Impairment of long-lived assets

Depreciation spreads an asset's cost over its life on the assumption that the asset will earn at least that much. Sometimes that assumption fails: a technology becomes obsolete, a market collapses, a regulation bans a product, a plant sits idle. When the carrying amount of an asset is more than the entity can recover from it, the asset is impaired and must be written down. This lesson explains when to test for impairment, how the frameworks measure it and why they can give different answers for the same asset: the IFRS one-step test against recoverable amount, and the two-step test used by US GAAP and, for private enterprises in Canada, by ASPE. It also covers cash-generating units and asset groups, how losses are allocated and when they can be reversed. Goodwill impairment is introduced here and completed in lesson 12.

When to test

IAS 36, Impairment of Assets, requires an entity to assess at the end of each reporting period whether there is any indication that an asset may be impaired, and if there is, to estimate its recoverable amount. Regardless of indicators, goodwill, intangible assets with indefinite useful lives and intangible assets not yet available for use must be tested at least annually. Indicators include external sources (a significant decline in market value, adverse changes in technology, markets, the economy or law, increases in market interest rates that raise discount rates, and the entity's net assets exceeding its market capitalization) and internal sources (obsolescence or physical damage, plans to discontinue or restructure, idle assets, and evidence that economic performance is worse than expected).

ASPE Section 3063 requires a long-lived asset to be tested for recoverability whenever events or changes in circumstances indicate that its carrying amount may not be recoverable, using indicators similar to those above but without a requirement to assess indicators at every reporting date.

The IFRS model: recoverable amount

Under IAS 36, an asset is impaired when its carrying amount exceeds its recoverable amount, the higher of fair value less costs of disposal (FVLCD) and value in use (VIU). FVLCD is measured under IFRS 13 (lesson 2) less incremental disposal costs such as legal fees and removal costs. VIU is the present value of the future cash flows expected from continuing use of the asset and its ultimate disposal, based on reasonable and supportable projections (normally no more than five years of detailed budgets, then extrapolated with a steady or declining growth rate), excluding future restructurings not yet committed and improvements not yet made, and discounted at a pre-tax rate reflecting current market assessments of the time value of money and the risks specific to the asset. The impairment loss is the excess of carrying amount over recoverable amount, recognized in profit or loss (or against any revaluation surplus for revalued assets).

ASPE Section 3063 uses the two-step approach also found in US GAAP: first a recoverability test comparing the carrying amount with the undiscounted cash flows expected from use and eventual disposal; if the carrying amount is not recoverable, the impairment loss is the excess of carrying amount over fair value. Because undiscounted cash flows exceed discounted ones, the ASPE recoverability test acts as a cushion: an asset can be worth less than its carrying amount yet pass step 1.

# Same asset, two impairment models (illustrative)
carrying = 1_800_000
annual_cash_flow, years, disposal_value = 330_000, 6, 100_000
rate = 0.10
fair_value, costs_of_disposal = 1_350_000, 50_000

undiscounted = annual_cash_flow * years + disposal_value
viu = sum(annual_cash_flow / (1 + rate) ** t for t in range(1, years + 1)) + disposal_value / (1 + rate) ** years
fvlcd = fair_value - costs_of_disposal
recoverable = max(viu, fvlcd)

print(f"Undiscounted cash flows {undiscounted:,.0f}; value in use {viu:,.0f}; FVLCD {fvlcd:,.0f}")
ifrs_loss = max(0, carrying - recoverable)
print(f"One-step test (IFRS): recoverable {recoverable:,.0f}; impairment {ifrs_loss:,.0f}")
two_step_loss = 0 if undiscounted >= carrying else carrying - fair_value
print(f"Two-step test: recoverable on undiscounted basis? {undiscounted >= carrying}; impairment {two_step_loss:,.0f}")

Undiscounted cash flows 2,080,000; value in use 1,493,683; FVLCD 1,300,000
One-step test (IFRS): recoverable 1,493,683; impairment 306,317
Two-step test: recoverable on undiscounted basis? True; impairment 0

Northlake's marine-sensor production line has a carrying amount of $1.8 million. Its undiscounted cash flows ($2.08 million) exceed the carrying amount, so under the two-step test it passes the recoverability screen and no loss is recognized. Under IAS 36 the recoverable amount is the higher of value in use ($1,493,683) and FVLCD ($1,300,000), and the line is written down by about $306,300. The same facts produce an impairment under one framework and none under the other. If cash flows fell further so that the undiscounted total dropped below $1.8 million, the two-step test would measure the loss against fair value ($1,350,000), giving $450,000.

Cash-generating units

Most assets do not generate cash flows independently: a calibration machine contributes to the output of a whole production line. IAS 36 therefore tests at the level of the cash-generating unit (CGU), the smallest identifiable group of assets that generates cash inflows largely independent of the cash inflows from other assets or groups. If an active market exists for the output of a group, it is a CGU even if the output is used internally. Corporate assets (head office, research centre) and goodwill are allocated to CGUs or groups of CGUs on a reasonable and consistent basis. An impairment loss for a CGU is allocated first to reduce the carrying amount of any goodwill allocated to it, then to the other assets pro rata on the basis of their carrying amounts, but no asset is reduced below the highest of its FVLCD, its VIU (if determinable) and zero.

Reversals

At each reporting date an entity assesses whether there is any indication that an impairment loss recognized in prior periods for an asset other than goodwill may no longer exist or may have decreased. If so, it re-estimates recoverable amount and reverses the loss to the extent of the increase, but the reversed carrying amount cannot exceed what the carrying amount would have been (net of depreciation) had no impairment been recognized. Reversals are recognized in profit or loss (or OCI for revalued assets). Impairment losses on goodwill are never reversed. Under ASPE Section 3063, impairment losses on long-lived assets are not reversed.

Goodwill and indefinite-life intangibles: a first look

Goodwill is not tested on its own because it does not generate cash flows independently; it is allocated to the CGUs (or groups of CGUs) expected to benefit from the business combination, at the lowest level at which it is monitored for internal management purposes, and no larger than an operating segment. Each such group is tested at least annually, and whenever there is an indication of impairment, by comparing its carrying amount, including goodwill, with its recoverable amount. ASPE Section 3064 tests goodwill only when events or changes in circumstances indicate that the carrying amount of a reporting unit may exceed its fair value. Lesson 12 completes the treatment of goodwill and other intangibles.

Estimating cash flows and discount rates

Whichever framework applies, the quality of an impairment test depends on the cash flow forecast. Forecasts should be based on the most recent budgets approved by management, cover the asset or unit in its current condition, include cash flows from continuing use and from eventual disposal, and exclude financing costs and income taxes (because the discount rate already reflects the cost of capital and, under IAS 36, is pre-tax). Growth beyond the detailed budget period should be steady or declining and should not exceed the long-term average growth rate for the products, industries or country in which the entity operates, unless a higher rate can be justified. Overly optimistic forecasts are the most common weakness auditors and regulators find in impairment tests.

Disclosure and judgement

Impairment testing is one of the areas of accounting that depends most on judgement. Cash flow forecasts, growth rates, discount rates and the definition of CGUs or asset groups all affect the result, and management has incentives to avoid write-downs (which hit profit) or, occasionally, to take large write-downs in a bad year to make future results look better (a 'big bath'). Standards respond with disclosure: the events that led to the impairment, the amount, the recoverable amount or fair value and how it was measured, the key assumptions, and, under IFRS, sensitivity analysis when a reasonably possible change in a key assumption would cause an impairment. Auditors treat impairment as a key audit matter or critical audit matter in many audit reports.