IAS 36 (Impairment of Assets)

IAS 36, or International Accounting Standard 36, is a crucial rulebook that prevents companies from carrying their assets on the books at a value that's wildly optimistic and out of touch with reality. In simple terms, it forces a company to take a hard look at its belongings—from factories and machinery to brand names and goodwill—and ask, “Is this really worth what we say it is?” If an asset's recorded value (its carrying amount) is higher than the economic benefits it's expected to generate (its recoverable amount), the asset is considered “impaired.” IAS 36 dictates that the company must recognize an impairment loss by writing down the asset's value to its true recoverable amount. This isn't just an accounting exercise; it's a moment of truth that hits the income statement directly, reducing reported profits. As part of the broader IFRS framework used across Europe and many other parts of the world, IAS 36 ensures that a company's balance sheet presents a more faithful picture of its financial health.

Think of IAS 36 as a mandatory annual health check for a company's major assets. The process isn't random; it's triggered by specific clues or “indicators of impairment.”

Companies don't test every asset every year. They look for signs that an asset might have lost value. These can be:

• External signs: A significant drop in the asset's market value, negative changes in the economic or technological landscape (like a new invention making a factory's equipment obsolete), or increases in market interest rates that affect the asset's value calculations.
• Internal signs: Physical damage to an asset, evidence of obsolescence, or proof that the asset is performing much worse than expected (e.g., a factory division that is consistently losing money).

For certain intangible assets like goodwill, an impairment test is mandatory at least once a year, regardless of whether there are any obvious signs of trouble.

If an indicator is present, the company must perform a formal impairment test.

1. Step 1: Find the Carrying Amount. This is the easy part. It’s the asset’s value as recorded on the balance sheet, which is its original cost minus any depreciation and previous impairment losses. You might also know this as its book value.
2. Step 2: Determine the Recoverable Amount. This is the core of the test. The recoverable amount is the higher of two values:
   • Fair Value less Costs of Disposal: What the company could get from selling the asset in an orderly transaction, minus any direct costs of the sale (like legal fees or removal costs).
   • Value in Use: This is an estimate of the future cash flows the asset will generate for the company, discounted back to their present value. It's essentially a mini Discounted Cash Flow (DCF) analysis for a single asset or a group of assets (known as a Cash-Generating Unit).
3. Step 3: Compare and Recognize the Loss. If the Carrying Amount (Step 1) is greater than the Recoverable Amount (Step 2), the asset is impaired. The company must record an impairment loss equal to the difference. This loss is reported as an expense, which reduces the company's net income for the period.

An impairment charge is far more than just accounting jargon; it's a story about management, strategy, and value. For a value investor, understanding IAS 36 is like having a special lens to see through a company's narrative.

A large or recurring impairment charge is a significant red flag. It often signals that management made a poor capital allocation decision in the past, such as overpaying for an acquisition (leading to a goodwill impairment) or investing in a project that failed to deliver its promised returns. As Warren Buffett often notes, huge write-offs are typically the consequence of foolish acquisitions made at the peak of a business cycle. An impairment is management’s quiet admission: “We messed up.”

Here's a fascinating twist in IAS 36. If the reasons for a previous impairment no longer exist and an asset's recoverable amount has increased, a company can reverse the impairment loss (with the major exception of goodwill). This reversal is recognized as income. For a savvy investor, this creates an opportunity. A company that was forced to take a big, painful write-down during a recession might be sitting on undervalued assets. If you believe the company's prospects are improving, you might be buying assets at a steep discount to their potential future (and re-appraised) value.

This potential for reversals is a crucial difference between IFRS and US GAAP (the accounting standards used in the United States). Under US GAAP, the reversal of an impairment loss is generally forbidden. Once an asset is written down, it stays down. This means an investor analyzing a European company under IFRS might spot recovery potential that simply doesn't exist from an accounting perspective for a similar American company.