Impairment occurs when an asset — usually a fixed asset — depreciates in fair market value below the book value of the asset on the business' financial statements. Under the U.S. generally accepted accounting principles (GAAP), assets considered "impaired" must be recognized as a loss on a business' income statement. Impairments are tested regularly and, when discovered, the difference is written off.
The majority of assets written down are goodwill assets (intangible assets acquired through the purchase of another company), accounts receivables and long-term assets that (physically) depreciate over time like machinery and equipment.
What Is Impairment Loss?
Before determining how to calculate the impairment loss, it is important to understand what the term means. The technical definition of impairment loss is a decrease in net carrying value — the acquisition cost minus depreciation — of an asset greater than the future undisclosed cash flow of the same asset.
Impairment occurs when assets are sold or abandoned because the company no longer expects them to benefit long-run operations. This is different from a write-down, though impairment losses often result in a tax deferral for the asset. Depending on the type of asset being impaired, stockholders of a publicly held company may also lose equity in their shares, which results in a lower debt-to-equity ratio.
How Is Impairment Loss Calculated?
Calculating Impairment Loss
When you calculate an impairment loss, you are letting people know the value of an asset has fallen in value since the time the company first made the purchase.
In order to calculate an impairment loss, the factors leading to the asset's impairment must first be identified. Some factors may include changes in market conditions, new legislation or regulatory enforcement, workforce turnover, or decreased asset functionality due to aging. In some circumstances, the asset itself may be functioning as well as ever, but new technology or new techniques may cause the fair market value of the asset to drop significantly. This could be a manufacturing process in an industrial setting or software used by a technology company.
The key to calculating an impairment loss is the fair market value — asset impairment cannot be recognized without a good approximation of this value.
Fair market value is the price the asset would fetch if it was sold on the market. This is sometimes described as the future cash flow the asset would expect to generate in continued business operations. Another term for this value is "recoverable amount." Once the fair market value is assigned, it is then compared to the carrying value of the asset as represented on the business' financial statements. Carrying value does not need to be recalculated at this time since it exists in previous accounting records. If the calculated costs of holding the asset exceed the calculated fair market value, the asset is considered to be impaired. If the asset in question is going to be unloaded, the costs associated with the disposal must be added back into the net of the future net value less the carrying value.
Impairment losses are either recognized through the cost model or the revaluation model, depending on whether the debited amount was changed through the new, adjusted fair market valuation described above. Even when impairment results in a small tax benefit for the company, the realization of impairment is bad for the company as a whole. It usually represents the need for an increased reinvestment.
The Bottom Line
Impairment determines the difference between the fair market value and the book value of an asset on a company's balance sheet. Calculating an impairment loss is an important way to let the market know the true value of a company's assets at a particular point in time.