What is an impairment test for assets and how is it performed?

What is Impairment Testing?

Impairment testing is the process of checking whether an asset's carrying amount (book value) exceeds its recoverable amount. If so, an impairment loss must be recognized.

Key Definitions:

• Carrying Amount: Asset's book value (cost less accumulated depreciation/amortization)
• Recoverable Amount: Higher of Fair Value Less Costs to Sell (FVLCS) and Value in Use (VIU)
• Impairment Loss: Carrying amount minus recoverable amount
• Cash Generating Unit (CGU): Smallest identifiable group of assets generating cash inflows

Accounting Standard:

IAS 36 - Impairment of Assets governs impairment testing.

How to Calculate Recoverable Amount

Recoverable Amount Formula:

Recoverable Amount = Higher of (Fair Value Less Costs to Sell) and (Value in Use)

1. Fair Value Less Costs to Sell (FVLCS):

Amount obtainable from sale in arm's length transaction minus disposal costs.

• Fair Value: Price in orderly transaction between market participants
• Costs to Sell: Legal costs, stamp duty, transaction taxes, removal costs
• Determination Methods:
  1. Active market price (most reliable)
  2. Recent transaction price for similar assets
  3. Valuation techniques (DCF, multiples)

2. Value in Use (VIU):

Present value of future cash flows expected from asset or CGU.

VIU Calculation Steps:

1. Cash Flow Projections: Budget/forecast for max 5 years (unless justified)
2. Terminal Value: Growth rate for beyond projection period (max long-term growth rate)
3. Discount Rate: Pre-tax rate reflecting current market assessment of time value and risks
4. Present Value: Discount all future cash flows

Cash Flow Considerations:

• Include cash inflows from continuing use
• Include cash outflows necessarily incurred
• Exclude financing cash flows
• Exclude income tax receipts/payments
• Use management's best estimates

Practical Example:

Asset Details:

• Carrying amount: $500,000
• Fair value less costs to sell: $450,000
• Value in use calculation:
  • Year 1-5 cash flows: $100,000 annually
  • Discount rate: 10%
  • Terminal growth: 2% after year 5
  • Present value: $100,000 × 3.791 + terminal value = $420,000

Recoverable Amount:

• FVLCS: $450,000
• VIU: $420,000
• Recoverable amount = $450,000 (higher)

Impairment Test:

• Carrying amount: $500,000
• Recoverable amount: $450,000
• Impairment loss: $500,000 - $450,000 = $50,000

Journal Entry:

• Dr Impairment Loss $50,000 (P&L)
• Cr Accumulated Impairment $50,000

Goodwill Impairment Testing:

Special rules for goodwill (IAS 36):

1. Tested at Cash Generating Unit (CGU) level
2. Compare CGU carrying amount (including allocated goodwill) with recoverable amount
3. If impaired, allocate loss:
   1. First: Reduce goodwill to zero
   2. Then: Reduce other CGU assets pro-rata based on carrying amounts
4. Goodwill impairment losses cannot be reversed

CGU Allocation Example:

• CGU carrying amount: $1,000,000
  • Goodwill: $200,000
  • Property: $500,000
  • Equipment: $300,000
• Recoverable amount: $800,000
• Impairment loss: $200,000
• Allocation:
  • First: Eliminate goodwill ($200,000)
  • Remaining loss: $0

Reversal of Impairment Losses:

Allowed for assets except goodwill:

• Conditions: Change in estimates used to determine recoverable amount
• Limit: Cannot increase carrying amount above what would have been without impairment
• Journal Entry: Dr Asset, Cr Impairment Loss Reversal (P&L)

Disclosure Requirements:

1. Amount of impairment losses/reversals recognized
2. Events and circumstances leading to impairment
3. For CGUs with goodwill/intangibles:
   • Description of CGU
   • Carrying amount of goodwill/intangibles
   • Basis for determining recoverable amount
   • Key assumptions and sensitivities
4. Discount rates and growth rates used

Common Challenges:

1. Subjectivity: Significant judgment in cash flow projections
2. Discount Rate: Determining appropriate rate
3. CGU Identification: Determining appropriate level for testing
4. Goodwill Allocation: Allocating goodwill to CGUs
5. Market Data: Lack of reliable market prices
6. Future Uncertainty: Projecting cash flows in volatile markets

Key Points to Remember:

1. Compare carrying amount with recoverable amount
2. Recoverable amount = higher of FVLCS and VIU
3. Annual test mandatory for goodwill and indefinite-life intangibles
4. Test other assets when impairment indicators exist
5. Goodwill impairment losses cannot be reversed
6. Significant judgment and disclosure required