In accounting, impairment represents a permanent reduction in the value of a company asset. It could pertain to either a fixed asset or an intangible asset.
When evaluating an asset for impairment, the total profit, cash flow, or other benefits expected to be generated by the asset is periodically compared with its current book value. If the book value of the asset exceeds the future cash flow or other benefits of the asset, the excess is written off, leading to a decrease in the asset’s value on the company’s balance sheet.
Key Takeaways
- Impairment can occur due to unusual or one-time events such as significant changes in legal or economic conditions, shifts in consumer demand, or damage impacting an asset.
- Assets should be tested for impairment regularly to prevent overstatement on the balance sheet.
- Impairment exists when an asset’s fair value is less than its carrying value on the balance sheet.
- Upon confirming impairment, an impairment loss should be recorded, appearing as an expense on the income statement while simultaneously reducing the impaired asset’s value on the balance sheet.
Understanding Impairment
Impairment often signifies a drastic reduction in the recoverable value of a fixed asset, caused by changes in company circumstances or unforeseen disasters.
For example, a construction company might face extensive damage to its outdoor machinery and equipment due to a natural disaster, marking a sudden and significant decline in their fair value, which would appear below their carrying value on the books.
An asset’s carrying value, synonymous with book value, is the asset’s value net of accumulated depreciation listed on a company’s balance sheet.
Periodic Evaluation for Impairment
Accountants test assets for potential impairment periodically. If impairment exists, the difference between the fair value and the carrying value is written off. Fair value typically derives from the sum of an asset’s undiscounted expected future cash flows and its expected salvage value, which is what the company anticipates receiving from selling or disposing of the asset at the end of its life.
Beyond equipment and machinery, company’s goodwill and accounts receivable can also become impaired and need to be regularly reviewed and adjusted. Additionally, a company’s capital might become impaired if the total capital falls below the par value of its stock, although this can naturally reverse when the total capital rises above the par value.
Impairment vs. Depreciation
Impairment indicates unexpected damage, whereas depreciation involves expected wear and tear.
Fixed assets like machinery lose value over time due to depreciation, following a predetermined schedule using methods such as the straight-line or various accelerated depreciation methods. Unlike regular depreciation schedules, which outline a set reduction of an asset’s value over its lifetime, impairment accounts for unexpected and significant value drops.
For instance:
- A tractor’s value gradually depreciates annually over its useful life.
- A tractor crushed by a falling tree has undergone impairment, necessitating prompt recording as such.
GAAP Requirements for Impairment
Under generally accepted accounting principles (GAAP), assets are deemed impaired if their fair value falls below their book value. Any impairment write-off can adversely impact a company’s balance sheet and financial ratios, making periodic asset testing essential.
Certain assets, like intangible goodwill, must be tested for impairment annually to prevent inflated asset values on the balance sheet. GAAP also advises considering economic events and circumstances between annual tests to determine if it’s likely that an asset’s fair value has dropped below its carrying value.
Causes of Impairment
Assets might become impaired and unrecoverable due to significant changes in their intended use, decreased consumer demand, damage, or legal factors. Immediate impairment testing is necessary upon witnessing such scenarios mid-year.
Standard GAAP procedure involves testing fixed assets for impairment at the lowest level where identifiable cash flows exist. An auto manufacturer, for example, should assess impairment for individual machines in a plant rather than the plant as a whole. If low-level cash flows are indistinguishable, testing at the asset group or entity level is permissible.
Inspiring Case of Impairment
ABC Company, based in Florida, purchased a building at a historical cost of $250,000, with $100,000 in accumulated depreciation recorded, leading to a book value of $150,000.
A severe hurricane extensively damages the structure, prompting impairment testing.
After evaluation, ABC Company decides the building’s worth is now just $100,000. Therefore, the asset is deemed impaired and its asset value needs adjustment on the balance sheet.
A debit entry of $50,000 ($150,000 book value – $100,000 fair value) is made to
Related Terms: Fixed Asset, Intangible Asset, Book Value, Fair Value, GAAP, Depreciation, Write-off, Accumulated Depreciation.
References
- AccountingTools. “Impairment Definition”.
- International Accounting Standards Board. “IAS 36 Impairment of Assets”.
- LH Frishkoff & Company. “Accounting for Impairment of Property, Plant, and Equipment (US GAAP)”, Pages 4,6.
- LH Frishkoff & Company. “Accounting for Impairment of Property, Plant, and Equipment (US GAAP)”, Pages 6,8.
- LH Frishkoff & Company. “Accounting for Impairment of Property, Plant, and Equipment (US GAAP)”, Pages 2,4.
- Financial Accounting Standards Board. “Intangibles—Goodwill and Other (Topic 350), Business Combinations (Topic 805), and Not-for-Profit Entities (Topic 958)”, Page 8.
- Financial Accounting Standards Board. “Intangibles—Goodwill and Other (Topic 350), Business Combinations (Topic 805), and Not-for-Profit Entities (Topic 958)”, Page 16.
- Xavier Paper. “Statement of Financial Accounting Standards No. 144”, Page 7.
- LH Frishkoff & Company. “Accounting for Impairment of Property, Plant, and Equipment (US GAAP)”.
- LH Frishkoff & Company. “Accounting for Impairment of Property, Plant, and Equipment (US GAAP)”, Page 7.
