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

ASC 360-10 requires long-lived assets held and used (including PP&E and finite-lived intangibles) to be tested for recoverability whenever events or changes in circumstances indicate that the carrying amount may not be recoverable. Triggering events include a significant decrease in market price, a significant adverse change in how the asset is used or in its physical condition, adverse legal or business climate changes, costs significantly above budget to build it, current-period operating or cash flow losses with a history or forecast of continuing losses, and an expectation that the asset is more likely than not to be sold or disposed of significantly before the end of its useful life. Goodwill and indefinite-lived intangibles are tested at least annually under ASC 350 (lesson 12).

IFRS's IAS 36 is broader: entities must assess at every reporting date whether any indicator exists, and the test itself is different, as shown below.

The US GAAP model: recoverability, then fair value

Under ASC 360, impairment of an asset (or asset group) held and used is a two-step process. Step 1, the recoverability test: compare the carrying amount with the sum of the undiscounted future cash flows expected from the use and eventual disposition of the asset. If the undiscounted cash flows equal or exceed the carrying amount, the asset is recoverable and no loss is recognized, even if its fair value is lower. Step 2, measurement: if the carrying amount is not recoverable, recognize an impairment loss equal to the excess of carrying amount over fair value (measured under ASC 820). The written-down amount becomes the new cost basis and is depreciated over the remaining useful life.

IFRS's IAS 36 uses a single step: an asset is impaired whenever its carrying amount exceeds its recoverable amount, the higher of fair value less costs of disposal and value in use (the present value of expected cash flows at a pre-tax discount rate). Because there is no undiscounted recoverability screen, IFRS recognizes impairments earlier and more often than US GAAP for the same facts.

# 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.

Asset groups

Most assets do not generate cash flows independently: a calibration machine contributes to the output of a whole production line. ASC 360 therefore tests long-lived assets at the level of the asset group, the lowest level for which identifiable cash flows are largely independent of the cash flows of other assets and liabilities. If the asset group fails the recoverability test, the impairment loss (carrying amount of the group less its fair value) is allocated to the long-lived assets of the group pro rata on the basis of their carrying amounts, but no individual asset is reduced below its own fair value if that is determinable without undue cost. Goodwill is not included in ASC 360 asset groups unless the group is a reporting unit; it is tested separately under ASC 350. IFRS uses cash-generating units, with goodwill allocated to them and absorbing losses first.

Reversals

US GAAP prohibits reversal of impairment losses on long-lived assets held and used and on goodwill: the written-down carrying amount becomes the new cost basis. (Losses on assets held for sale may be reversed up to the cumulative losses previously recognized while held for sale.) IFRS, by contrast, requires reversal of impairment losses on assets other than goodwill when recoverable amount increases, limited to the depreciated amount that would have been carried without the impairment.

Goodwill and indefinite-life intangibles: a first look

Under ASC 350, goodwill is assigned to reporting units (operating segments or one level below) and tested at least annually, and between tests if a triggering event occurs. An entity may first assess qualitative factors to decide whether it is more likely than not that a reporting unit's fair value is below its carrying amount; if so, or if it skips the qualitative step, it compares fair value with carrying amount and recognizes an impairment equal to the excess, limited to the goodwill allocated (ASU 2017-04 eliminated the old step of computing implied goodwill). Private companies may elect to amortize goodwill over up to ten years and test only on triggering events. 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 judgment

Impairment testing is one of the areas of accounting that depends most on judgment. 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.