Understanding Impairment Accounting: An Overview of Impairment Accounting Rules and Regulations
There is no single definition of impairment in accounting, but it typically refers to a decrease in the value of an asset below its carrying amount. This can occur because of economic factors, such as recession, or because of physical deterioration.
What is Impairment in Accounting?
In accounting, impairment refers to a reduction in the value of a company’s assets. It occurs when the carrying value of an asset exceeds its recoverable amount, which is the amount of money the company expects to receive from the asset’s sale or use.
Impairment can occur due to various reasons such as changes in market conditions, changes in technology, or changes in the company’s operations. For example, if a company owns a piece of equipment that is no longer being used due to a change in its manufacturing process, the equipment may be impaired.
When an impairment occurs, the company must recognise the loss in value by reducing the asset’s carrying value on the balance sheet. The impairment loss is recognised as an expense on the income statement and reduces the company’s net income.
The impairment test is conducted annually or more frequently if there are indications that an asset may be impaired. The test involves comparing the asset’s carrying value with its recoverable amount. If the recoverable amount is less than the carrying value, an impairment loss is recognised.
How Does Impairment Of Assets Work?
Impairment of assets works by recognising a loss in the value of an asset. When the carrying value of an asset exceeds its recoverable amount, which is the amount that can be recovered from the asset’s future use or sale, the asset is considered to be impaired.
The impairment process involves several steps:
- Identify the asset: The first step is to identify the asset that may be impaired. This could be a tangible asset such as property, plant, and equipment, or an intangible asset such as patents, trademarks, or goodwill.
- Estimate the recoverable amount: The next step is to estimate the recoverable amount of the asset. This includes the asset’s fair value, costs to sell and value in use. The fair value is the amount that can be obtained from selling the asset in an open market transaction. The value in use is the present value of the future cash flows the asset is expected to generate.
- Compare the recoverable amount with the carrying value: The third step is to compare the recoverable amount with the carrying value of the asset. The carrying value is the asset’s cost minus any accumulated depreciation or amortisation. If the recoverable amount is less than the carrying value, the asset is impaired.
- Recognise the impairment loss: The fourth step is to recognise the impairment loss. The impairment loss is the amount by which the carrying value exceeds the recoverable amount. This loss is recognised as an expense in the income statement.
- Adjust the carrying value: The final step is to adjust the carrying value of the asset on the balance sheet. The asset’s carrying value is reduced by the impairment loss.
Asset Depreciation vs Asset Impairment
Depreciation is the systematic allocation of the cost of an asset over its useful life. This means that as the asset is used, it gradually loses its value, and the cost of the asset is expensed over the period of its use. Depreciation is a non-cash expense, meaning it does not require any cash outflow. The purpose of depreciation is to match the cost of an asset with the revenue it generates over its useful life.
Asset impairment occurs when the carrying value of an asset exceeds its recoverable amount. The recoverable amount is the higher of an asset’s fair value, fewer costs to selling and its value in use. When the recoverable amount is less than the carrying value, an impairment loss is recognised, which reduces the carrying value of the asset. An impairment loss is a one-time expense recognised in the income statement, and it requires a cash outflow to the extent that the asset is sold or written off.
The main difference between asset depreciation and asset impairment is that depreciation is a systematic allocation of the cost of an asset over its useful life. In contrast, impairment is a recognition of a loss in value due to some specific event or circumstance. Depreciation is a recurring expense, while impairment is a one-time expense. Moreover, depreciation does not necessarily indicate a loss in the value of the asset, whereas impairment always indicates a loss in the value of the asset.
How Do Businesses Account For Impairment?
Businesses account for impairment by recognising a loss in the value of an asset on their financial statements. The accounting treatment for impairment depends on the type of asset that is impaired.
For tangible assets such as property, plant, and equipment, the impairment is recognised as follows:
- Impairment test: The company tests the asset for impairment by comparing the carrying value of the asset (which is the cost of the asset less accumulated depreciation) to its recoverable amount.
- Calculate the impairment loss: If the recoverable amount is less than the carrying value, the company recognises an impairment loss. The impairment loss is calculated as the difference between the carrying value and the recoverable amount.
- Record the impairment loss: The impairment loss is recorded as an expense in the income statement, and the carrying value of the asset is reduced by the amount of the impairment loss.
For intangible assets, such as patents, trademarks, and goodwill, the impairment is recognised as follows:
- Impairment test: The company tests the asset for impairment by comparing its carrying value to its recoverable amount.
- Calculate the impairment loss: If the recoverable amount is less than the carrying value, the company recognises an impairment loss. The impairment loss is calculated as the difference between the carrying value and the recoverable amount.
- Record the impairment loss: The impairment loss is recorded as an expense in the income statement, and the carrying value of the asset is reduced by the amount of the impairment loss.
Goodwill is tested for impairment at least annually, and the impairment test for goodwill involves comparing the carrying value of the reporting unit to its fair value. An impairment loss is recognised if the fair value is less than the carrying value. The impairment loss is recorded as an expense in the income statement, and the carrying value of the reporting unit is reduced by the amount of the impairment loss.
Conclusion
In conclusion, impairment is a key concept used in accounting that helps measure the financial condition of a company. Impairment can occur when a company’s assets are less than its liabilities, and it can be used as a basis for making decisions about whether to sell or liquidate assets.
FAQS
What does the financial phrase "impaired" mean?
A firm asset, whether fixed or intangible, is said to be impaired when its value is decreased to reflect a loss in the asset’s quality, quantity, or market value.
What distinguishes depreciation from impairment?
Depreciation is the outcome of anticipated wear and tear, whereas impairment typically refers to unanticipated harm to an asset.
Impairment: A gain or a loss?
When the fair market value of a business asset decreases more than the asset’s book value on the company’s financial statements, the asset is said to be impaired. Assets that are deemed to be impaired must be shown as a loss on an income statement in accordance with U.S. generally accepted accounting principles (GAAP).
