When a company or business acquires an asset, it records it in its financial statements at cost. After every accounting period, the company must also calculate and record a depreciation or amortization charge related to the asset. Sometimes, however, companies must recognize an impairment against the asset under various circumstances as well.
What is the impairment of assets?
Impairment of assets refers to the concept in accounting when the book or carrying value of an asset exceeds its ‘recoverable amount’. IAS 36 defines the recoverable amount of an asset as the higher of its fair value less cost to sell (or net realizable value) and its value in use. When an asset is impaired, the company must record a charge for the impairment expense.
The reason why companies record impairment to assets is to reflect their correct value in the financial statements. It goes in line with the prudence concept of accounting. Furthermore, any asset, whether tangible or intangible, can suffer impairment. Therefore, IAS 36 requires companies to record the impairment whenever it occurs.
Causes of Impairment:
There are many causes of impairment to assets. These causes can be internal or external. Companies must always identify them and evaluate whether they have resulted in impairment of their assets.
1) External factors
External factors can impact an asset’s value and result in impairment. External factors may include economic, social, technological, political, legal or environmental issues. Furthermore, if an asset’s fair value reduces in the market, it may also cause impairment to it. Similarly, changes in the market can also impact the company adversely, causing impairment to its assets.
2) Internal factors
Internal factors are straightforward to identify. Things that cause impairment internally include physical damage to the asset, causing a reduction in its value. Obsolescence of assets also results in impairment losses. Furthermore, if the company alters the way it uses an asset, it may impact its value in use and, therefore, its recoverable value. Lastly, if a company finds evidence that one of its assets is performing worse than anticipated or expected, it may be an indicator of impairment.
Scope of Asset Impairment
IAS 36 – Impairment of Assets has a wide scope and applies to all assets that companies use. However, it does not include assets that have specific standards that take care of impairment. Therefore, impairment of assets does not apply to the following areas of a company:
- Assets arising from employee benefits.
- Construction contracts.
- Deferred tax assets.
- Financial assets or instruments.
- Investment property measured at fair value.
- Assets classified as held for sale.
All these types of assets have a specific standard that addresses how companies should deal with impairment for them. Therefore, the standard does not apply to these assets. Other than these, the impairment of assets applies to all other assets within a company.
The journal entry to record impairment is straightforward. However, before recording the impairment loss, a company must first determine the recoverable value of the asset. As mentioned above, it is the higher of an asset’s net realizable value and its value in use.
Once a company calculates the recoverable amount of the asset, it must compare it with the asset’s carrying value.
If the carrying value of the asset exceeds the recoverable amount, then the company must recognize an impairment loss. The amount of impairment loss will be the difference between an asset’s carrying value and recoverable amount. The double entry to record an impairment loss is as follows.
The impairment loss becomes a part of the Income Statement and reduces the profits of the company. On the other hand, it also affects the Balance Sheet of the company. That is because it results in a decrease in the value of the asset that suffered the loss.
A company, ABC Co., has total assets worth $1 million after calculating the carrying value at the end of the accounting period. Among these, ABC Co. has a vehicle with a carrying value of $100,000, which has suffered physical damage. According to the company’s calculation, the vehicle has a net realizable value of $80,000 and a value in use of $75,000.
The recoverable amount of the vehicle is its net realizable value of $80,000, which is higher than its value in use. However, it is still lower than the vehicle’s carrying value of $100,000. Therefore, ABC Co. must record an impairment loss of $20,000 ($100,000 – $80,000). The double entry for recording the loss is as follows.
|Dr||Impairment loss||$ 20,000|
After the loss, ABC Co.’s expenses will increase by $20,000, while its total assets would decrease by the same amount as well.
There are several advantages of impairment of assets. Firstly, it helps companies present a true and fair view to their stakeholders of the true value of their assets. Similarly, it can help stakeholders determine if a company might be facing any failures or damages and can be an indicator of their efficiency and effectiveness. Impairment losses can also help stakeholders determine if a company’s policies or decisions may have failed.
Impairment may also have several disadvantages. Firstly, it is difficult for companies to calculate a recoverable amount. It’s because obtaining a fair value or calculating the value in use of an asset are costly and, sometimes, inaccurate.
Similarly, while the standard shows how to recognize impairment losses, it does not give detailed information about the process that companies can follow.
Impairment is a crucial concept in accounting. Impairment losses come as a result of the carrying value of an asset being different from its recoverable amount. When companies detect an impairment, due to external or internal factors, they must recognize a loss immediately.