Lesson 62: Impairment of Intangible Assets
In this lesson, we will learn what impairment is and
how it applies to different types of intangibles. We will finish by learning to
record the impairments in 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.
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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.
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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.
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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.