Annual Impairment Test

Last Updated on March 14, 2024 by Morgan Beard

Companies that lease assets such as real estate, equipment, or vehicles must now be compliant with the new lease accounting standard, ASC 842, issued by the Financial Accounting Standards Board (FASB). One of the key requirements under this standard is the annual impairment review for right-of-use (ROU) assets. An ROU asset represents a lessee’s right to use an underlying asset during the lease term, and it is recorded on the balance sheet as an asset, along with a corresponding lease liability. 

The annual impairment review is a crucial process that helps ensure that the carrying value of these ROU assets accurately reflects their fair value. If an impairment is detected, the company must recognize an impairment loss, which can have significant financial implications.

What is an Annual Impairment Review? 

An annual impairment test is a review to identify if a ROU asset has experienced a decrease in value. Upon identifying potential indicators of impairment, entities must perform an impairment test to determine if the carrying amount of the leased asset exceeds its recoverable amount. If the recent fair value calculation of the asset is less than what you paid for it, you have to acknowledge that it’s impaired, and reduce its value on your books.

Factors that could indicate impairment are changes in industry or market considerations, macroeconomic conditions, technological advancements, physical condition or damage, or other circumstances impacting the utility or economic benefit derived from the leased assets.

Certain intangible assets and goodwill are exceptions to your annual impairment test. Goodwill appears as an intangible asset on the buyer’s balance sheet when a company acquires another company. 

Annual Impairment Review during Accounting Audits

While impairment review should be an ongoing process for your lease accounting team. If it is not, then during your annual audit process is a great time to evaluate your  ROU assets for potential impairment. This review is crucial because it ensures that the financial statements accurately reflect the true value of these assets. If an impairment is detected, the accounting treatment  must recognize the impairment loss, which can have a significant impact on its overall financial performance or position. 

Where are Impairment Losses Recorded

If an impairment loss is identified during the impairment review, it must be recorded in the company’s financial statements — like your balance sheet, income statement, and cash flow statement.  The impairment loss is typically recognized as an expense in the income statement, reducing the company’s net income for the period. Additionally, the carrying value of the ROU asset on the balance sheet is reduced by the amount of the impairment loss. 

How to Evaluate your ROU Asset for Impairment

The process of evaluating an ROU asset for impairment under ASC 842 involves several steps:

Identify Potential Impairment Indicators

Companies should make a qualitative assessment whether there are any indicators that the ROU asset may be impaired. These indicators can include a significant decrease in the asset’s fair value, adverse changes in the legal or business environment, or a decision to sublease or terminate the lease before the end of the lease term. 

Estimate the Fair Value of the ROU Asset:

If impairment indicators are present, the company must make a quantiative assessment and estimate the fair value of the ROU asset. This can be done using various valuation techniques, such as discounted cash flow analysis or market-based approaches.

Compare the Fair Value with the Carrying Value: 

The fair value of the ROU asset is then compared to its carrying value (the amount recorded on the balance sheet). If the carrying value exceeds the fair value, an impairment loss is recognized.

Calculate and Record the Impairment Loss: 

The impairment loss is calculated as the difference between the carrying value and the fair value of the ROU asset. This loss is then recorded in the financial statements, reducing the carrying value of the ROU asset and recognizing an impairment expense on your journal entry.

Impairment vs. Depreciation

It’s important to note that impairment is different from depreciation, which is a separate concept in accounting for leases under ASC 842. Depreciation is the systematic allocation of the cost of an asset over its useful life. For ROU assets, the cost is typically amortized on a straight-line basis over the lease term or the useful life of the underlying asset, whichever is shorter.

Impairment, on the other hand, is a non-routine event that occurs when the carrying value of an asset exceeds its fair value. It represents an unexpected and potentially significant reduction in the asset’s value, which may be caused by various factors such as a decline in market conditions, technological obsolescence, or changes in the asset’s intended use.

While depreciation is a predictable and planned expense that reduces the carrying value of an asset over time, impairment is an unanticipated event that requires the company to recognize an immediate loss in the value of the asset. This loss is recognized as an impairment charge in the income statement, further reducing the company’s profitability for the period.

Impairments Summarized

In lease accounting, impairment is a reduction in the value of a company’s right-of-use asset. It may occur due to various factors, such as a decline in the asset’s fair value or changes in the economic or legal environment. When testing an asset for impairment, the total profit, cash flow, or other benefits that can be generated by the asset are periodically compared with its current book value. If the carrying value exceeds the fair value, an impairment loss must be recognized, which can have a significant impact on the company’s financial statements.

Conducting an annual impairment test ensures that entities accurately reflect the value of their leased assets on their financial statements, providing stakeholders with transparent and reliable information regarding the entity’s financial position and performance. Compliance with ASC 842’s impairment review requirements is essential for entities to adhere to Generally Accepted Accounting Principles (GAAP) in the United States.