The higher of two numbers, and why "higher"

An asset is impaired when it will not earn back its carrying amount

Depreciation spreads cost over an expected life; it says nothing about whether the asset can still generate that much. Impairment is the check. Under IFRS (IAS 36) an asset is impaired when its carrying amount exceeds its recoverable amount, and the excess is written off immediately. Two questions follow: when must the company look, and what is the recoverable amount?

When to look — the indicators

IFRS requires an entity to assess at every reporting date whether there is any indication that an asset may be impaired (goodwill and indefinite-life intangibles get an annual test regardless; PP&E is tested only when an indicator exists). The indicators come in two families:

• External — a significant decline in the asset's market value beyond normal ageing; adverse changes in technology, markets, the economy or the law; a rise in market interest rates that will raise the discount rate used in value in use; the company's market capitalisation falling below the carrying amount of its net assets.
• Internal — evidence of physical damage or obsolescence; a significant change in how the asset is or will be used (idle, restructured, disposal planned early); internal reports showing the asset's economic performance is worse than expected.

An indicator does not mean a loss is recorded. It means a test must be run: the recoverable amount is estimated and compared with the carrying amount. If the recoverable amount is higher, nothing happens.

What the recoverable amount is

$$\text{Recoverable amount}=\max (\text{value in use},\text{fair value less costs of disposal})$$

Value in use is the present value of the cash flows the entity expects from using the asset and disposing of it at the end — entity-specific assumptions, discounted. Fair value less costs of disposal (FVLCD) is what a market participant would pay, net of the costs of getting the sale done — commissions, legal costs, dismantling. Some first-year texts simplify the recoverable amount to "fair value less costs to sell" alone; that is the simplification it is, and the exam wants the full definition.

Why the higher? Because a rational owner does whichever is better. If the asset is worth more in use than in a sale, the owner keeps it, and its value to the company is value in use; if a buyer would pay more than continued use is worth, the owner sells. The recoverable amount is the best the owner can do, and an asset is impaired only when even the best option falls short of the carrying amount.

Worked example — Cobalt Ridge's ore crusher

Cobalt Ridge Mining Corp. owns a crusher: cost $800,000\ast \ast ,accumulateddepreciation\ast \ast$300,000, carrying amount $500,000. A collapse in the price of the ore it processes — an external indicator — triggers a test at year-end.

Management's discounted cash-flow projection for continued use gives a value in use of $380,000. A dealer would pay $400,000, but dismantling and commission would cost $30,000, so FVLCD is 400,000 − 30,000 = $370,000.

$$\text{Recoverable amount}=\max (380,000,370,000)=380,000$$

380,000 is below the carrying amount of 500,000, so the crusher is impaired, and L3.4 records the loss. Had a dealer offered $425,000, FVLCD would be 395,000, the recoverable amount would rise to 395,000, and the loss would be smaller — the sale would be the better option and the asset would be worth what a buyer would pay.

One line on cash-generating units

Many assets earn nothing on their own — a conveyor feeds a crusher that feeds a mill. IAS 36 then tests the smallest group of assets with independent cash inflows, the cash-generating unit. AFM 182 stays at the single-asset level; know the term.