Impairment and Derecognition of PPE and Intangible Assets

While depreciation and amortization spread the cost of a long-lived asset over its useful life, impairment charges address unexpected value decreases. An asset is impaired when its carrying amount is higher than its recoverable amount.

International Financial Reporting Standards (IFRS) and Generally Accepted Accounting Principles (US GAAP)P define recoverability slightly differently, but both recognize impairment losses when the asset’s carrying amount is not recoverable. Moreover, both IFRS and US GAAP require companies to reduce the carrying amount (book value) of impaired assets. IFRS allows reversals of impairment for identifiable long-lived assets, while US GAAP typically does not.

Impairment and derecognition can significantly impact a company’s financial statements and financial ratios. For instance, impairment charges directly reduce a company’s asset value on the balance sheet. Derecognition removes the asset entirely. Both scenarios decrease total assets.

On the income statement, impairment charges appear as expenses, lowering reported net income. In terms of financial ratios, changes in asset and income statement figures can affect ratios such as return on assets (ROA), debt-to-equity ratio, and price-to-book ratio. Lower asset values or higher expenses due to impairment can negatively impact these ratios.

Impairment of Property, Plant and Equipment

Accounting regulations do not mandate annual impairment tests for property, plant, and equipment. Instead, at the end of each reporting period, typically a fiscal year, companies must evaluate if there are any signs that an asset might be impaired. If no such indications exist, no impairment test is conducted. However, if signs such as obsolescence, falling demand for products, or technological improvements are detected, the asset’s recoverable amount must be calculated to conduct an impairment test.

In cases where the carrying amount of property, plant, and equipment is greater than its recoverable amount, impairment losses are recorded. These losses decrease the asset’s reported value on the balance sheet and also reduce the net income on the income statement. Note that these impairment losses are non-cash charges and do not impact operational cash flow.

The standards for recognizing and measuring impairment losses differ between IFRS and US GAAP. Under IAS 36 (IFRS), an impairment loss is determined as the amount by which the carrying amount exceeds the recoverable amount. Specifically, the recoverable amount is the higher of an asset’s fair value, less costs to sell and its value in use.  On the other hand, the value in use is estimated based on the present value of the expected future cash flows.

Conversely, U.S. GAAP separates the assessment of recoverability from the actual measurement of an impairment loss. For a group of assets, the carrying amount is considered non-recoverable if it is higher than the undiscounted future cash flows expected from those assets. When this is the case, the impairment loss is calculated as the difference between the asset’s fair value and carrying amount.

Example: Impairment Analysis of Property, Plant, and Equipment

Arbor Industries, a hypothetical company, specializes in the manufacturing of eco-friendly packaging materials. Following a surge in competitive products that are both cheaper and more durable, Arbor has observed a significant downturn in sales. The company’s management has collected the following financial data related to one of their key manufacturing machine:

$$\begin{array}{l|l}
\textbf{Parameter} & \textbf{Value} \\
\hline
\text{Carrying Amount} & \text{AUD 120,000} \\
\hline
\text{Undiscounted Expected Future Cash Flows} & \text{AUD 100,000} \\
\hline
\text{Present Value of Expected Future Cash Flows} & \text{AUD 90,000} \\
\hline
\text{Fair Value if Sold} & \text{AUD 95,000} \\
\hline
\text{Costs to Sell} & \text{AUD 5,000} \\
\end{array}$$

Under IFRS and US GAAP, what would the company report for the manufacturing machine?

Solution:
Under IFRS:

Arbor Industries must determine the recoverable amount by comparing the carrying amount (AUD 120,000) with the higher of two figures: the fair value less costs to sell (AUD 90,000) and the value in use (AUD 90,000).

\begin{align}
\text{max}\left(\left[\text{Fair value} – \text{Costs to sell}\right], \text{Value in Use}\right) &= \text{max}\left(\left[95,000 – 5,000\right], 90,000\right) \\
&= \text{AUD 90,000}
\end{align}

Here, both figures are the same and lower than the carrying amount. Therefore, an impairment loss of AUD 30,000 would be recognized, bringing down the carrying amount to AUD 90,000.

$$\begin{align}\text{Impairment Loss Calculation}&=\text{Carrying Amount – Higher of Fair Value}\\&\text{ Less Costs to Sell or Value in Use}\\ &=\text{AUD 120,000-AUD 90,000}\\&=\text{AUD 30,000}\end{align}$$

This loss would be recorded in the income statement, and Arbor Industries would need to revise the depreciation schedule based on the new carrying amount.

Under US GAAP:

Under US GAAP, the focus would be on comparing the carrying amount (AUD 120,000) with the undiscounted expected future cash flows (AUD 100,000). Since the undiscounted cash flows are less than the carrying amount, an impairment is confirmed. The impairment loss is calculated by comparing the carrying amount to the fair value:

$$\begin{align}\text{Impairment Loss Calculation}&=\text{Carrying Amount – Fair Value}\\ &=\text{ 120,000-95,000}\\&=\text{AUD 25,000}\end{align}$$

This loss would be recognized in the income statement, reducing the asset’s carrying amount to AUD 95,000 (Fair Value) on the balance sheet.

Impairment of Finite Life Intangible Assets

Intangible assets that have a finite lifespan are amortized, leading to a gradual reduction in their value over time. These assets may also face impairment. As with physical assets like property and equipment, intangible assets are not assessed for impairment annually, and as such assessment only occurs when significant events warrant it.

The company evaluates if any substantial events that indicate potential impairment have arisen by the conclusion of each reporting period. Such events might involve a noteworthy drop in market value or a significant adverse shift in legal or economic circumstances. Accounting for impairment in intangible assets of finite life mirrors that of tangible assets. An impairment loss lessens the asset’s recorded value on the balance sheet, reducing net income on the income statement.

Impairment of Indefinite Life Intangibles

Intangible assets of an indefinite lifespan are not subject to amortization. They’re recorded on the balance sheet at historical cost and are evaluated for impairment at least once a year. Impairment occurs if the carrying amount exceeds the asset’s fair value.

Impairment of Long-Lived Assets Held for Sale

When management intends to sell a long-lived asset and its sale is highly likely, the asset is reclassified as “held for sale” instead of “held for use.” This reclassification requires the asset to be immediately sale-ready in its current state. For instance, if a company plans to sell a building it no longer requires and meets the accounting criteria, the building is reclassified from property, plant, and equipment to non-current assets held for sale.

Upon reclassification, assets previously held for use undergo an impairment test. If, upon reclassification, the carrying amount is higher than the fair value less selling costs, an impairment loss is recognized. The asset’s value is then written down to fair value minus selling costs. Assets held for sale are no longer subject to depreciation or amortization.

Reversals of Impairments of Long-Lived Assets

After an impairment loss has been recognized for an asset, circumstances might change such that the asset’s recoverable amount increases. For example, the outcome of a successful appeal in a patent infringement lawsuit could raise the recoverable amount of a previously devalued patent.

Under IFRS, there is an allowance for the reversal of impairment losses if the recoverable amount of an asset improves, irrespective of whether the asset is held for use or sale. It is important to note that IFRS only permits the reversal of impairment losses; it does not allow the recoverable amount to be revalued above the original carrying amount if it exceeds it.

Conversely, US GAAP treat the reversal of impairment differently based on the classification of the asset. For assets classified as held for use, any impairment loss recognized cannot be reversed. This means once the value of such an asset is reduced due to impairment, it cannot be subsequently increased. However, for assets classified as held for sale, reversals are permitted if the fair value of the asset increases following the impairment loss.

Derecognition

When a company derecognizes an asset, it removes it from the financial statements. This happens when the asset is no longer expected to deliver future benefits through use or disposal. The derecognition of a long-lived operating asset can occur through sale, exchange, abandonment, or distribution to existing shareholders.

Recall that non-current assets that management plans to sell or distribute to shareholders and which are immediately available for sale in their current condition and where a sale is highly probable are categorized as non-current assets held for sale.

Derecognition by Sale

When an asset is derecognized through selling, the profit or loss from the sale of long-lived assets is calculated by subtracting the asset’s carrying amount at the time of sale from the sales proceeds. Typically, an asset’s carrying amount is its net book value, which is its historical cost less any accumulated depreciation. However, this amount may be adjusted to account for any impairment or revaluation of the asset.

A gain or loss from the sale of an asset is reported on the income statement, either integrated with other gains and losses or as a distinct line item if the amount is substantial.

Derecognition Other than by Sale

Long-lived assets intended for disposal through means other than sale (abandonment, exchange for another asset, or distribution to owners in a spin-off) are classified as held for use until they are disposed of or until they meet the criteria to be reclassified as held for sale or for distribution. As such, these assets continue to be depreciated and are subject to impairment testing, similar to other long-lived assets owned by the company, unless their carrying amount reaches zero.

When an asset is retired or abandoned, the accounting treatment is akin to that of a sale, except that no cash proceeds are recorded. The asset is removed from the books at its carrying amount at the time of retirement or abandonment, and a loss equal to this carrying amount is recognized.

In the case of an asset exchange, the accounting involves removing the carrying amount of the asset that is given up, recognizing the fair value of the asset received, and recording any difference between the carrying amount and the fair value as a gain or loss. The fair value of the asset given up is generally used unless the fair value of the asset received is more clearly evident. If there is no reliable measure of fair value, the acquired asset is recorded at the carrying amount of the asset given up.

A gain is recognized if the fair value of the newly acquired asset exceeds the carrying amount of the asset given up. Conversely, a loss is recognized if the fair value of the newly acquired asset is less than the carrying amount of the asset given up. If the acquired asset is valued at the carrying amount of the given-up asset due to the absence of a reliable, fair value, no gain or loss is recognized.

Question

Which of the following statements is the most accurate?

1. Impairment losses reduce the carrying amount of assets and increase the net income reported on the income statement.
2. If revaluation increases an asset’s carrying amount, the increase in the asset’s value will appear as a gain on the income statement.
3. When an asset is retired, the carrying amount is removed from the balance sheet, and a loss (or gain) is recorded for the difference between the carrying amount and any proceeds received from the disposal of the asset.

Solution

The correct answer is C.

When an asset is retired or sold, its carrying amount is removed from the balance sheet, and any difference between the carrying amount and the proceeds from the disposal is recorded as a gain or loss in the income statement.

A is incorrect. Impairment losses reduce the carrying amount of assets and decrease, not increase, the net income reported on the income statement.

B is incorrect. Under IFRS, increases in the carrying amount from revaluation are generally recognized in other comprehensive income and accumulated in equity under the heading of revaluation surplus, not as a gain in the income statement (unless it reverses a previous revaluation decrease that was recognized in profit or loss).