What Is Impairment?
In accounting, impairment describes a permanent reduction in the value of a company's asset, typically a fixed asset or an intangible asset. When testing an asset for impairment, the total profit, cash flow, or other benefit expected to be generated by that specific asset is periodically compared with its current book value. If it is determined that the book value of the asset exceeds the future cash flow or benefit of the asset, the difference between the two is written off and the value of the asset declines on the company's balance sheet.
- Impairment can occur as the result of an unusual or one-time event, such as a change in legal or economic conditions, change in consumer demands, or damage that impacts 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.
- If impairment is confirmed as a result of testing, an impairment loss should be recorded.
- An impairment loss records an expense in the current period which appears on the income statement and simultaneously reduces the value of the impaired asset on the balance sheet.
Impairment is commonly used to describe a drastic reduction in the recoverable amount of a fixed asset. Impairment may occur when there is a change in legal or economic circumstances surrounding a company or a casualty loss from unforeseen devastation.
For example, a construction company may experience impairment of its outdoor machinery and equipment in the aftermath of a natural disaster. It appears as a sudden and large decline in the fair value of an asset to below its carrying value. An asset's carrying value, also known as its book value, is the value of the asset net of accumulated depreciation that is recorded on a company's balance sheet.
An accountant tests assets for potential impairment periodically; if any impairment exists, the accountant writes off the difference between the fair value and the carrying value. Fair value is normally derived as the sum of an asset's undiscounted expected future cash flows and its expected salvage value, which is what the company expects to receive from selling or disposing of the asset at the end of its life.
Other accounts that may be impaired, and thus need to be reviewed and written down, are the company's goodwill and accounts receivable. Long-term assets are particularly at risk of impairment because the carrying value has a longer span of time to become potentially impaired.
Similar to an impaired asset, a company's capital can also become impaired. Impaired capital event occurs when a company's total capital becomes less than the par value of the company's capital stock. However, unlike the impairment of an asset, impaired capital can naturally reverse when the company's total capital increases back above the par value of its capital stock.
Impairment vs. Depreciation
Fixed assets, such as machinery and equipment, depreciate in value over time. The amount of depreciation taken each accounting period is based on a predetermined schedule using either straight line or one of multiple accelerated depreciation methods. Depreciation schedules allow for a set distribution of the reduction of an asset's value over its entire lifetime. Unlike impairment, which accounts for an unusual and drastic drop in the fair value of an asset, depreciation is used to account for typical wear and tear on fixed assets over time.
Requirements for Impairment
Under generally accepted accounting principles (GAAP), assets are considered to be impaired when the fair value falls below the book value. Any write-off due to an impairment loss can have adverse affects on a company's balance sheet and its resulting financial ratios. It is, therefore, very important for a company to test its assets for impairment periodically. Certain assets, such as the intangible goodwill, must be tested for impairment on an annual basis in order to ensure the value of assets are not inflated on the balance sheet.
GAAP also recommends that companies take into consideration events and economic circumstances that occur between annual impairment tests in order to determine if it is "more likely than not" that the fair value of an asset has dropped below its carrying value. Specific situations where an asset might become impaired and unrecoverable include when there is a significant change to an asset's intended use, decrease in consumer demand, damage to the asset, or adverse changes to legal factors that affect the asset. If these types of situations arise mid-year, it's important to test for impairment immediately.
Standard GAAP practice is to test fixed assets for impairment at the lowest level where there are identifiable cash flows. For example, an auto manufacturer should test for impairment for each of the machines in a manufacturing plant rather than for the high-level manufacturing plant itself. However, if there are no identifiable cash flows at this low level, it's allowable to test for impairment at the asset group or entity level.
Example of Impairment
ABC Company, based in Florida, purchased a building many years ago at a historical cost of $250,000. It has taken a total of $100,000 in depreciation on the building, and therefore has $100,000 in accumulated depreciation. The building's carrying value, or book value, is $150,000 on the company's balance sheet. A category 5 hurricane damages the structure significantly, and the company determines the situation qualifies for impairment testing.
After assessing the damages, ABC Company determines the building is now only worth $100,000. The building is therefore impaired and the asset value must be written-down to prevent overstatement on the balance sheet. A debit entry is made to "Loss from Impairment," which will appear on the income statement as a reduction of net income, in the amount of $50,000 ($150,000 book value - $100,000 calculated fair value). As part of the same entry, a $50,000 credit is also made to the building's asset account, to reduce the asset's balance, or to another balance sheet account called the "Provision for Impairment Losses."