What is Impairment in Accounting?

A corporate asset is impaired in accounting when its value drops permanently. It might be a fixed or intangible asset. This is known as impairment.

During impairment testing, we compare the potential profit, cash flow, or advantages of the asset to its existing book value. If the asset’s book value exceeds its future cash flow or other advantages, and its balance sheet value decreases, we write off the difference.

Understanding Impairment

A severe decrease in a fixed asset’s recoverable value is usually called impairment. The notion may be from a legal or economic shift or an unanticipated calamity.

Natural disasters can destroy outdoor machinery and equipment for a building company. This will significantly decrease the fair value of these assets below their carrying value on company books.

Net of cumulative depreciation, an asset’s carrying value (book value) which the company records on a balance sheet.

Periodic Impairment Assessment

An accountant periodically checks assets for problems. If it occurs, the accountant deducts the difference between fair value and carrying value.

People often calculate the fair value of an asset by adding the projected future cash flows and estimating the salvage value, which represents the expected profit from selling or disposing of the item at the end of its life.

Additionally, the company may harm its goodwill and accounts receivable and need to evaluate and document them.

Companies can also harm their capital. An impaired capital event occurs when a company’s total capital falls below its capital stock’s par value.

Impaired capital can naturally reverse when the company’s total capital returns above its capital stock par value.

Impairment vs. Depreciation

Unexpected harm impairs. Depreciation is normal wear.

Fixed assets like machinery and equipment depreciate. Depreciation is used in each accounting period according to a predetermined schedule using either a straight line or an accelerated approach.

Depreciation schedules distribute an asset’s value decline over its lifetime, unlike an impaired asset, which causes a sudden drop in fair value.

For instance:

Throughout its lifespan, a tractor depreciates.

GAAP Impairment Requirements

According to GAAP, assets are impaired when their fair value falls below their book value.

A write-off for losses can harm a company’s balance sheet and financial ratios. Thus, companies must routinely assess their assets for impairment.

Intangible goodwill must be evaluated for impaired assets annually to avoid inflating asset values on the balance sheet.

GAAP advises corporations to analyze events and economic conditions between yearly impairment tests to assess if an asset’s fair value has declined below its carrying value “more likely than not.”

Causes

An asset may become degraded and unrecoverable if its intended use changes, consumer demand drops, it is damaged, or legal considerations change.

If these events occur mid-year, the assessment reduces immediately.

Where cash flows are identifiable, GAAP tests fixed assets for impairment at the lowest level. An automaker should examine each machine in a manufacturing facility for impairment, not the high-level plant. Asset groups or entities can be tested for impairment if no cash flows are identified at this low level.

Example

In Florida, ABC Company bought a building for $250,000 years ago. The building has accrued $100,000 in depreciation. The company’s balance statement lists the building’s carrying value as $150,000.

Category 5 hurricanes severely damage the structure. The company decides to test for impairment.

ABC Company values the building at $100,000 after examining the damages. The building is impaired. Hence, the asset value must be written down to avoid balance sheet overstatement.

A $50,000 debit entry to “Loss from Impairment,” which reduces net income on the income statement, is made.

The identical entry also credits $50,000 to the building’s asset account to reduce its balance or to the “Provision for Impairment Losses.”

How to Assess Impairment?

GAAP considers an asset impaired when its fair value is lower than its book value. We compare the total profit, cash flow, or other benefit projected from an asset to its book value to check for impairment. We record an impairment if the asset’s book value exceeds its future cash flow or benefit.

Impairment Losses: Where?

The income statement and balance sheet reveal this type of loss. An impairment loss reduces the balance sheet value of the impaired asset and increases the income statement expense.

Impairment Accounting: How?

A company’s accountant will deduct the difference between fair and carrying values if an impairment reduces the asset’s worth on the balance sheet. The firm usually calculates fair value by adding the undiscounted future cash flows of an asset and its expected salvage value, which the firm expects to obtain from selling or disposing of it.

The Purpose of Asset Impairment?

A company periodically assesses its assets to ensure there is no overvaluation.
An impaired asset has a market value below the company’s balance sheet. Periodically evaluating an asset’s value is intelligent business management because many factors can affect it.

Can You Call Impaired Assets Loss?

GAAP requires income statement losses for damaged assets. Comparing the asset’s worth to its fair market value helps calculate loss.

The Verdict

It reduces the value of a fixed or intangible firm asset. If the asset’s book value exceeds its expected cash flow, it the gap between them is the loss.

Periodically assessing asset value helps a corporation avoid overstating asset worth, which could cause financial issues.

Conclusion

Unusual or one-time events like legal or economic changes, consumer demand changes, or asset damage can cause issues.

• To avoid balance sheet overstatement, regularly assess assets for impairment.
• It can impair an asset when its fair value exceeds its balance sheet carrying value.
• Record impairment loss if testing shows any issues.
• The losses diminish the value of the impaired asset on the balance sheet and increase the income statement expense.