An impairment is a permanent reduction in the carrying value of an asset below its fair value (US GAAP) or recoverable amount (IFRS), which occurs when it is deemed improbable that the loan or lease receivable will be recovered in accordance with the contractual terms of the loan or lease. A nonrecurring charge taken to reduce an impaired asset to its fair or recoverable value is an impairment loss, it equaling the amount by which the asset’s carrying value exceeds its expected recovery value.
Impairment = Fair Market Value < Carrying Value
The carrying amount of the asset is compared with its recoverable amount. The carrying amount is the amount at which an asset is recognized in the balance sheet after deducting accumulated depreciation, loss allowance or impairment losses. The recoverable amount is the higher of an asset’s fair value less costs to sell (net selling price) and its value in use, it equaling the amount that the entity would receive for the asset in a sale at the reporting date. Value in use is the discounted present value of the future cash flows expected from the continued use of an asset and its disposal at the end of its useful life.
| Lifetime Expected Loss (Example) | ||||
| Office Equipment 48-Month lease for $15,000 | ||||
| Year | ||||
| 1 | 2 | 3 | 4 | |
| PD | 0.03 | 0.0575 | 0.065 | 0.04 |
| EAD ($) | 13,348 | 10,031 | 6,293 | 2,082 |
| LGD ($) | 0.46 | 0.45 | 0.43 | 0.4 |
| Annual EL ($) | 184 | 260 | 176 | 33 |
| Annual EL (%) | 1.38% | 2.59% | 2.80% | 1.60% |
| Lifetime EL ($) | 491 | |||
| Lifetime EL (%) | 3.27% | |||
| Source: ELA | ||||
When the current fair value or carrying value of the lease is less than the net investment in the lease, the impairment loss reduces the asset’s overstated book value to its fair or recoverable amount. Under US GAAP, the credit loss is recognized as an expense in the income statement; under IFRS, impairment loss is recognized in other comprehensive income (OCI). The impairment allowance balance represents the changes in lifetime expected losses from initial recognition. The adjusted carrying amount of the asset is its new basis for amortization of the unearned income.
An asset’s fair value or recoverable amount must be tested periodically. Big-ticket and larger-size mid-ticket assets are individually tested for impairment, whereas homogeneous smaller-ticket assets are grouped by similarity and tested for impairment collectively.