Impairment

According to accounting, impairment is considered to be a regular decrease in the value of a firm's assets, which can be both fixed assets and intangible assets. To determine if an asset is impaired, it is required to compare the current asset’s book value with its total income, money flows or any benefits that may be received from it. The value of an asset on the balance sheet of the enterprise can be reduced if the current book value of this asset is higher than the expected cash flow from it. In this case, an impairment will be recorded, and the resulting difference will be written off.

What is Impairment

The term “impairment” is most frequently applied to describe a sharp decline in the recoverable value of a fixed asset. Legal or economic circumstances of the company or loss from unforeseeable disasters, or other unusual situations may be reasons for an impairment.

When a book value of the asset is higher than fair one, then an impairment process takes place. For example, company X recorded losses as a result of an elemental disaster. Damage was inflicted on its equipment and machinery installations.

This event will be reflected in the accounting as an unexpected but significant decrease in the fair value of these assets to the level below the carrying value. In order to determine a carrying value of an asset, the second name of which is a book value, it is necessary to subtract an accumulated depreciation recorded on a firm’s balance sheet from the asset’s value.

Fair value is commonly calculated as a sum of upcoming cash flows from an asset and its expected salvage value that an entity would receive on the asset’s sale or disposal at the end of its useful life.

Impairment versus depreciation

Fixed assets such as production equipment and machinery are subject to depreciation. To calculate the amount of depreciation accrued in a given period, a special schedule is used with a straight-line technique or another accelerated depreciation method. An allowable distribution of the decrease in the value of an asset over its useful life has been established, which is reflected in the depreciation schedule.

The expected and logical asset’s wear and tear over time is depreciation, which is accounted for through a specific technology and schedule. Unlike depreciation, impairment implies an atypical and sharp drop in the value of an asset. 

As an example, an entity’s equipment depreciates in its value from year to year during its usage. The same entity’s equipment that was damaged by a hurricane has experienced an impairment and will be recorded on the balance sheet as such. Thus, unexpected damages are considered to be an impairment characteristic, while anticipated wear and tear peculiar to depreciation. 

Impairment example

10 years ago, X Company bought a facility at a historical cost of $350,000. It has taken a total of $150,000 in depreciation on the facility, so the accumulated depreciation is $150,000. The facility's book value is $200,000 on the firm's balance sheet. 

The structure was significantly damaged as a result of an earthquake measuring 9 on the Richter magnitude scale. The firm decided that the current situation is suitable for impairment testing.

Based on the assessment of the damage, it was found that the value of the facility at the current moment is $90,000. As a result, this facility is impaired and the value of the asset should be written down in order to avoid overstatement on the balance sheet.

In the income statement, there will be reflected as a decrease of net income in the amount of $110,000. $110,000 = (book value $200,000 - fair value $90,000).

Reasons and GAAP requirements for Impairment 

Certain cases in which an asset is impaired and irrecoverable are events that involve its large-scale and significant changes. Such reasons may be a decrease in consumer demand, some damage to an asset, or adverse legislative changes in one way or another affecting the asset. If such events occur, an impairment test should be performed.

According to generally accepted accounting principles (GAAP), if the asset’s carrying amount is greater than its fair value, the assets may be considered impaired. Write-offs due to impairment losses can have a negative impact on a company's balance sheet and financial ratios, that is why assets should be tested for impairment periodically. The difference between the fair value and the carrying one is written off by the accountant when impairment is determined. 

Some specific assets must be tested for impairment annually with the aim to make sure that the value of assets is not inflated on the balance sheet. 

The GAAP guidance provides advice to companies on how to account for economic events and other circumstances that take place between annual impairment tests, which helps understand whether it is "more likely than not" that the fair value of an asset will fall below its book value.

The firm's accounts receivable and its goodwill are other accounts that are subject to review and write down due to the possibility of impairment. In addition, the capital of the company may also be impaired. This occurs if the total capital of the company becomes less than the nominal value of the company's fixed capital.

In addition, the capital of a company may also be impaired. This occurs if the par value of the company's capital stock becomes greater than the total capital. In contrast to an asset’s impairment, impaired capital can naturally repair itself when the total capital of the firm enhances back above the par value of its capital stock