Impairment of Assets - GAAP v. IFRSMatthew DeMark
February 20, 2009 — 4,556 views
One cannot open a newspaper or watch the evening news without hearing about "globalization of the world's economies". Simply stated, it is the process by which local or regional economic customs and traditions become one and meld into a single functioning society. It comes as no surprise to those who follow worldwide accounting standards that US Generally Accepted Accounting Principles (GAAP) as promulgated by the Financial Accounting Standards Board (FASB) and the International Financial Reporting Standards (IFRS) as promulgated by the International Accounting Standards Board (IASB) are beginning the process of melding into a single functioning set of accounting rules. Although the convergence of these rules is not expect to take place until 2011 (at the earliest) awareness of the differences is important for accounting professionals.
Accounting for impairment of assets is one area where there are significant differences between GAAP and IFRS. Both GAAP and IFRS generally agree that when it becomes apparent a company cannot reasonably expect to recover the carrying amount of certain plant asset through sale or use, the asset should be written down to its fair value. This write-off is referred to as impairment. Most often, asset impairment is due to a significant decrease in asset market value or use, adverse legal factors, drastic cost increases, and/or a projection that demonstrates continuing losses associated with an asset. However, GAAP and IFRS differ as to the methodology used to determine impairment.
GAAP methodology of determining impairment uses a two-step recoverability test. Step one, requires a company to estimate the future undiscounted cash flows expected from the use of that asset and its eventual disposition. If the sum of the expected future net cash flows is less than the carrying amount of the asset, the company considers that asset impaired. However, if the sum of the expected future net cash flows is equal to or greater than the carrying amount, the asset is not impaired. If an impairment has occurred, step two would determine the loss by subtracting the fair value from the carrying amount of the asset.
To illustrate, assume that ABC Inc. owns an asset with a carrying amount of $600,000 ($800,000 cost less $200,000 accumulated depreciation) and a fair market value of $525,000. ABC Inc. expects that future undiscounted cash flows from the asset to be $580,000. Applying the GAAP methodology above, the recoverability test would indicate that the expected future net cash flows are less that the carrying amount of $600,000. As such, an impairment has occurred and the difference between the carrying amount of the asset and its fair market value is the impairment loss. ABC Inc. would record the impairment loss as follows:
Loss on Impairment $75,000
Accumulated Depreciation $75,000
Conversely, IFRS methodology uses a one step approach. This approach requires that impairment loss be calculated if "impairment indicators" exist. This approach does not rely on net undiscounted future cash flows and subsequent comparison to asset carrying value as required in the GAAP methodology. In addition, the impairment loss is calculated as the amount by which the carrying amount of the asset exceeds it recoverable amount. The recoverable amount is the higher of the following: 1) fair value less cost to sell; or 2) value in use (i.e. the present value of future cash flows including disposal value).
Another significant difference between GAAP and IFRS is how restoration of impairment loss is handled. According to GAAP, after an impairment los, the reduced carrying amount of an asset held for use becomes it new cost basis. A company can only change its cost basis for depreciation or amortization in future periods or for additional impairments. To illustrate, in the above example ABC Inc. wrote down the asset to reflect its fair value of $525,000 at the end of 2008. However, at the end of 2009, ABC Inc. determines that the fair value of the asset is $550,000. The carrying amount of the asset should not change in 2009 except for the depreciation taken in 2009. Thus, ABC Inc. is prohibited from restoring an impairment loss for an asset held for use.
By contrast, IFRS requires that all long-lived assets (other than goodwill) must be reviewed annually for reversal indicators. If appropriate, loss may be reversed up to the newly estimated recoverable amount, not to exceed the initial carrying amount adjusted for depreciation. This of course is a significant departure from GAAP and will likely lead to interesting discussions and the convergence date draws nearer.
About the Author
Matthew DeMark is an attorney, MBA, Chartered Life Underwriter, Chartered Financial Counselor and currently completing an accounting degree at West Chester University in Pennsylvania. In addition, Mr. DeMark has nearly a decade of professional experience working in the financial services industry.