What Is an Asset’s Recoverable Amount?
Understand the concept of an asset's recoverable amount, a core principle for ensuring a company's assets are not carried at more than their economic value.
Understand the concept of an asset's recoverable amount, a core principle for ensuring a company's assets are not carried at more than their economic value.
An asset’s recoverable amount is an accounting measure of the total value expected to be retrieved from it, either through continued use or by selling it. This concept is central to financial reporting under International Financial Reporting Standards (IFRS). The primary regulation is IAS 36, Impairment of Assets, which prevents a company from carrying an asset on its financial statements at a value that it can no longer realistically recover.
The recoverable amount is calculated during an impairment test. This test identifies a loss in value, which occurs when an asset’s recorded value on the balance sheet is higher than the amount that can be recovered from it. An asset’s recorded value is its “carrying amount” or “book value,” determined by taking the asset’s original cost and subtracting its accumulated depreciation and any previously recorded impairment losses.
If the carrying amount is greater than its recoverable amount, the asset is considered impaired. This process can also be applied to a “Cash-Generating Unit” (CGU). A CGU is the smallest identifiable group of assets that produces cash inflows largely independent of other assets.
The first component is an asset’s fair value less the costs of disposal. Under IFRS 13, fair value is the price received for selling an asset in an orderly transaction between market participants. This value is based on a hierarchy of inputs, with the most reliable being a price for an identical asset in an active market or a binding sales agreement.
This calculation also requires subtracting the direct costs of disposal, which are the incremental expenses needed to complete the sale. Examples include legal fees, stamp duty, transaction taxes, costs of removing the asset, or expenses to bring it into a condition for sale. Costs already recognized as liabilities are excluded from this calculation.
The second component, Value in Use (VIU), is the present value of future cash flows expected from an asset’s continued operation and its eventual disposal. This calculation is more subjective than determining fair value and requires a forecast of net cash flows the asset will produce in its current condition. Projections should not include the impact of future upgrades.
To estimate VIU, management must project future cash flows based on reasonable assumptions. These projections are limited to a maximum of five years unless a longer period can be justified. Beyond this period, a terminal value is calculated using a growth rate that does not exceed the long-term industry average.
These projected cash flows are then discounted to their present value using a pre-tax discount rate. This rate reflects the time value of money and asset-specific risks but should not account for risks already factored into the cash flow estimates. The rate is often derived from the company’s weighted average cost of capital (WACC), adjusted for the asset’s risk profile.
After calculating both Fair Value Less Costs of Disposal and Value in Use, the recoverable amount is determined. The recoverable amount is the higher of these two figures. A company is not required to calculate both components; if one is already higher than the asset’s carrying amount, the asset is not impaired, and no further calculation is needed.
This recoverable amount is then compared to the asset’s carrying amount. If the carrying amount exceeds the recoverable amount, an impairment loss must be recognized for the difference between the two figures. This loss is recorded through a journal entry, with a debit to an “Impairment Loss” account (an expense on the income statement) and a credit to an “Accumulated Impairment Loss” account, which reduces the asset’s net book value.