IAS 36, which stands for International Accounting Standard 36, is part of the IFRS (International Financial Reporting Standards) that provides guidance on how to account for the impairment of assets. The core purpose of IAS 36 is to ensure that assets are not carried at more than their recoverable amount, which could lead to overstatement on a company’s balance sheet.
When an asset's value falls below its carrying amount (the amount at which an asset is recognized on the balance sheet), it is considered impaired. IAS 36 outlines how to recognize this impairment, how to measure the recoverable amount, and how to reverse an impairment loss if the circumstances change.
Impairment of an asset refers to a situation where the recoverable amount of an asset is less than its carrying amount on the financial statements. The recoverable amount is the higher of an asset's fair value less costs to sell and its value in use (the present value of the future cash flows expected to be derived from the asset).
If the recoverable amount is lower than the carrying amount, the asset needs to be written down, and an impairment loss is recognized.
1. When to Test for Impairment
At each reporting date: Companies must assess if there are any indicators that assets might be impaired. This assessment can be done at the end of each financial period.
External indicators: These could include a significant decline in market value, adverse economic conditions, or significant changes in the environment that negatively affect the asset.
Internal indicators: This may include evidence of physical damage to the asset, obsolescence, or underperformance of the asset (i.e., generating less cash flow than originally expected).
In case there are any signs of impairment, the company must perform a more detailed impairment test to determine the recoverable amount.
2. Recoverable Amount
The recoverable amount is defined as the higher of:
Fair Value less costs to sell: The amount obtainable from the sale of an asset in an arm's length transaction between knowledgeable, willing parties, minus the costs of disposal.
Value in Use: The present value of the future cash flows expected to be derived from an asset or cash-generating unit (CGU). This is determined by discounting the expected future cash flows at a discount rate that reflects the asset's risk.
3. Measuring Impairment Loss
If the carrying amount of an asset exceeds its recoverable amount, the asset is considered impaired, and the company must:
Write down the carrying amount of the asset to its recoverable amount.
Recognize an impairment loss in the profit and loss statement.
The impairment loss is recognized immediately unless it is related to a revalued asset (like property or equipment), in which case it is recognized in other comprehensive income.
4. Reversing an Impairment Loss
In some cases, after an impairment loss is recognized, there may be a change in the circumstances, and the recoverable amount of the asset may increase.
Reversal of impairment is allowed if the recoverable amount has increased due to changes in circumstances or estimates.
Reversal of impairment losses is not allowed for goodwill (which cannot be reversed).
When the impairment loss is reversed, the carrying amount of the asset is increased to the new recoverable amount, but it cannot exceed what the carrying amount would have been had no impairment loss been recognized.
The reversal is recognized in the profit and loss statement.
Let’s consider a company that owns a machine with a carrying amount of €100,000. Due to a sudden decline in demand for the product it produces, the company realizes that the machine will only generate future cash flows of €60,000.
In this case, the recoverable amount of the machine is €60,000 (because value in use would likely be higher than its fair value less cost to sell), and the company must recognize an impairment loss of €40,000 (i.e., €100,000 - €60,000).
If in the following year the market for the product improves and the machine can now generate future cash flows of €80,000, the company will reverse the impairment loss to €80,000.
Cash-Generating Units (CGUs)
If an asset is part of a group of assets that generates cash inflows, the impairment test is typically done at the level of the cash-generating unit (CGU). A CGU is the smallest identifiable group of assets that generates cash inflows independently of other assets or groups of assets.
The concept of CGU is essential because many assets don’t generate income on their own, but together with other assets, they do. So, the impairment test should focus on the CGU rather than just individual assets.
Goodwill and Impairment
Goodwill is subject to annual impairment testing, regardless of whether there is an indication of impairment. Unlike other assets, goodwill impairment losses cannot be reversed under IAS 36.
Financial Assets: IAS 36 does not apply to the impairment of financial assets like loans, receivables, and investments in subsidiaries. For these, the impairment rules are covered under other standards like IFRS 9 (Financial Instruments).
Investment Property: If the asset is classified as investment property, impairment rules under IAS 40 may apply, but the company can choose to follow the fair value model instead.
Impairment testing should be carried out if there is an indication that an asset may be impaired.
Impairment losses are recognized immediately in the income statement, except for revalued assets.
The recoverable amount is the higher of fair value less costs to sell or value in use.
Impairment losses can be reversed, except for goodwill.
For assets that generate cash flows as a group, impairment is tested at the CGU level.
IAS 36 ensures that assets are accurately reflected on financial statements and that companies do not overstate the value of assets that have lost their recoverable amounts. By following the guidance in IAS 36, companies can better manage their financial reporting, providing investors and other stakeholders with a more realistic view of the financial health of the business.