IAS 36 - Impairment of Assets

IAS 36 is a financial accounting standard that focuses on ensuring a company's assets are not carried at more than their recoverable amount. In simpler terms, it helps prevent companies from overvaluing their assets on the balance sheet by making them check whether an asset's value has decreased (impaired) over time.

Key Terms in IAS 36:

1. Impairment: When an asset’s market value or usefulness has declined to a point where it’s worth less than its book value (the value recorded on the balance sheet).
2. Carrying Amount: The value of an asset currently shown in the company’s financial statements (balance sheet).
3. Recoverable Amount: The higher of the following two amounts:
   • Fair Value less Costs to Sell: What the asset could be sold for, minus selling costs.
   • Value in Use: The present value of future cash flows expected from the asset.

If the carrying amount exceeds the recoverable amount, the asset is considered impaired, and the company must write down its value on the balance sheet.

When Should a Company Test for Impairment?

IAS 36 requires impairment testing when there are indicators of impairment, such as:

• A significant drop in the market value of an asset.
• Physical damage or obsolescence of the asset.
• Changes in market demand that affect the asset's use.
• Significant changes in economic conditions, such as a recession.

Additionally, for certain assets like goodwill and intangible assets with indefinite useful lives, companies must test for impairment annually, regardless of whether indicators are present.

How Does Impairment Testing Work?

1. Identify Impairment Indicators: First, the company checks if any of the indicators mentioned above exist. If there are none, no impairment test is needed.
2. Calculate the Recoverable Amount: If there are impairment indicators, the company calculates the recoverable amount (whichever is higher between fair value less costs to sell and value in use).
3. Compare the Carrying and Recoverable Amounts: If the carrying amount exceeds the recoverable amount, the asset is impaired.
4. Record the Impairment Loss: The impairment loss is the difference between the carrying amount and the recoverable amount, and it is recorded in the income statement.

How to Calculate the Present Value of Future Cash Flows (Value in Use)

To calculate Value in Use, companies need to estimate the future cash flows that the asset will generate and discount them to their present value using a discount rate that reflects the time value of money and the risks associated with the asset.

The formula to calculate present value of future cash flows is:

$$\text{Present Value (PV)} = \frac{\text{Cash Flow}_1}{(1 + r)^1} + \frac{\text{Cash Flow}_2}{(1 + r)^2} + \dots + \frac{\text{Cash Flow}_n}{(1 + r)^n}$$

Where:

• Cash Flow₁, Cash Flow₂, ... Cash Flowₙ are the future cash flows for each period.
• r is the discount rate (which reflects the risk and time value of money).
• n is the number of periods.

Example:

Imagine a company owns a factory. The company estimates the factory will generate cash flows of ₦10 million per year for the next 3 years. The discount rate is 10%. Here's how to calculate the present value of future cash flows:

• Year 1 Cash Flow:

$$\frac{₦10,000,000}{(1 + 0.10)^1} = \frac{₦10,000,000}{1.10} = ₦9,090,909$$

• Year 2 Cash Flow:

$$\frac{₦10,000,000}{(1 + 0.10)^2} = \frac{₦10,000,000}{1.21} = ₦8,264,463$$

• Year 3 Cash Flow:

$$\frac{₦10,000,000}{(1 + 0.10)^3} = \frac{₦10,000,000}{1.331} = ₦7,513,148$$

Total Present Value of Future Cash Flows (Value in Use):

$$₦9,090,909 + ₦8,264,463 + ₦7,513,148 = ₦24,868,520$$

This ₦24.87 million represents the value in use of the factory, based on future cash flows. The company will compare this value to the asset's carrying amount to determine if impairment has occurred.

Example on impairment testing:

Let’s say a company owns a factory building in Lagos, Nigeria, which it bought for ₦100 million. The carrying amount of this factory on the balance sheet is ₦80 million (due to depreciation over time). However, due to a drop in demand for the goods produced in the factory and competition, the company feels the factory may no longer be worth as much.

Here’s how the company tests for impairment:

1. Fair Value Less Costs to Sell: A real estate agent estimates the factory could be sold for ₦50 million, but the company will have to spend ₦5 million to find a buyer and complete the sale. So, the fair value less costs to sell is ₦45 million (₦50 million - ₦5 million).
2. Value in Use: The company calculates the present value of the future cash flows it expects to generate from continuing to use the factory. Let’s say this value comes to ₦60 million.
3. Recoverable Amount: Since the recoverable amount is the higher of fair value less costs to sell (₦45 million) and value in use (₦60 million), the recoverable amount is ₦60 million.
4. Compare with Carrying Amount: The carrying amount is ₦80 million, but the recoverable amount is ₦60 million. This means the asset is impaired.
5. Impairment Loss: The company would record an impairment loss of ₦20 million (₦80 million - ₦60 million). This ₦20 million loss would appear in the income statement, and the carrying amount of the factory would be reduced to ₦60 million on the balance sheet.

Other Key Points in IAS 36:

• Cash-Generating Units (CGUs): Sometimes, individual assets don’t generate cash on their own, so they must be grouped into CGUs, which are the smallest identifiable groups of assets that generate independent cash flows. For example, a retail store might include buildings, fixtures, and stock as a single CGU.
• Goodwill Impairment: Goodwill is often tested for impairment as part of a CGU. If the CGU as a whole is impaired, the goodwill allocated to that CGU is also impaired.
• Reversal of Impairment Losses: If, in the future, the asset’s value increases again (for instance, if market conditions improve), companies are allowed to reverse the impairment loss (except for goodwill). However, the asset cannot be written back up higher than its original carrying amount before impairment.

Practical Example on IAS 36:

Let’s take a retail company that owns a chain of supermarkets. The company bought a supermarket for ₦200 million five years ago, and the carrying amount after depreciation is now ₦150 million. Due to economic challenges, sales have declined, and they suspect the supermarket’s value might be impaired.

1. They calculate the fair value less costs to sell as ₦120 million.
2. They then calculate the value in use, the present value of future cash flows the supermarket can generate, which is ₦130 million.

Since the value in use is higher (₦130 million), that’s the recoverable amount. The carrying amount of ₦150 million is higher than the recoverable amount, so the company records an impairment loss of ₦20 million on its statement of profit or loss.

Read Also:

IAS 38 - Intangible Assets

IAS 16 - Accounting for Property, Plant, and Equipment