Impairment refers to the loss of value of a fixed asset. In accounting, impairment loss quantifies this loss. Several factors may contribute to a fixed asset losing its value. These factors may be external or internal. Usually, companies conduct an impairment test to determine if a fixed asset has suffered an impairment loss.
What is an Impairment Test?
The term impairment test refers to an accounting method to establish whether an asset has suffered impairment. It allows companies to determine the value of the impairment loss on that asset. As stated above, several factors can cause this loss. Once companies notice these factors, they must conduct an impairment test to quantify the impairment loss on the asset.
How to perform an Impairment Test?
The impairment test differs based on the accounting framework a company uses. Usually, these include the IFRS and GAAP. The impairment test under each framework is as below.
IFRS
An impairment test under IFRS involves establishing two values for an asset, including the following:
- Carrying value
- Recoverable amount
The former comes from the balance sheet. On the other hand, an asset’s recoverable amount is the higher of the following amounts.
- Fair value less cost to sell
- Value in use
If the recoverable value is lower than the asset’s carrying value, companies must record an impairment loss. It will be the difference between the carrying value and the recoverable amount.
GAAP
Under GAAP, the same test does not apply. Instead, companies must determine the following two values for a fixed asset.
- Carrying value
- Sum of undiscounted expected cash flows
If the carrying value exceeds the latter, companies must record an impairment loss on the asset. This loss will equal the difference between the carrying value and the sum of undiscounted expected cash flows.
What are the indicators of Impairment?
Several factors indicate impairment loss on an asset. Once companies notice these factors, they must conduct an impairment test on that asset. These factors may occur due to external or internal reasons.
External factors
The external factors that may indicate an impairment loss on a fixed asset include the following.
- A decline in the market value of an asset
- Technological, economic, legal, or market factors that impact a company adversely
- Changes in interest rates that result in discount rate fluctuations
Internal factors
Internal factors that may indicate an impairment loss on a fixed asset may include the following.
- Evidence of damage or obsolescence of the fixed asset
- Changes in the usage of the fixed asset
- Evidence indicating the economic performance of an asset is worse than expected
Example
A company, Green Co., bought a vehicle for $10,000. This asset has a carrying value of $8,000 on the company’s balance sheet. Recently, the vehicle had an accident resulting in its economic performance declining. Currently, Green Co. estimates the recoverable value of the asset to be $6,000. Green Co. uses the IFRS framework for accounting.
The impairment test conducted by Green Co. indicates an impairment loss on the vehicle. Since the recoverable value is lower than the carrying value, the company must record an impairment loss. This loss will be equal to $2,000 ($8,000 – $6,000).
Conclusion
Impairment refers to a decline in the value of a fixed asset. Several factors can indicate this decline occurring for assets, including external and internal factors. Once companies notice these factors, they must conduct an impairment test. This test may differ based on the accounting framework used by companies.
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