Welcome to Impairment of Assets (IAS 36)!
Hello there! Today we are diving into one of the most important "sanity checks" in accounting: Impairment. Don't let the name intimidate you. At its heart, impairment is simply making sure that we don't show our assets at a value higher than what they are actually worth to the business. Think of it as a "reality check" for your Balance Sheet.
In this chapter, we will learn how to spot when an asset might be losing value, how to calculate that loss, and what to do with the numbers. Let’s get started!
1. What is Impairment?
In simple terms, an asset is impaired when its Carrying Amount (CA) is higher than its Recoverable Amount (RA).
• Carrying Amount: This is the value currently sitting in your accounts (Cost minus Accumulated Depreciation).
• Recoverable Amount: This is the maximum value the company can get back out of the asset, either by using it or selling it.
The Golden Rule: An asset must never be recorded at more than its recoverable amount. If it is, we must "write it down" (reduce its value) and recognize an impairment loss.
Analogy: Imagine you bought a smartphone for \$800 a year ago. It’s now recorded in your "personal books" at \$600 after some use. However, you drop it and crack the screen. Now, the most someone would pay you for it is \$200, and it’s not very useful to you anymore. That \$400 gap (\$600 - \$200) is the impairment!
2. When to Test for Impairment
You don’t have to check every single asset for impairment every single day—that would be exhausting! Instead, IAS 36 says you should perform an impairment review only when there is an indication that an impairment may have occurred. These indicators are split into two categories:
External Sources of Information
• A significant fall in the asset's market value (more than expected).
• Negative changes in the technology, market, economy, or laws in which the company operates.
• An increase in market interest rates (this reduces the "Value in Use" calculation).
• The company’s stock market value is lower than the book value of its net assets.
Internal Sources of Information
• Evidence of physical damage or obsolescence (e.g., a machine breaks).
• Plans to discontinue or restructure the operation the asset belongs to.
• Evidence that the economic performance of an asset is worse than expected (e.g., it's producing fewer units than planned).
Quick Review Box
Important! Most assets are only tested when there is an indicator. However, Goodwill and Intangible assets with indefinite useful lives must be tested for impairment annually, regardless of whether there are indicators or not.
3. Calculating the Recoverable Amount
This is where students sometimes get confused, but there is a simple trick to remember it. The Recoverable Amount is the HIGHER of two figures:
1. Fair Value Less Costs of Disposal (FVLCD): How much cash you would get if you sold the asset today, minus the costs to sell it (like delivery or legal fees).
2. Value in Use (VIU): The "internal" value. This is the present value of the future cash flows the asset is expected to generate by staying in the business.
Formula:
\( RA = \text{Higher of (FV - Costs to Sell) and (Value in Use)} \)
Why the higher of the two? Because as a rational business owner, if your asset is worth more to sell than to use, you would sell it! If it's worth more to keep and use, you'd keep it. You will always choose the option that gives you the most value.
4. Calculating and Recording the Impairment Loss
Once you have your Recoverable Amount (RA), compare it to your Carrying Amount (CA).
If CA > RA: You have an impairment loss.
Formula:
\( \text{Impairment Loss} = \text{Carrying Amount} - \text{Recoverable Amount} \)
If RA > CA: No impairment has occurred. Do nothing! (We don't "write up" assets under IAS 36).
Accounting Treatment
Where does the loss go? It depends on whether the asset has been revalued before:
• For assets held at historical cost: Charge the loss immediately as an expense in the Statement of Profit or Loss (P&L).
• For revalued assets: First, use the loss to "eat up" any existing Revaluation Surplus for that specific asset in equity. Any remaining loss goes to the P&L.
Key Takeaway
Always check if there is a Revaluation Surplus first! It acts like a "buffer" that protects the Profit or Loss account from the impact of the impairment.
5. Cash Generating Units (CGUs)
Sometimes, it’s impossible to calculate the recoverable amount for a single asset because it doesn't generate cash on its own. Think of a single machine in a massive assembly line—it doesn't produce cash unless the whole line is working. In this case, we group assets into a Cash Generating Unit (CGU).
Definition: A CGU is the smallest identifiable group of assets that generates cash inflows that are largely independent of the cash inflows from other assets.
Allocating an Impairment Loss to a CGU
If a CGU is impaired, we have to spread the "pain" (the loss) across all the assets in that unit. There is a very specific order you must follow—think of it as a priority list:
1. Specific Assets: If you know one specific asset is damaged, write it down first.
2. Goodwill: Next, write off the entire amount of Goodwill allocated to that CGU.
3. Other Assets (Pro-rata): Any remaining loss is spread across the other assets in the CGU (like Property, Plant, and Equipment) based on their carrying amounts.
Critical Rule: When spreading the loss, you cannot reduce the carrying amount of an asset below the highest of:
• Its individual Fair Value Less Costs of Disposal (if known);
• Its individual Value in Use (if known); or
• Zero.
Don't worry if this seems tricky! Just remember the "Order of Destruction": Specific Asset → Goodwill → Everything else (pro-rata).
6. Common Mistakes to Avoid
• Don't use the lower of FVLCD and VIU: Always use the higher one for Recoverable Amount. Remember, businesses want to maximize their returns!
• Don't ignore costs to sell: If the exam gives you "Fair Value" and "Selling Costs," you must subtract the costs before comparing it to Value in Use.
• Watch the Revaluation Surplus: If you have a loss of \$10,000 and a Revaluation Surplus of \$4,000, only \$6,000 goes to the P&L. The first \$4,000 just clears out the surplus.
• Depreciation after impairment: After an impairment, you must calculate future depreciation based on the new, lower carrying amount over the remaining useful life.
7. Summary Checklist
• Step 1: Look for indicators (Internal/External).
• Step 2: Calculate Recoverable Amount (Higher of FVLCD and VIU).
• Step 3: Compare RA to Carrying Amount. If CA is higher, you have a loss.
• Step 4: Recognize the loss in P&L (unless there's a revaluation surplus).
• Step 5: For CGUs, follow the specific allocation order (Goodwill first!).
Final Encouragement: Impairment is just a way to keep accounts honest. Master the "Higher of" rule and the CGU "Order of Destruction," and you'll be well on your way to success in your FR exam!