Asset ImpairmentsAsset impairment occurs when the fair value of an asset declines below the amount at which it is recorded on the books (its carrying amount). Impairment losses may occur with respect to depreciable/amortizable assets as well as assets not subject to depreciation or amortization. In addition, an impairment loss may be identified with respect to either an individual asset or for a group of assets considered together. One aspect of accounting for impairments that can be confusing is that there are different criteria for determining impairment losses, depending on the nature of the asset being tested, particularly under U.S. GAAP. For example, investments in equity and debt securities are subject to their own impairment testing, goodwill and intangible assets with indefinite lives have their own specific criteria.

Advertisement

In periods of economic downturns, impairment losses become even more common, including those incurred with respect to depreciable property. For example: an entity that purchased a new building shortly before the current economic downturn may find it necessary to adjust the basis of the asset downward as a result of declining market prices for real estate.

In this post, the focus is on impairments of long-lived assets, with the exception of goodwill that have their own rules elsewhere. One category of long-lived asset most commonly associated with impairment losses is intangible assets.  Some intangible assets are amortized over an estimated useful life, while others are not subject to amortization. Intangible assets not subject to amortization should be evaluated for impairment losses periodically. But even those intangible assets that are being amortized or depreciated may incur an impairment loss. Accounting standards specify how and when impairment assessments should take place. Read on…

 

 
Sources of U.S. GAAP and IFRS

U.S. GAAP for impairments of long-lived assets is SFAS 144, Accounting for the Impairment or Disposal of Long-Lived Assets. IFRS for asset impairments in connection with long-lived assets is found in two sources. IAS 36, Impairment of Assets, covers assets that are in use by an entity.

However, if a noncurrent asset is classified as held for sale, it is covered under IFRS 5, Non-current Assets Held for Sale and Discontinued Operations, rather than IAS 36. Under IFRS, once a noncurrent asset is held for sale, it is covered under IFRS 5 instead of IAS 36. An asset is held for sale when its carrying amount will be recovered primarily through its sale, rather than through ongoing use of the asset.

Accordingly, most long-lived noncurrent assets are covered under IAS 36 when they are first acquired, but at some point later may be held for sale and are then covered under IFRS 5. IFRS 5 requires that noncurrent assets held for sale be carried at the lower of cost or fair value, less selling costs.

There are important differences in the scopes of the SFAS 144 and IAS 36. Where they are similar is that each standard excludes from its scope several categories of assets, including the following:

  • Inventories
  • Financial assets, which have separate guidelines for impairment losses
  • Deferred tax assets

 

But where U.S. GAAP and IFRS differ is that IAS 36 applies to all intangible assets (other than those arising from certain insurance contracts), including goodwill. SFAS 144 specifically excludes from its scope each of the following:

  • Goodwill
  • Intangible assets that are not being amortized (i.e., those with indefinite lives in accordance with the preceding section) that are to be held and used

 

In developing SFAS 144, FASB concluded that the separate impairment criteria for goodwill included in SFAS 142, should be retained, resulting in a different approach to testing for impairment for goodwill than for other intangible assets. Therefore, the only intangible assets that are covered under the impairment criteria of SFAS 144 are those with finite lives, subject to amortization.

There are other differences in scope between SFAS 144 and IAS 36, but for purposes of our discussion in this post, they are not material.

 

Definition of an Impairment Loss

Under SFAS 144, an impairment loss is to be recognized if the carrying amount of a long-lived asset is not recoverable (e.g., via sale) and exceeds its fair value.

IAS 36 utilizes slightly different language to arrive at a similar concept, but one that can potentially lead to a different conclusion for some assets. IAS 36 states that an impairment loss occurs when the carrying amount of an asset exceeds its recoverable amount. The recoverable amount is defined as the higher of an asset’s fair value, less costs to sell, or its value in use.

Value in use is defined as the present value of future cash flows expected to be derived. In other words, an impairment loss exists under IAS 36 if the carrying amount of an asset exceeds its recoverable amount, which is the greater of:

  • Fair value, less costs to sell; or
  • Present value of future cash flows

 

Recall that IAS 36 applies only to assets in use by an entity—not to assets held for sale. Therefore, fair value is measured based on the greater of fair value or that asset’s value in use. Below is “value in use” IAS’s explanation.

 

Value In Use

Paragraph 30 of IAS 36 states that the following elements shall be reflected in the calculation of an asset’s value in use:

  • an estimate of the future cash flows the entity expects to derive from the asset;
  • expectations about possible variations in the amount or timing of those future cash flows;
  • the time value of money, represented by the current market riskfree rate of interest;
  • the price for bearing the uncertainty inherent in the asset; and
  • other factors, such as illiquidity, that market participants would reflect in pricing the future cash flows the entity expects to derive from the asset.

Paragraph 39 states that estimates of future cash flows shall include:

  • projections of cash inflows from the continuing use of the asset;
  • projections of cash outflows that are necessarily incurred to generate the cash inflows from continuing use of the asset (including cash outflows to prepare the asset for use) and can be directly attributed, or allocated on a reasonable and consistent basis, to the asset; and
  • net cash flows, if any, to be received (or paid) for the disposal of the asset at the end of its useful life.

 

Copyright © 2009 International Accounting Standards Committee Foundation. All rights reserved. No permission granted to reproduce or distribute.

 

The differences in definitions used under U.S. GAAP and IFRS can result in different conclusions regarding impairment losses. Most often, where differences exist they may result in earlier recognition of impairments under IFRS than under U.S. GAAP. This is due primarily to two factors:

  • Factor-1. The SFAS 144 test for recoverability is based on undiscounted cash flows (i.e., is the asset’s carrying amount recoverable, regardless of how far into the future?), whereas IAS 36 uses the present value of future cash flows.
  • Factor-2. SFAS 144 bases impairment on whether the carrying amount exceeds fair value, whereas IAS 36 uses fair value, less costs to sell. The SFAS 157 definition of fair value ignores transaction costs in determining fair value of an asset.

 

These differences, particularly the first one, can result in significant differences in both the identification and measurement of an impairment.

 

When to Test for Impairment

U.S. GAAP and IFRS are also similar in how they address the issue of when it is necessary to test for impairment in value of a long-lived asset. SFAS 144 states that an asset should be tested for impairment whenever events or changes in circumstances indicate that its carrying amount may not be recoverable. SFAS 142 states that goodwill and intangible assets that are not subject to amortization (i.e., those with indefinite lives) should be tested for impairment at least annually.

IAS 36, like SFAS 142, includes a requirement to test intangible assets with indefinite useful lives, as well as goodwill, for possible impairment on an annual basis, even if there are no obvious indicators of impairment. This testing for impairment need not be performed at year-end. It can be done at any time during the year. But it should be done at the same time every year.

With respect to assets other than intangible assets, IAS 36 states that testing for impairment losses should be performed only if there are indications that an asset may be impaired, similar to SFAS 144.

 

Indicators of Impairment of Assets

One of the keys to properly recording impairment losses is proper recognition of the signs that an impairment loss may have occurred. These same signs are what a fraud examiner or auditor should be aware of in evaluating whether an impairment loss may have been omitted from a set of financial statements. Both U.S. GAAP and IFRS identify some of the most important warning signs that an impairment exists.

 

Indicators of Impairment Losses under U.S. GAAP

Paragraph 8 of SFAS 144 identifies the following examples of events or changes in circumstances that could indicate that the carrying amount of a long-lived asset may not be recoverable:

  • A significant decrease in the market price of a long-lived asset (asset group)
  • A significant adverse change in the extent or manner in which a long-lived asset (asset group) is being used or in its physical condition.
  • A significant adverse change in legal factors or in the business climate that could affect the value of a long-lived asset (asset group), including an adverse action or assessment by a regulator
  • An accumulation of costs significantly in excess of the amount originally expected for the acquisition or construction of a long-lived asset (asset group)
  • A current-period operating or cash flow loss, combined with a history of operating or cash flow losses or a projection or forecast that demonstrates continuing losses associated with the use of a long-lived asset (asset group)
  • A current expectation that, “more likely than not,” a long-lived asset (asset group) will be sold or otherwise disposed of significantly before the end of its previously estimated useful life (The term more likely than not refers to a level of likelihood that is more than 50 percent).

 

Under both U.S. GAAP and IFRS, failure to recognize an impairment in connection with a long-lived asset is a fraud risk that is particularly challenging. In many cases, assessment of an asset’s fair value is easy when the asset is new. As it ages and is used, there are fewer market comparisons and the market prices that are available required significant adjustment to account for age, use, degree of obsolescence, and so on. This is often the case with specialized equipment, unique buildings, and certain other assets.

Other assets may actually become easier to value over time. This is sometimes the case with certain intangible assets. Assessing future cash flows can be very difficult when an intangible asset is first acquired. But, after a baseline and short history of cash flows has been established, forecasts of the next several years’ cash flows may actually become more reliable.

One thing is certain. Given the global reach and severity of the economic crisis of 2009, it is inevitable that the assets of many entities have become impaired.

 

Fraud Risk Alert!
Failing to recognize that an asset has experienced an impairment. The strategy employed when an entity intentionally fails to recognize an impairment loss is to conceal the fact that a loss has been incurred, either by concealing pertinent facts that would indicate a loss or by mischaracterizing or improperly describing the nature of the asset. The perpetrator is hoping that the reader of the financial statements fails to see the warning signs that an impairment loss has occurred.

 

Indicators of Impairment Losses under IFRS

IAS 36, Impairment of Assets, provides guidance on determining whether an asset impairment has been incurred. Paragraph 12 states that in assessing whether there is any indication that an asset may be impaired, an entity shall consider, as a minimum, the following indications:

External sources of information:

  • During the period, an asset’s market value has declined significantly more than would be expected as a result of the passage of time or normal use.
  • Significant changes with an adverse effect on the entity have taken place during the period, or will take place in the near future, in the technological, market, economic or legal environment in which the entity operates or in the market to which an asset is dedicated.
  • Market interest rates or other market rates of return on investments have increased during the period, and those increases are likely to affect the discount rate used in calculating an asset’s value in use and decrease the asset’s recoverable amount materially.
  • The carrying amount of the net assets of the entity is more than its market capitalization.
    Internal sources of information:
  • Evidence is available of obsolescence or physical damage of an asset.
  • Significant changes with an adverse effect on the entity have taken place during the period, or are expected to take place in the near future, in the extent to which, or manner in which, an asset is used or is expected to be used. These changes include the asset becoming idle, plans to discontinue or restructure the operation to which an asset belongs, plans to dispose of an asset before the previously expected date, and reassessing the useful life of an asset as finite rather than indefinite.
  • Evidence is available from internal reporting that indicates that the economic performance of an asset is, or will be, worse than expected.

 

Paragraph 14 of IAS 36 expands on item (g), indicating that evidence from internal reporting that indicates that an asset may be impaired includes the existence of:

  • Cash flows for acquiring the asset, or subsequent cash needs for operating or maintaining it, that are significantly higher than those originally budgeted;
  • Actual net cash flows or operating profit or loss flowing from the asset that are significantly worse than those budgeted;
  • A significant decline in budgeted net cash flows or operating profit, or a significant increase in budgeted loss, flowing from the asset; or
  • Operating losses or net cash outflows for the asset, when current period amounts are aggregated with budgeted amounts for the future.

 

Copyright © 2009 International Accounting Standards Committee Foundation. All rights reserved. No permission granted to reproduce or distribute.

 

The third external factor from the preceding list of external factors (market interest rates) is one of the potentially significant differences between IFRS and U.S. GAAP. Recall from the earlier explanation of the definitions of impairment losses that U.S. GAAP compares undiscounted cash flows with carrying amount, whereas IFRS compares the present value of future cash flows with the carrying amount in determining whether a loss has been incurred. As a result, changes in market interest rates become an impairment indicator under IFRS, but are not necessarily a factor under U.S. GAAP.

 

Extent of Impairment Loss

The amount of an impairment loss is equal to the amount by which its carrying value exceeds its recoverable amount, based on fair value or expected cash flow methodologies, as explained earlier. However, acknowledging that an impairment has occurred by recognizing it in the financial statements may actually be a method of disguising a much bigger loss.

Under this method, a completely different strategy is utilized. By acknowledging that a loss has been incurred, the perpetrator is hoping that the reader assumes that the financial statements have been prepared honestly.

The reader may not scrutinize the calculation of the loss very closely, since the preparer of the financial statements has voluntarily disclosed the existence of a loss, creating an air of honesty.

Accordingly, recognized impairments should be analyzed every bit as carefully as the conclusion that an impairment has not been incurred.

 

Reversal of Previous Impairment Losses

The issue of reversals of previously recognized impairment losses is another area where IFRS and U.S. GAAP have significant differences. Neither SFAS 144 nor SFAS 142 permit the recovery of a previous impairment loss. Under U.S. GAAP, the recognition of an impairment loss is permanent.

IAS 36 allows for the reversal of previously recorded impairment losses with respect to all intangible assets except for goodwill. Likewise, IFRS 5 allows for reversals of impairment losses as well. Under both IAS 36 and IFRS 5, the reversal of impairment losses can never exceed the cumulative amounts of losses previously recognized.

 

Reversals of Impairment Losses under IFRS

Paragraph 111 of IAS 36 states that in assessing 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, an entity shall consider, as a minimum, the following indications:


External sources of information
:

  • The asset’s market value has increased significantly during the period.
  • Significant changes with a favorable effect on the entity have taken place during the period, or will take place in the near future, in the technological, market, economic or legal environment in which the entity operates or in the market to which the asset is dedicated.
  • Market interest rates or other market rates of return on investments have decreased during the period, and those decreases are likely to affect the discount rate used in calculating the asset’s value in use and increase the asset’s recoverable amount materially.

 

Internal sources of information:

  • Significant changes with a favorable effect on the entity have taken place during the period, or are expected to take place in the near future, in the extent to which, or manner in which, the asset is used or is expected to be used. These changes include costs incurred during the period to improve or enhance the asset’s performance or restructure the operation to which the asset belongs.
  • Evidence is available from internal reporting that indicates that the economic performance of the asset is, or will be, better than expected.

 

Copyright © 2009 International Accounting Standards Committee Foundation. All rights reserved. No permission granted to reproduce or distribute.

 

A careful review of the preceding excerpt from IAS 36 shows that reversals of impairment losses can only be recorded when one or more of the underlying estimates about an asset’s recoverable amount have changed. For example, a change in the basis for determining the recoverable amount from fair value less selling costs to value in use, or vice versa, would be a potentially legitimate basis for reversing an impairment loss.

Likewise, changing estimated amounts or timing of future cash flows, or changes in the components of fair value or selling costs, would be potentially acceptable bases for reversing an impairment loss.

An important principal under IAS 36 is that a reversal of an impairment loss reflects an increase in the estimated service potential of an asset, either from use or from sale. IAS 36 requires an entity to identify the change in estimates that causes the increase in estimated service potential.

An asset’s value in use may become greater than the asset’s carrying amount simply because the present value of future cash inflows increases as they become closer. However, in this case, the service potential of the asset has not actually increased. Therefore, IAS 36 prohibits the reversal of an impairment loss just because of the passage of time (sometimes called the unwinding of the discount), even if the recoverable amount of the asset becomes higher than its carrying amount.

This last provision, which prohibits reversals of certain impairments, is an important consideration for auditors and investigators. Reversals of impairments originally based on discounted cash flows are prohibited if they are based solely on the passage of time, resulting in an increased present value. Only other changes in estimates can result in a reversal. To the untrained auditor or investigator, reversals based on the passage of time can appear to be reasonable. Yet recognizing such gains is not permitted and could actually be a method of perpetrating fraud.

Under IFRS, reversals of impairment losses can only be recorded up to the amount of the loss (i.e., the original carrying amount is the maximum carrying amount, unless the asset is of the type for which such gains can be recorded, such as with property and equipment). For amortizable intangible assets, increased carrying amount resulting from a reversal cannot exceed the carrying amount that would have resulted using the original basis, less accumulated amortization to date. One area in which IFRS and U.S. GAAP agree in terms of reversals of impairment losses pertains to goodwill. Reversals of losses reported regarding goodwill are prohibited under IFRS, as well as U.S. GAAP. When a recovery of an impairment loss is recognized under IFRS, it is reported in profit and loss, similar to how the loss itself was classified.