Impairment losses

What Is Impairment Losses?

Impairment losses represent a reduction in the carrying amount of an asset on a company's balance sheet that exceeds its recoverable amount. This concept is a crucial element of financial accounting, ensuring that the reported value of assets does not overstate the future economic benefits they are expected to generate. When an asset's market value declines significantly, or its future economic benefits diminish, an entity must assess if an impairment loss is necessary. Recognizing an impairment loss typically impacts a company's profit and loss statement by reducing its reported earnings.

History and Origin

The concept of impairment losses in modern accounting standards largely evolved to ensure that asset values presented on financial statements accurately reflect their ongoing utility and market realities. Prior to the formalization of impairment testing, companies might hold assets at their historical cost even if their real value had significantly deteriorated. This could mislead investors and creditors about a company's true financial health.

The International Accounting Standards Board (IASB) introduced IAS 36, "Impairment of Assets," in June 1998, which became operative for financial statements covering periods beginning on or after July 1, 1999. The objective of IAS 36 is to establish procedures to ensure that assets are not carried at more than their recoverable amount, and to define how this recoverable amount is determined¹⁴, ¹⁵. This standard brought a more rigorous framework for evaluating and recognizing declines in asset values, particularly relevant during periods of economic downturns or significant industry shifts. For instance, the global financial crisis highlighted the importance of accurate asset valuation, as widespread declines in asset values necessitated significant adjustments across many companies' balance sheets. Research has examined how financial crises are characterized by a sudden and widespread decline in asset values¹³. Subsequent amendments to IAS 36 have aimed to clarify disclosure requirements and measurement of recoverable amounts¹¹, ¹².

Key Takeaways

• Impairment losses occur when an asset's carrying amount on the balance sheet exceeds its recoverable amount, which is the higher of its fair value less costs of disposal and its value in use.
• They are recognized immediately in the profit and loss statement, reducing reported earnings.
• Impairment tests are required for most non-financial assets, including goodwill and intangible assets with indefinite useful lives, which must be tested annually regardless of impairment indicators.
• The primary goal is to prevent assets from being overstated on a company's balance sheet, providing a more accurate view of its financial position.
• Factors indicating a potential impairment include significant declines in market value, adverse changes in the economic or legal environment, technological obsolescence, or physical damage to the asset.

Formula and Calculation

An impairment loss is calculated as the difference between an asset's carrying amount and its recoverable amount. The recoverable amount is the higher of the asset's fair value less costs to sell and its value in use.

Where:

• Carrying Amount (CA): The amount at which an asset is recognized in the balance sheet after deducting any accumulated depreciation or amortization and accumulated impairment losses.
• Recoverable Amount (RA): The higher of:
  • Fair Value Less Costs to Sell (FVLCS): The price that would be received to sell an asset in an orderly transaction between market participants at the measurement date, minus the costs of disposal.
  • Value in Use (VIU): The present value of the future cash flow expected to be derived from the asset's continued use and ultimate disposal.

If the Carrying Amount (CA) is greater than the Recoverable Amount (RA), an impairment loss is recognized for the difference. If CA is less than or equal to RA, no impairment loss is recognized.

Interpreting the Impairment Losses

Interpreting impairment losses involves understanding their implications for a company's financial health and future prospects. A significant impairment loss signals that an asset, or a group of assets, is no longer expected to generate the economic benefits initially anticipated when it was acquired or developed. This can be due to various reasons, such as a decline in market demand for a product, technological obsolescence, increased competition, or adverse changes in the regulatory environment.

For investors, a large impairment loss can indicate underlying operational or strategic issues. It reduces the book value of assets and negatively impacts current period earnings on the profit and loss statement. While non-cash, it can affect future profitability by lowering the base for depreciation or amortization charges. The nature of the impaired asset (e.g., goodwill versus property, plant, and equipment) also provides insights. Impairment of goodwill, for instance, often suggests that an acquisition failed to deliver expected synergies or that the acquired business is underperforming relative to its purchase price.

Hypothetical Example

Consider "Tech Innovators Inc.," a company that purchased specialized manufacturing equipment for $5,000,000 three years ago. The carrying amount of this property, plant, and equipment (PP&E) on its balance sheet is now $3,500,000 after accumulated depreciation.

Recently, a new, more efficient technology emerged that makes Tech Innovators' equipment less competitive, and the market for its output has declined. The company assesses if an impairment loss is necessary.

1. Estimate Fair Value Less Costs to Sell (FVLCS): Tech Innovators consults with brokers who estimate the equipment could be sold for $2,000,000, with disposal costs of $100,000. So, FVLCS = $2,000,000 - $100,000 = $1,900,000.
2. Estimate Value in Use (VIU): The company projects the future cash flow the equipment can generate over its remaining useful life, discounted to its present value. Due to the new technology and market decline, the estimated present value of future cash flows from continuing to use the equipment is $2,200,000.
3. Determine Recoverable Amount: The recoverable amount is the higher of FVLCS ($1,900,000) and VIU ($2,200,000). Therefore, the recoverable amount is $2,200,000.
4. Calculate Impairment Loss:
   • Carrying Amount = $3,500,000
   • Recoverable Amount = $2,200,000
   • Impairment Loss = $3,500,000 - $2,200,000 = $1,300,000

Tech Innovators Inc. would recognize an impairment loss of $1,300,000 on its profit and loss statement. The carrying amount of the equipment on the balance sheet would then be reduced from $3,500,000 to $2,200,000.

Practical Applications

Impairment losses are a critical aspect of financial reporting and have broad implications across various sectors.

• Corporate Reporting: Public companies are required by accounting standards, such as IFRS (International Financial Reporting Standards) IAS 36 or U.S. GAAP, to regularly assess their assets for impairment. This is especially true for goodwill and intangible assets with indefinite useful lives, which undergo annual impairment tests⁹, ¹⁰. For example, in 2019, Kraft Heinz announced a significant $15.4 billion impairment charge, largely related to its brand goodwill, reflecting a decline in the value of its acquired brands and a challenging market environment⁸. This illustrates how strategic missteps or shifts in consumer preferences can directly translate into impairment losses.
• Mergers and Acquisitions (M&A): Impairment considerations are particularly relevant in M&A. When one company acquires another for a price higher than the fair value of its identifiable net assets, the excess is recorded as goodwill. If the acquired business fails to perform as expected, or the anticipated synergies do not materialize, the goodwill recorded may become impaired, leading to a substantial impairment loss.
• Real Estate and Property, Plant, and Equipment: Physical assets like buildings, machinery, and land can also suffer impairment due to obsolescence, physical damage, or a decline in their market value or expected future cash flow generation. This is common in industries undergoing rapid technological change or facing significant economic downturns.
• Regulatory Oversight: Regulators and auditors closely scrutinize impairment assessments to ensure companies are providing an accurate picture of their financial health. These assessments require significant judgment and assumptions about future performance, which can be a point of focus during audits and regulatory reviews.

Limitations and Criticisms

While designed to provide a more accurate depiction of asset values, the accounting for impairment losses has faced several limitations and criticisms, particularly concerning subjectivity and timing.

One primary critique is the high degree of management judgment involved in impairment testing. Estimating the recoverable amount requires significant assumptions about future cash flow, discount rates, and future market conditions to determine the value in use, as well as estimations of fair value less costs to sell. These estimates can be influenced by management's optimism or pessimism, potentially leading to less objective valuations. Some financial executives perceive IAS 36 as demanding subjective interpretation and allowing for adaptability to managerial needs, potentially facilitating "creative accounting"⁷.

Another limitation is the "lag" in recognition. Impairment losses are often recognized after a significant decline in an asset's value has already occurred, rather than proactively signaling potential issues. While accounting standards require companies to assess for impairment indicators at each reporting date, the actual impairment test and subsequent recognition may still come after the market has already reacted to the underlying issues.

Furthermore, the non-reversal of goodwill impairment under IFRS (and generally under U.S. GAAP) is a point of contention. If goodwill is impaired and written down, it cannot be written back up even if the underlying conditions improve significantly⁶. This asymmetrical treatment can mean that the balance sheet may not fully reflect a subsequent recovery in the acquired business's value, which can distort financial metrics over time. For private companies, specific alternatives for goodwill amortization and impairment testing have been provided to simplify financial reporting requirements⁴, ⁵.

Impairment Losses vs. Write-Downs

The terms "impairment losses" and "write-downs" are often used interchangeably in general financial discussions, but in financial accounting, "impairment loss" is a specific type of write-down.

A write-down is a general accounting adjustment that reduces the book value of an asset because its current market value or utility is less than its recorded value. Write-downs can occur for various reasons, such as inventory obsolescence, a decline in the value of marketable securities, or bad debts. For example, if inventory spoils or becomes outdated, its value might be "written down" to its net realizable value.

An impairment loss, specifically, refers to the reduction in the carrying amount of a long-lived asset (like property, plant, and equipment, intangible assets, or goodwill) when its recoverable amount falls below its carrying amount. It is determined through a formal impairment test mandated by accounting standards. All impairment losses are write-downs, but not all write-downs are impairment losses. The key distinction lies in the specific assets affected and the rigorous testing methodology applied for impairment.

FAQs

What types of assets are subject to impairment losses?

Impairment losses primarily apply to long-lived non-financial assets such as property, plant, and equipment, intangible assets (like patents, trademarks, and customer lists), and goodwill. Certain assets, such as inventory and financial assets, are generally outside the scope of specific impairment accounting rules because their valuation is covered by other accounting standards², ³.

How often are assets tested for impairment?

Under IFRS and U.S. GAAP, companies must assess at each reporting period whether there are any indicators that an asset may be impaired. If indicators exist, a formal impairment test is conducted. However, goodwill and intangible assets with indefinite useful lives are required to be tested for impairment at least annually, regardless of whether there are indicators of impairment¹.

Does an impairment loss affect a company's cash flow?

An impairment loss is a non-cash expense, meaning it does not directly impact a company's current cash flow. However, it reduces the asset's carrying amount on the balance sheet, which can affect future depreciation or amortization charges and ultimately impact reported earnings and profitability in subsequent periods. While not a cash outflow, it signals a reduction in the future economic benefits expected from the asset.