IAS 36 – Impairment of Assets
Why is impairment accounting necessary under IFRS?
According to the definition of an asset and the recognition criteria as set out in the Conceptual Framework for Financial Reporting, an asset may not be measured in the financial statements at an amount exceeding the total economic benefits expected to flow from it. The basic need to recognise an impairment loss therefore stems from applying this fundamental principle in cases where the cost basis is used to measure the asset. However, applying this principle raises significant practical questions regarding the timing of impairment tests, the recognition date and the measurement of the resulting impairment loss, if any. Consequently, accounting standards were required to lay down provisions and guidance that the reporting entity must apply to ensure that its assets are not measured at amounts exceeding the total economic benefits expected to be derived from them.
Which types of assets are subject to impairment standards?
The accounting treatment is determined by the nature of the assets concerned, which can be divided into three main categories: financial assets, inventories of various types and productive assets. There are IFRS Accounting Standards that specifically address the impairment of certain assets. For example, IFRS 9 Financial Instruments addresses impairment of financial assets and IAS 2 Inventories addresses impairment of different types of inventories.
What is the focus and objective of IAS 36?
IAS 36 Impairment of Assets focuses on impairment of productive assets used by the reporting entity, such as property, plant and equipment and intangible assets, including goodwill, as well as investments in shares of an entity accounted for using the equity method. These assets are critical resources that enable the reporting entity’s operations and help achieve its objectives. When the value of these assets is impaired, it may affect the entity’s ability to meet its objectives. Accordingly, to present a picture that properly reflects the entity’s economic, financial, and business condition, this must be reflected in the financial statements.
How are expected economic benefits measured for impairment purposes?
A basic conceptual question arising from the above is how to estimate the expected economic benefits for measuring an impairment loss, if any. Two accounting concepts may lead to different measurement bases: fair value and recoverable amount. The recoverable amount of an asset represents the economic benefits expected to flow from it and is determined as the higher of its fair value less costs of disposal and its value in use. In contrast, under the fair value concept, the asset’s economic benefits are measured from the viewpoint of market participants. Fair value is defined as the price that would be received to sell an asset in an orderly transaction between market participants at the measurement date.
Why does IAS 36 adopt the recoverable amount concept?
Under the recoverable amount concept, the asset’s economic benefits are estimated as the higher of fair value less costs of disposal and value in use, based on the assumption that measuring recoverable amount should reflect reasonable behavior of a rational management, which would choose to maximise the asset’s value (to continue using it or to sell it). The rationale is as follows:
- If the reporting entity can generate higher cash flows by using the asset, it would be misleading to base the recoverable amount solely on the market price, since a rational entity would not sell the asset. For example, the value in use of an administrative building previously purchased by a profitable industrial company is not necessarily impaired even if, due to a decline in real estate prices, its fair value is significantly below its carrying amount, provided the company intends to continue using the building.
- If the asset’s fair value less costs of disposal is higher than its value in use, a rational reporting entity would sell the asset, and in that case it makes sense to base the recoverable amount on fair value less costs of disposal, to avoid recognising an impairment loss that does not reflect economic reality. That is, one should not base the recoverable amount solely on value in use, since if in this case the entity irrationally decides to retain the asset, any additional loss (the difference between fair value less costs of disposal and value in use) will arise in later periods because it stems from the management’s decision to keep the asset.
How do fair value and value in use differ conceptually?
Economically, both fair value and value in use reflect present value calculations of estimated future net cash flows expected from the asset, since both consider the time value of money and the risks that the amount and timing of the actual cash flows from the asset may differ from the estimates. However, while fair value reflects the market’s assessment of the present value of the asset’s future cash flows (an objective estimate from the viewpoint of market participants), value in use is the reporting entity’s estimate of the present value of the future cash flows expected to arise from the asset’s continued use and from its ultimate disposal (a subjective estimate from the viewpoint of the reporting entity that owns the asset).
Why might value in use differ from fair value?
The present value of the future cash flows the reporting entity expects to derive from the asset is not necessarily identical to the fair value of those cash flows. Examples of reasons why a reporting entity may expect to receive or pay cash flows that differ from those envisaged by other market participants include:
A. The effect of synergies from combining the asset with other assets (including internally generated goodwill within the reporting entity). For illustration: each of two confectionery companies owns a chocolate-production machine whose fair value less costs of disposal is identical for both companies. However, the value in use of the same machine may differ significantly solely because one company has greater goodwill than the other. A potential argument could be that this seems inconsistent with IAS 38 Intangible Assets, which prohibits recognising internally generated goodwill as an asset. Nevertheless, under this approach it is more important to focus on whether the machine’s carrying amount is recoverable than on whether part of the recoverability arises from internally generated goodwill.
B. The reporting entity may intend to use the asset differently from how others would. For example, management designates a plot of land for use as a sports field, although other market participants believe the optimal use is a parking lot.
C. The reporting entity may possess information, trade secrets or processes that enable it to receive (or avoid paying) cash flows that are different from those observed by others in the market.
D. The reporting entity may have special advantages that others do not.
E. The reporting entity may prefer to assume a liability risk (e.g., product warranty) and manage it internally rather than transfer the risk to another entity.
When must impairment tests be performed under IAS 36?
IAS 36 adopts the recoverable amount concept. Accordingly, the Standard requires estimating recoverable amount whenever there is an indication that an asset may be impaired or that a previously recognised impairment loss may need to be reversed. In addition, it provides guidance on how management should develop cash flow forecasts used to estimate value in use. Note that the US GAAP approach, as reflected in FAS 144, recognises impairment based on the asset’s fair value (a fair value concept).
What are the main provisions of IAS 36 regarding impairment?
Beyond detailed guidance on the timing and measurement of impairment losses, the Standard includes several important provisions, the main ones being:
A. Timing of the impairment test
A key procedure the reporting entity must apply to ensure that assets are not measured above their recoverable amounts, concerns the timing of the impairment test. The timing has implications for the need to make significant estimates and for recognising impairment losses. The guiding principle is to identify indications of impairment. That is, identifying indications for a particular asset triggers a comprehensive impairment assessment for that asset.
In addition, regardless of indications, the Standard requires an annual impairment test for three types of assets that are not amortised on a systematic basis (or whose amortisation has not yet begun): intangible assets with indefinite useful lives, intangible assets not yet available for use and goodwill.
B. Recognition of an impairment loss – adoption of the economic criterion
The Standard adopts an economic criterion for recognising impairment losses and therefore requires immediate recognition whenever an asset’s recoverable amount is lower than it carrying amount. The underlying principle is that when assessing the time value of money and asset-specific risks to determine whether an asset is impaired, factors such as the probability of impairment or whether it is permanent are already reflected. This provides useful information to users for assessing the entity’s future cash flows.
The Standard rejects the permanence criterion, under which an impairment loss was not recognised unless the decline was “other than temporary.” This created practical difficulties in the past due to the challenge of distinguishing between temporary and non-temporary declines, leaving wide room for judgment.
The Standard also rejects the probability criterion, under which an impairment loss is recognised only when it is expected that the asset’s carrying amount will not be fully recoverable. The U.S. standard FAS 144 adopts a probability-based trigger test using undiscounted cash flows.
C. Grouping of assets
Where an individual asset does not generate cash inflows that are largely independent of those from other assets, the Standard requires identifying the smallest group of assets that includes the asset and generates largely independent cash inflows from continuing use. In such cases, the impairment test is performed not at the individual asset level but at the cash–generating unit (CGU) level to which the asset belongs. The rationale is that value in use, and thus recoverable amount, can be determined only for the group of assets, not separately for each asset within the CGU, because the expected cash flows of one asset depend on those of another. As a result, situations can arise where the fair value less costs of disposal of a particular asset is below its carrying amount, but because the CGU’s value in use exceeds the aggregate carrying amount of its assets, no impairment loss is recognised for that individual asset.
Identifying the CGU is a crucial process forming the basis for impairment accounting in most entities and has significant implications for recognition and measurement. This identification requires management judgment and poses one of the most significant challenges in applying impairment accounting.
D. Distinguishing between investments in subsidiaries and investments accounted for using the equity method
The Standard makes a basic distinction between investments in investees that are consolidated in the financial statements and investments in investees accounted for using the equity method (e.g., associates). For consolidated investees, impairment is tested at the level of each asset (within the scope of the Standard) in the consolidated statement of financial position, since control exists over each individual asset, while its legal ownership (parent or subsidiaries) is economically irrelevant. Conversely, For non-consolidated investees (such as associates), impairment is tested with respect to the investment as a whole, rather than the investee’s underlying assets. The rationale is that the investor does not control the associate’s individual assets but rather the investment itself. Thus, the investment itself is considered to be the “productive asset” that generates cash flows (e.g., dividends or proceeds on disposal).
E. Reversal of impairment losses
Where an asset’s carrying amount has been reduced due to an impairment loss, the Standard requires, subject to certain conditions, reversal in subsequent periods of all or part of that impairment loss. However, no reversal is permitted for goodwill, since it is unclear whether the increase reflects the restoration of a previously existing asset or the creation of a new asset. The concept is that impairment losses are recognised and measured based on estimates. A change in the measurement of an impairment loss therefore reflects a change in the estimate of the asset’s future economic benefits. Accordingly, the effect of the change in accounting estimate is included in profit or loss in the period of the change. The objective is to maintain consistency with IFRS requirements and to reflect the fact that future economic benefits previously not expected from the asset have been reassessed and are now expected.
This approach is applied consistently in IFRS Accounting Standards dealing with impairment of other items, e.g., impairment of inventories under IAS 2 and impairment of loans and receivables under IFRS 9.
Note that US GAAP takes a different approach: impairment losses are not reversed, based on the notion that the reduced amount after an impairment becomes the asset’s new cost basis. Accordingly, FAS 144, which addresses impairment of long-lived assets, does not permit reversal of previously recognised impairment losses.