An impairment loss occurs when the carrying amount (book value) of an asset exceeds its recoverable amount. The recoverable amount of an asset is the higher of its fair value less costs to sell and its value in use. The fair value less costs to sell is the amount that could be received from selling an asset in an arm’s length transaction between knowledgeable, willing parties. The value in use is the present value of the future cash flows expected to be derived from an asset or cash-generating unit.
Impairment losses are recognized in the income statement (profit and loss account) and reduce the carrying amount of the asset on the balance sheet. This usually happens when there is a sudden decline in the fair value of an asset below its carrying amount, or when the asset is not expected to generate enough cash flows to justify its carrying value.
Once an asset is written down, it cannot be written back up for a later recovery in value under International Financial Reporting Standards (IFRS). However, U.S. Generally Accepted Accounting Principles (GAAP) does allow for the reversal of impairment losses in certain situations.
Impairment losses can apply to a variety of long-term assets such as buildings, machinery, goodwill, patents, or investments in securities. Impairment testing, and any resulting impairment loss, can have a significant impact on a company’s net income and balance sheet.
Example of an Impairment Loss
Suppose XYZ Company owns a machine that originally cost $500,000. After accumulated depreciation, the carrying value (book value) of the machine is now $300,000. However, due to changes in the market and the emergence of newer, more efficient machinery, the fair value of the machine (what it could be sold for in the current market) is now only $200,000. Let’s also assume that the costs to sell the machine are negligible for this example.
Additionally, XYZ Company has assessed that the future cash flows that this machine is expected to generate are less than its current fair value, so the value in use is also below $200,000.
Given this situation, XYZ Company would have an impairment loss. The recoverable amount is the higher of the machine’s fair value less costs to sell ($200,000) and the value in use (less than $200,000). Therefore, the recoverable amount is $200,000.
Since the carrying value of the machine ($300,000) is higher than its recoverable amount ($200,000), XYZ Company would need to recognize an impairment loss. The impairment loss is the difference between the carrying value and the recoverable amount, which is $100,000 ($300,000 – $200,000).
This $100,000 impairment loss would be recognized as an expense on XYZ Company’s income statement, reducing its net income. Also, the carrying value of the machine on the balance sheet would be written down from $300,000 to $200,000 to reflect the impairment loss.
Please note that this is a simplified example and the actual process of measuring an impairment loss involves more detailed assessments.