A long-lived asset has become impaired when the book value of the asset as recorded on the balance sheet is not expected to be recovered during future operations.
A call center operator recently capitalized a $2 million investment in production fixtures at a leased building. The call center company’s primary client in this site cancels the existing business contract two months after the investment is made. The call center firm’s capitalized assets associated with this building may have become impaired, if the company feels that it cannot place new business in this site and must cease operations there.
Events that may cause a “lack of asset value recoverability” could be:
- A decrease in the asset’s market value.
- Adverse changes in the law.
- Adverse changes in the business climate involving the asset.
- Cost overruns on a project associated with the asset.
- The experience or anticipation of income statement or cash flow losses associated with the asset.
US GAAP – Determining Asset Impairment Charge
US GAAP has a two-step process for determining if an asset impairment charge is required:
- Recoverability Test – An asset impairment must be recognized once the UNDISCOUNTED future cash flows from an asset fall below the book value of the asset on the balance sheet.
- Loss Measurement – The amount by which an impaired asset it to be reduced equals the difference between its book value and its fair market value (this can be called “mark to market accounting”). A charge is taken on the income statement equal to the reduction in asset value on the balance sheet.
Types of Asset Impairment
- Write-downs – Asset values have changed as a result of changing market conditions.
- Restructurings – Asset value declines associated with the re-organization of business operations.
The US approach to impairment of long-lived assets has flaws because company management retains the ability to determine the assumptions, which go into performing a recoverability test.
In a period of economic recession, an analyst should be suspicious of a firm that does not experience any asset impairment, as management may be sticking to older, more optimistic assumptions about the expected future cash flows generated by its assets.