. One significant challenge lies in the subjective nature of the impairment test, particularly when determining the "value in use" or "fair value" of an asset. These valuations often rely on future cash flow projections and discount rates, which are inherently estimates and can be influenced by management's judgments and assumptions.¹¹, ¹² This can lead to variability in how impairment losses are recognized across different companies or even within the same company over time.

Critics also point out that impairment accounting can sometimes be backward-looking. Impairment losses are typically recognized when there's an indication that an asset's carrying amount may not be recoverable, meaning the decline in value has already occurred. This can lead to sudden, large write-downs that surprise investors, as seen in cases where companies face regulatory investigations for delayed or inadequate disclosures of potential impairment.⁹, ¹⁰

Furthermore, the "triggering event" approach for most assets (except goodwill and indefinite-lived intangibles, which are tested annually) means that companies only test for impairment when specific indicators suggest a loss in value. This can result in a delay in recognizing true asset values on the balance sheet, as opposed to a continuous fair value assessment.⁸ The complexity of the standards, such as IAS 36 and ASC 360, also presents challenges for companies in consistent application and for financial statement users in fully understanding the reported figures.⁷

Impaired Asset vs. Obsolete Asset

While both terms relate to a decrease in an asset's utility or value, an impaired asset and an obsolete asset are distinct concepts in finance.

An impaired asset refers to a situation where the carrying amount of an asset on a company's balance sheet is greater than its recoverable amount. This loss in value can be due to various reasons, including, but not limited to, obsolescence. The focus of impairment is on the financial recoverability of the asset as per accounting standards, requiring a write-down.

An obsolete asset, on the other hand, specifically describes an asset that is no longer useful or competitive due to technological advancements, changes in industry standards, or shifts in consumer preferences. An obsolete asset can become an impaired asset if its obsolescence leads to its carrying amount exceeding its recoverable amount. However, not all impaired assets are obsolete; an asset might be impaired due to a decline in its fair value caused by a downturn in the general economy, even if it is still functionally viable.

FAQs

What causes an asset to become impaired?

An asset can become impaired due to a variety of factors, including a significant decline in its market value, adverse changes in the business climate, technological obsolescence, physical damage, or a decrease in its expected future cash flows.⁵, ⁶

How is an impairment loss recorded on financial statements?

An impairment loss is recognized as an expense on the company's income statement, which reduces the company's net income. Concurrently, the carrying amount of the asset on the balance sheet is reduced by the amount of the impairment loss. This adjustment effectively revalues the asset to its recoverable amount.⁴

Can an impaired asset be reversed?

Under certain accounting standards, an impairment loss recognized for assets other than goodwill can be reversed if there is an indication that the impairment loss may no longer exist or has decreased. This reversal is limited to the asset's original carrying amount, adjusted for depreciation that would have been recognized if no impairment loss had been recorded.³

Do all assets undergo impairment testing?

Most long-lived assets, such as property, plant, and equipment, are tested for impairment only when there are "indicators of impairment" or "triggering events" that suggest their carrying amount may not be recoverable. However, certain assets like goodwill and intangible assets with indefinite useful lives are required to be tested for impairment annually, regardless of whether there are such indicators.¹, ²