Impairment is calculated by determining how much an asset's carrying cost on the balance sheet exceeds its recoverable amount. The resulting difference is recognized as an impairment loss, reflecting a decline in the asset's economic value.
Understanding Impairment
An asset is considered impaired when its carrying amount (book value) on a company's financial statements is greater than the future economic benefits expected to be derived from it. This decline can be due to various factors, such as:
- Technological obsolescence: Newer, more efficient technology making an older asset less valuable.
- Physical damage: An asset suffering significant damage that reduces its utility or lifespan.
- Market downturns: A general economic decline impacting the demand or value of certain assets.
- Changes in usage: A company planning to discontinue or significantly alter the use of an asset.
The Calculation of Impairment Loss
The core formula for calculating an impairment loss is:
Impairment Loss = Carrying Cost – Recoverable Amount
Let's explore each component in detail:
| Component | Definition |
|---|---|
| Carrying Cost | This is the asset's value as recorded on the balance sheet. It is typically calculated as the asset's original cost minus any accumulated depreciation or amortization. It represents the historical cost less any systematic reduction in value over its useful life. |
| Recoverable Amount | This is the higher of the asset's fair value less costs to sell or its value in use. It represents the maximum amount a company can expect to recover from the asset, whether by selling it or by continuing to use it to generate revenue. |
Determining the Recoverable Amount
The recoverable amount is a critical step in the impairment calculation, requiring an assessment of two different valuation methods:
1. Fair Value Less Costs to Sell
This is the amount that could be obtained from the sale of an asset in an orderly transaction between market participants, less the costs that would be incurred to sell the asset. These "costs to sell" can include direct expenses such as legal fees, sales commissions, or transportation costs necessary to get the asset to a market.
- How it's estimated:
- Market Prices: The most reliable method, if available, is to use quoted prices in an active market for identical assets.
- Comparable Transactions: If direct market prices aren't available, prices from recent transactions for similar assets can be used.
- Valuation Models: In the absence of market data, valuation techniques like discounted cash flow models (from a market participant's perspective) or multiplier approaches may be employed.
2. Value in Use
This represents the present value of the estimated future cash flows expected to be derived from the asset's continued use and its eventual disposal. It considers the unique economic benefits the asset provides to the company.
- Key factors in calculating Value in Use:
- Future Cash Flow Projections: Estimates of the cash inflows and outflows (e.g., revenues generated, operating costs) that the asset is expected to produce over its remaining useful life. These projections should be reasonable and justifiable.
- Residual Value: The estimated cash flow from the ultimate disposal of the asset at the end of its useful life.
- Appropriate Discount Rate: A rate that reflects the time value of money and the risks specific to the asset. This rate is used to bring the future cash flows back to their present-day equivalent.
Steps to Calculate an Impairment Loss
Companies follow a structured approach to identify and record impairment:
- Identify Impairment Indicators: Management first looks for signs that an asset's value may have declined. These can be external (e.g., significant fall in market prices, adverse technological changes) or internal (e.g., physical damage, evidence of obsolescence, changes in asset usage).
- Determine Carrying Amount: The current book value of the asset is retrieved from the financial records.
- Calculate Recoverable Amount: Both the fair value less costs to sell and the value in use are estimated. The higher of these two values is selected as the recoverable amount.
- Compare and Recognize Loss: If the asset's carrying cost is found to be greater than its recoverable amount, an impairment loss must be recognized. The loss recorded is the exact difference between the carrying cost and the recoverable amount.
Example Scenario:
A manufacturing company owns specialized machinery with a carrying cost of $500,000. Due to a sudden decline in demand for the product it manufactures, the company assesses the machinery for impairment.
- Fair Value Less Costs to Sell: An appraisal suggests the machinery could be sold for $350,000, after deducting disposal costs.
- Value in Use: A financial analysis projects that the machinery's future cash flows, discounted to their present value, amount to $400,000.
- Recoverable Amount: The higher of $350,000 (Fair Value Less Costs to Sell) and $400,000 (Value in Use) is $400,000.
- Impairment Loss:
- Carrying Cost = $500,000
- Recoverable Amount = $400,000
- Impairment Loss = $500,000 - $400,000 = $100,000
The company would record an impairment loss of $100,000. This loss reduces the machinery's value on the balance sheet to its recoverable amount ($400,000) and is recognized as an expense on the income statement, impacting the company's reported profit.
Significance of Impairment
Impairment calculations are crucial for accurate financial reporting. They ensure that a company's assets are not overstated on its balance sheet, providing a more realistic view of its financial health to investors, creditors, and other stakeholders.
