Lesson Objectives:- The definition of impairment
- How impairment applies to different types of intangibles
- Recording impairment journal entries
Impairment is a material decrease in the value of an asset that warrants reporting of a loss. A company has an intangible asset that is decreasing in value that is significant enough to affect decision making. Intangible assets are required to be reviewed annually for possible impairment and adjusted if necessary.
Impairment requires the company to write down the amount of the loss and adjust the asset down to its new fair value. There are two ways that they can do this: either through limited life or indefinite intangible assets.
Let's review limited life assets first.
This concept falls in line with its title, as the asset has a life that only lasts a certain amount of time. In order to look at impairment with this type of intangible asset, we will need to conduct a recoverability test.
To do this, the company will review the amounts of undiscounted cash flows and compare them to the carrying value. The carrying value is calculated by subtracting the accumulated amortization from the cost.
For example, if the carrying value recorded for a patent on software technology is $12,000,000. The cash flows each year would be as follows: $1,000,000 for year 1, $2,000,000 for year 2 and 3, $3,000,000 for year 4 and $1,000,000 for year 5.
If we look at the undiscounted cash flows for the 5 years, we would have a total of $9,000,000. Since the cash flows are less than the $12,000,000 carrying value, we know that the asset is impaired because the company is not able to recover their investment.
We would then need to record the fair value as the undiscounted cash flow value of the $9,000,000. This example would be prevalent in cases such as if the company is having trouble remaining competitive or if part of the software patent becomes obsolete.
Next, let's look at how the impairment will be accounted for.
The difference between the carrying value of $12,000,000 and the fair value of $9,000,000 is $3,000,000, therefore we would need to record the impairment as a loss. The impairment loss would be debited and the patent would be credited as its value is decreasing.
This journal entry would show up when creating the continuing operations section of the income statement.
Now that we've looked at an example of limited life assets and how impairment is recorded, let's review indefinite assets.
Indefinite means that the asset can be renewed so there is no defined time period for the usable life. We don't know how long the asset will be recorded on the company's books.
When compared to looking at a timeline for limited life, we don't truly know how long the indefinite asset will be useful for the company. Hence the uncertainty of the time period, we won't be able to use the recoverability test for indefinite assets. The cash flows for indefinite assets will often extend for many years, they will almost always exceed the carrying value.
Instead of using the recoverability test, the company will estimate the fair value of what the asset is worth. To do this, we can look at a similar asset in an active market or define the discounted cash flows that will come from the intangible.
For example, we have a trademark worth $100,000 and they encounter litigation from another company trying to use the trademark. If the company's cash flow is not enough to cover the litigation costs, they would be forced to retire the trademark asset.
Now how would this transaction be recorded?
The asset has been impaired by the full value because the company is unable to defend the litigation. In this case, the company is taking a loss for $100,000 and they do not have any funds to put toward litigation. This would be recorded as a debit for the loss on impairment for $100,000 and a credit to the trademark as it is decreasing for $100,000.
The main thing to remember is that both finite and indefinite assets can be impaired. When looking at finite assets, the recoverability test is used to find the impairment amount while indefinite intangible are recorded based on the amount of loss.