Performing the US GAAP Impairment Test

An impairment test under U.S. Generally Accepted Accounting Principles (US GAAP) ensures a company’s assets are not overstated on its financial statements by verifying that an asset’s carrying amount does not exceed its recoverable amount. This process requires companies to write down assets that have lost value. The goal is to ensure the balance sheet presents a realistic picture of the company’s financial health for investors, creditors, and other stakeholders.

Identifying Impairment Triggers

An impairment test is not required annually for every asset but is prompted by “triggering events” suggesting an asset’s carrying amount may not be recoverable. Accounting Standards Codification (ASC) 360 outlines when to test long-lived assets based on these triggers. These factors can be categorized as either external or internal.

External triggers originate from the broader economic environment. An adverse change in the legal landscape or business climate could impair an asset’s value, such as new regulations rendering a plant obsolete. A decline in an asset’s market price is a direct indicator, as is an increase in market interest rates, which lowers the present value of an asset’s future cash flows.

Internal triggers arise from a company’s operations. Physical damage indicates diminished value, and a history of operating or cash flow losses for an asset suggests declining economic viability. A change in how an asset is used or a plan to dispose of it before the end of its estimated useful life also requires an impairment test.

The Impairment Test for Long-Lived Assets

The impairment test for long-lived assets, like property, plant, and equipment (PP&E) and finite-lived intangible assets, is a two-step model. The process begins by grouping assets at the lowest level for which identifiable cash flows are largely independent of the cash flows of other assets. This model first screens for potential impairment before requiring a fair value measurement.

The Recoverability Test

The first step is the recoverability test, which compares the asset’s carrying amount to the sum of its undiscounted future cash flows. This test does not consider the time value of money. If the undiscounted cash flows are greater than the carrying amount, no impairment has occurred and the test ends. For example, a machine has a carrying amount of $100,000. The company projects total undiscounted future cash flows of $130,000 from its use and sale, so the asset passes the test.

Measuring the Impairment Loss

If an asset fails the recoverability test, the company proceeds to the second step to measure the loss. The impairment loss is the difference between the asset’s carrying amount and its fair value, which is the price it would fetch in an orderly sale. For instance, if the machine’s undiscounted cash flows were only $90,000, it would fail the test. If its fair value is determined to be $75,000, the impairment loss is $25,000 ($100,000 carrying amount – $75,000 fair value).

The Impairment Test for Indefinite-Lived Intangible Assets

The test for intangible assets with indefinite lives, such as trademarks or brand names, is governed by Accounting Standards Codification (ASC) 350. These assets are not amortized, as they are expected to contribute to cash flows indefinitely. The impairment test is performed at least annually, or more frequently if events indicate a potential impairment.

This test is a one-step approach that compares the asset’s carrying amount directly with its fair value. If the carrying amount exceeds the fair value, an impairment loss is recognized for the difference. Unlike the test for long-lived assets, there is no preliminary recoverability test based on undiscounted cash flows.

US GAAP also permits an optional qualitative assessment, known as “Step 0.” Before the quantitative test, a company can assess qualitative factors to determine if it is more likely than not (a greater than 50% likelihood) that the asset is impaired. These factors include macroeconomic conditions, industry considerations, and asset-specific issues. If the assessment indicates an impairment is not likely, no further testing is required for that period.

For instance, a company has a trademark with a carrying amount of $500,000. A quantitative test determines the trademark’s fair value is now $400,000. An impairment loss of $100,000 ($500,000 – $400,000) is recorded, reducing the trademark’s carrying amount to $400,000.

The Impairment Test for Goodwill

Goodwill, which arises from acquiring a business for more than the fair value of its net assets, has its own impairment testing rules. Goodwill cannot be tested on its own because it does not generate independent cash flows. Instead, it must be tested for impairment at a higher level.

Reporting Unit Level

Goodwill is tested at the “reporting unit” level, which is an operating segment or one level below it. This is the level where management reviews business performance and to which goodwill was assigned during the acquisition. The impairment test for goodwill is performed at least annually.

Qualitative Assessment (Step 0)

As with indefinite-lived intangibles, companies can first perform an optional qualitative assessment (“Step 0”). This involves evaluating factors affecting the reporting unit’s fair value, such as economic conditions and financial performance. If this assessment shows an impairment is not likely, the quantitative test can be skipped.

Quantitative Test

If the qualitative assessment is skipped or indicates a potential impairment, the company performs the quantitative test. This is a one-step test that compares the fair value of the reporting unit with its carrying amount, including goodwill. If the fair value is less than the carrying amount, an impairment loss is recognized for the difference. The loss cannot exceed the total goodwill allocated to that unit. For example, a reporting unit has a carrying amount of $2 million, including $300,000 of goodwill. If its fair value is $1.8 million, the impairment loss is $200,000, which is recorded by reducing the goodwill account.

Accounting for and Disclosing an Impairment Loss

After calculating an impairment loss, a company must follow specific procedures to record and disclose it in the financial statements. This provides transparency to investors and other stakeholders about the nature and impact of the impairment.

Recording the Loss

The impairment loss is recorded by debiting an “Impairment Loss” expense account and crediting the asset account. For long-lived assets, the credit is often to Accumulated Depreciation, while for goodwill or other intangibles, the credit is made directly to the asset. This loss is reported on the income statement as part of income from continuing operations.

New Carrying Value

After the loss is recognized, the asset’s carrying amount is reduced to its fair value, which becomes its new accounting basis. Future depreciation will be calculated based on this new value. A significant rule under US GAAP is that an impairment loss for an asset held for use cannot be reversed, even if its fair value increases. This differs from International Financial Reporting Standards (IFRS), which may permit reversals.

Disclosure Requirements

Companies must provide detailed disclosures in the footnotes to their financial statements about impairment losses. Disclosures must include a description of the impaired asset and the circumstances that led to the impairment. The amount of the loss and where it is included on the income statement must also be disclosed, along with the methods used to determine the asset’s fair value.