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
For the lessor, 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.
| Lifetime EL – 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 | ||||
A leased asset’s fair value or recoverable amount must be tested periodically. Big-ticket and larger-size mid-ticket leases are individually tested for impairment, whereas homogeneous smaller-ticket leases are grouped by similarity of contract and tested for impairment collectively.