What it means
Assets are recorded at cost and depreciated or amortised on a schedule that assumes the asset will earn back its cost over its useful life. Sometimes that assumption breaks.
A factory built for a product nobody buys, a fleet grounded by regulation, software superseded by a competitor, a brand damaged by scandal, an acquired business that has lost its customers: in each case the asset will not generate the cash flows that justified its carrying value. Accounting standards require the company to recognise that loss when it becomes apparent rather than continuing to depreciate an asset that is already worth less than the books say.
The test compares the carrying amount with the recoverable amount, which under IFRS is the higher of fair value less costs to sell (what the asset would fetch) and value in use (the present value of the cash flows the asset will generate if kept). If the recoverable amount is lower, the asset is written down to it.
Companies must assess at each reporting date whether there are indicators of impairment, such as a fall in market value, adverse changes in technology or markets, evidence of physical damage, worse than expected performance, or plans to restructure or dispose. Goodwill and indefinite-lived intangibles must be tested every year whether or not indicators exist.
Many assets do not generate cash on their own, so the test is applied to the smallest group of assets that does, called a cash-generating unit under IFRS: a store, a factory, a product line, a business division. Goodwill is allocated to the units expected to benefit from it and tested at that level.
The impairment loss is allocated first to goodwill and then to the other assets in the unit. An impairment is a non-cash charge; the cash was spent when the asset was bought.
But it reduces profit and equity, can breach covenants based on net worth, and is a public admission that capital was misallocated. Impairments can be reversed under IFRS if the asset's value recovers, except for goodwill; under US GAAP they cannot be reversed.
Because the test rests on forecasts and discount rates, it involves significant judgement and is closely examined by auditors, and the assumptions must be disclosed.
In practice
Real-world examples.
Example
An airline impairs a fleet of older aircraft by $300 million after fuel prices and emissions rules make them uneconomic to operate, writing them down to their expected sale values.
Example
A retailer tests each store as a cash-generating unit and impairs the fixtures and right-of-use assets of 14 stores whose forecast cash flows no longer cover their carrying values.
Example
A technology company impairs $50 million of capitalised development costs when it abandons the product the costs related to.
Think of it
“Impairment means an asset is worth less than the books show-you have to write it down.
Formula
Calculation
Impairment Loss = Carrying Amount minus Recoverable Amount, if positive
Recoverable Amount = the higher of (Fair Value less Costs to Sell) and (Value in Use)
Value in Use = Present value of the future cash flows expected from the asset or cash-generating unit
Worked example. A manufacturer operates a production line for a product whose market is shrinking. At the year end the line has a carrying amount of $4,200,000 (cost $7,000,000 less accumulated depreciation $2,800,000). Management prepares a five-year cash flow forecast for the line and estimates its sale value.
Value in use, discounted at the company's 10% pre-tax rate:
- Year 1: $1,000,000 / 1.10 = $909,000
- Year 2: $900,000 / 1.21 = $744,000
- Year 3: $700,000 / 1.331 = $526,000
- Year 4: $500,000 / 1.464 = $342,000
- Year 5: $400,000 plus scrap value $200,000 = $600,000 / 1.611 = $372,000
- Value in use = $2,893,000
Fair value less costs to sell: a broker indicates the line could be sold for $2,400,000 less $150,000 of dismantling and sale costs = $2,250,000.
Recoverable amount = higher of $2,893,000 and $2,250,000 = $2,893,000
Impairment loss = $4,200,000 minus $2,893,000 = $1,307,000
The company records the loss, reduces the line's carrying amount to $2,893,000, and recalculates depreciation on the new amount over the remaining five years ($2,893,000 minus $200,000 scrap = $2,693,000, or about $539,000 a year). Total equity falls by $1,307,000; cash is unaffected.Case study
Seen in the real world.
A consumer goods group acquired a snack brand for $120 million, allocating $70 million to the brand name as an indefinite-lived intangible and $30 million to goodwill. Three years later a competitor's product had taken a third of the brand's market share and the group's own forecasts showed flat revenue and falling margins. The annual impairment test, however, continued to pass, because management's forecasts assumed a recovery to 8% annual growth from a marketing relaunch.
The auditors challenged the assumption: the brand had missed its budget three years running and the relaunch had not been approved or funded. Using growth of 1%, the value in use fell to $55 million against a carrying amount of $100 million, and an impairment of $45 million was recorded.
The group's shares fell 8% on the announcement, not because of the non-cash charge itself but because the market read it as confirmation that the acquisition had failed. The following year the board introduced a policy that impairment forecasts must be consistent with the budget the board has actually approved.
Watch out
Common mistakes.
- Using optimistic forecasts in the impairment test to avoid a write-down. The test must reflect the company's own approved plans and reasonable external evidence.
- Assuming an impairment is a cash loss. It is a write-down of an asset already paid for, though it may breach covenants and signals earlier overpayment.
- Testing assets individually when they only generate cash as a group, or the reverse.
Questions
People also ask.
What triggers an impairment test?
Indicators such as falling market value, adverse market or technology changes, physical damage, poor performance or restructuring plans, plus mandatory annual tests for goodwill and indefinite-lived intangibles.
Can an impairment be reversed?
Under IFRS, yes for most assets if the recoverable amount recovers, but never for goodwill. Under US GAAP, impairments are not reversed.
Does impairment affect cash flow?
No. It is a non-cash charge added back in the cash flow statement. The cash left when the asset was acquired.
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