Recoverable amount

What Is Recoverable Amount?

Recoverable amount is a core concept in financial accounting that represents the higher of an asset's fair value less costs of disposal and its value in use. It is a critical figure used primarily in the context of impairment loss testing within financial accounting to ensure that a company's assets are not carried on the balance sheet at an amount greater than what could be recovered through their continued use or sale. If the carrying amount of an asset exceeds its recoverable amount, an impairment loss must be recognized, reducing the asset's value to its recoverable amount.

History and Origin

The concept of recoverable amount is central to international accounting standards, particularly IAS 36 Impairment of Assets. This standard was adopted by the International Accounting Standards Board (IASB) in April 2001, building upon earlier requirements issued by the International Accounting Standards Committee in June 1998. IAS 36 consolidated guidelines on how to assess the recoverability of an asset, which were previously fragmented across various standards like IAS 16 Property, Plant and Equipment and IAS 22 Business Combinations. The standard's objective is to ensure that assets are not overstated in a company's financial statements and to define a clear method for determining their recoverable amount.¹⁵ Subsequent amendments, such as those in May 2013, further refined disclosure requirements related to the recoverable amount of non-financial assets.¹⁴

Key Takeaways

• Recoverable amount is the higher of an asset's fair value less costs of disposal and its value in use.
• It is used to determine if an asset is impaired, meaning its carrying amount on the balance sheet is higher than its economic value.
• The concept is fundamental to international accounting standards, notably IAS 36 Impairment of Assets.
• Calculating recoverable amount involves estimating future cash flows or market-based selling prices.
• If an asset's carrying amount exceeds its recoverable amount, an impairment loss is recognized, reducing the asset's recorded value.

Formula and Calculation

The recoverable amount of an asset or a cash-generating unit is determined by comparing two values and taking the higher of the two:

Where:

• Fair Value Less Costs of Disposal (FVLCS): This is 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 disposing of the asset.¹³ This represents an "arm's length" sale price.
• Value In Use (VIU): This is the present value of the future cash flows expected to be derived from an asset or cash-generating unit. Calculating value in use requires estimating future cash flows and discounting them to their present value using an appropriate discount rate.¹²

It is not always necessary to calculate both fair value less costs of disposal and value in use. If either amount exceeds the asset's carrying amount, the asset is not impaired, and the other amount does not need to be estimated.¹¹

Interpreting the Recoverable Amount

The recoverable amount serves as a ceiling for an asset's book value. When a company assesses its assets for impairment, it compares the asset's carrying amount (its value on the balance sheet after depreciation or amortization) to its recoverable amount. If the carrying amount is higher, it indicates that the asset's recorded value is no longer supported by its economic potential. This disparity triggers an impairment loss, which is then recognized on the income statement, reducing the asset's value to its calculated recoverable amount. This process is crucial for presenting a true and fair view of a company's financial health and ensuring that investors and creditors have accurate information regarding the value of reported assets.

Hypothetical Example

Consider a manufacturing company, "Alpha Corp.," which owns a specialized machine with a carrying amount of $500,000 on its books. Due to a sudden downturn in its industry, Alpha Corp. suspects that the machine's value might have decreased. They need to calculate the machine's recoverable amount.

1. Fair Value Less Costs of Disposal (FVLCS): Alpha Corp. researches the market and finds that similar used machines are selling for around $420,000. Estimated selling costs (broker fees, transportation) would be $20,000.

   • FVLCS = $420,000 - $20,000 = $400,000

2. Value In Use (VIU): Alpha Corp. estimates the net cash flows the machine is expected to generate over its remaining useful life, discounting them back to the present. After calculation, the present value of these future cash flows is determined to be $450,000.

Now, Alpha Corp. determines the recoverable amount by taking the higher of the two:

• Higher of ($400,000, $450,000) = $450,000

Since the machine's carrying amount of $500,000 is greater than its recoverable amount of $450,000, the machine is impaired. Alpha Corp. must recognize an impairment loss of $50,000 ($500,000 - $450,000), reducing the machine's carrying amount to its recoverable amount of $450,000.

Practical Applications

The concept of recoverable amount is applied broadly in corporate finance and accounting standards. Companies are required to assess assets, particularly goodwill and certain intangible assets, for impairment at least annually, or more frequently if there are indicators of impairment.¹⁰ These indicators can include significant changes in the asset's use, obsolescence, physical damage, or a decline in market value.⁹

Publicly traded companies, in particular, face scrutiny from regulators like the U.S. Securities and Exchange Commission (SEC) regarding their impairment disclosures. The SEC expects registrants to provide detailed disclosures about material impairment charges, including the specific events and circumstances that led to the charge and the methods used to determine fair value.⁸,⁷ For example, a company might report a significant impairment charge if the value of an acquired brand (goodwill) declines due to poor performance, as seen in recent corporate financial reports.⁶,⁵ The Federal Reserve also monitors asset valuations across the economy, as widespread revaluations can impact financial stability.⁴

Limitations and Criticisms

While the recoverable amount framework aims to provide a reliable measure for asset valuation and impairment, it is not without limitations. A key challenge lies in the inherent subjectivity involved in its calculation, particularly for "value in use." Estimating future cash flows and selecting an appropriate discount rate involves significant management judgment and assumptions about future economic conditions and business performance. Errors or biases in these assumptions can lead to misstatements of the recoverable amount.

Similarly, determining fair value can be challenging for specialized assets or in illiquid markets where comparable transactions are scarce. Critics argue that these subjective elements can provide opportunities for earnings management, where companies might manipulate assumptions to avoid or delay recognizing impairment losses. The complexity also means that applying the standard requires considerable expertise, and the resulting financial disclosures can be difficult for non-experts to fully understand. Nonetheless, regulators continue to emphasize the importance of transparent impairment reporting to provide investors with better insights into a company's asset values and management's past investment decisions.³

Recoverable Amount vs. Carrying Amount

The recoverable amount and the carrying amount are two distinct but interconnected concepts in accounting, particularly relevant for impairment testing. The carrying amount, also known as the book value, is the value of an asset as recorded on a company's balance sheet. It is typically the original cost of the asset minus any accumulated depreciation or amortization and any accumulated impairment losses already recognized. It represents the asset's historical cost-based value.

In contrast, the recoverable amount is a forward-looking measure. It seeks to determine the economic value an asset can generate for the company through its use or by selling it. The comparison between the carrying amount and the recoverable amount is the cornerstone of impairment testing. An asset is considered "impaired" if its carrying amount exceeds its recoverable amount, indicating that the asset's value on the books is inflated compared to its actual economic worth.

FAQs

What types of assets are subject to recoverable amount assessment?

Most non-current assets are subject to recoverable amount assessment, including property, plant, and equipment; intangible assets (like patents or trademarks); and goodwill. Some assets, such as inventory or financial assets, have different impairment rules governed by other accounting standards.²

How often is recoverable amount assessed?

Companies are generally required to assess for indicators of impairment at the end of each reporting period. If any indicators exist, they must estimate the recoverable amount. For certain assets, like intangible assets with indefinite useful lives and goodwill, an annual impairment test (and thus recoverable amount estimation) is mandatory, even without specific impairment indicators.¹

What happens if the recoverable amount is higher than the carrying amount?

If the recoverable amount of an asset is higher than its carrying amount, the asset is not impaired, and no impairment loss is recognized. The asset continues to be carried on the balance sheet at its existing carrying amount.

Can an impairment loss be reversed?

Under international accounting standards (IFRS), an impairment loss recognized in prior periods for an asset (other than goodwill) may be reversed if there has been a change in the estimates used to determine the asset's recoverable amount since the last impairment loss was recognized. The reversal is limited so that the asset's carrying amount does not exceed what its carrying amount would have been (net of depreciation or amortization) had no impairment loss been recognized.