The impairment test is the testing procedures that perform by the companies on the assets that they have to find out if the assets are impaired that make the carrying value of assets in the reporting date less than the recoverable value of assets.
For example, the company performs the impairment test on the computers that it has as of 31 December 2020 with the carrying value amounting to USD500,000 to see if there any impairment on the computers.
The impairment test is done to find out if the carrying amount of the asset exceeds the recoverable value. The carrying amount of assets means the value of an asset less accumulated depreciation. At the time of the acquisition, the carrying amount of an asset equals its original cost price.
The company must conduct tests at each balance sheet date that if the asset is impaired. If such a situation persists, the firm must estimate the recoverable value of an asset.
The following indicators show the impairment of assets:
- The carrying amount of an asset is more than the market capitalization
- The proof of its external damage or obsolescence is present
- A significant decline in operating profit or net cash flows from the asset
- Increase in market interest rates
- Negative changes in technology, economic situation, laws, or political situation
How to determine the recoverable value?
- If we can’t determine the fair value less costs of disposal then the recoverable amount can be taken as its value in use
- The recoverable value of the disposable asset is higher than fair value minus the costs of its disposal and value in use
Value in use:
It represents the present value of future expected cash flows from the continuous use of an asset and its disposal discounted to reflect the underlying risk and time value of money. If the recoverable amount is less than the carrying amount, the carrying amount is reduced to its recoverable amount. This reduction is the impairment loss.
Impairment loss of revalued assets should be recognized as an expense immediately. However, for a revalued asset, an impairment loss is recognized against any revaluation surplus to the extent that such loss doesn’t exceed the revaluation surplus.
If the impairment loss is greater than the carrying amount, then the company must recognize it as liability.
In measuring value in use:
- The cash flow projections must be based on the most recent approved financial budgets/projects
- Cash flow projections beyond the covered period must be estimated by extrapolation of projects based on forecasts using the declining rate for subsequent periods or a steady rate. This growth rate must not exceed the long-term average growth rate of the product or industry.
Example of impairment of assets:
Company C purchased Company D ltd. and paid USD 1,000,000. The book value of assets was USD 700,000. The extra USD300,000 paid by Company C Ltd. above the book value of assets of D is to be recorded as goodwill. Over the year after purchase, the fair market value of Company D Ltd. fell from USD700,000 to USD400,000.
As a rule, the company is required to test for impairment of assets every year. So, after a year Company C ltd will compare the carrying amount of its assets with the fair value of Company D Ltd, and with the differential amount, the goodwill will be reduced. So, the goodwill, in this case, is the impaired asset. The journal entry for recording impairment loss is:
Journal entry for revaluation:
How to test the impairment?
The measurement of amount of loss involved in impairment involves following steps:
- Perform the recoverability test: It involves evaluating whether the future value of asset undiscounted cash flows is less than the book value of the asset. If the cash flow is less then, the impairment loss is calculated.
- Measurement of impairment loss: It is calculated by finding the difference between book value and market value of the asset.
- The use of undiscounted cash flows in this process assumes that the cash flows are definite and risk-free and the timing of the cash flow is not taken into account.
Tips for impairment test:
- Cash flows in the impairment calculations should be reasonable.
Forecasted statements in the prior periods may need to be revisited. It must be based on the latest management reports or budgets or estimates.
It must be backed by reasonable assumptions that should represent management’s best estimate of economic situations that will remain over the remaining lives of the asset. Greater weight should be given to external evidence.
- Value in use should comply with the standard:
Future cash flows should be estimated for assets in the present situation. The major problems that might occur in making assumptions about the value in use relate to future restructuring and capital expenditures on investment.
Where management has approved the restructuring plans, the approved budget is likely to include the costs and benefits of the restructuring.
- Focus on market capitalization:
Market capitalization below net asset value is an indicator of the impairment test. If the market capitalization is less than the value in use then the impairment test is carried out. The fall in the market value of an asset is the indicator of impairment.
A lower market value acts as a trigger but it doesn’t necessarily mean so. However, when management determines the recoverable value above the market value then the assumptions of market conditions should be checked in the light of available external evidence.
- Check the discount rate:
Many companies follow the capital asset pricing method to determine the discount rate. The factors like cost of capital, corporate loan rates, and risks associated with the cash flows are to be taken into account since these may result in an increase in the discount rate.
- Reconcile the conclusion with the external market data:
The current economic assumptions made a year ago might not be reasonable in the current scenario. Consumer expenditure is falling due to the economic situations hence cash flow growth assumptions must be reviewed carefully. The analyst reports should be obtained to support growth assumptions.
- Compare the assets being tested for impairment with the cash flows coming from that asset:
It is to be ascertained that the cash flows being tested are consistent with the assets being tested. IAS 36 states that cash flows related to assets that generate cash flow independently should not be included in the cash flow forecasts. Cash flows should exclude cash related to financing.