Impairment, in accounting, refers to a permanent decrease in the value of an asset to a level much less than its carrying amount. The carrying amount of an asset is its original cost, less any accumulated depreciation or accumulated amortization.
An impairment loss takes place when the market value or recoverable amount of an asset—such as machinery, real estate, or goodwill—drops below its carrying value. This typically occurs as a result of adverse changes in the business environment or poor business performance.
Impairments are recognized as expenses against income in the period the impairment is identified. The impaired asset is written down to its recoverable amount, and the loss is recorded on the income statement, which can significantly impact a company’s profitability.
Companies are required to test assets for impairment on a regular basis. This involves comparing the carrying value of the asset with its recoverable amount. If the recoverable amount is less than the carrying amount, an impairment loss must be recognized.
The rules for how and when to test for impairment can vary depending on the accounting standards being followed. For example, under International Financial Reporting Standards (IFRS), companies must conduct annual impairment tests for intangible assets with indefinite lives, such as goodwill.
Example of Impairment
Imagine a company called Techtronics Inc., which has a manufacturing plant. This plant was purchased 5 years ago for $1 million. After accounting for accumulated depreciation, the plant currently has a book value (or carrying value) of $800,000.
However, due to a recent downturn in the manufacturing sector and new, more efficient technologies available on the market, the plant’s market value has dropped significantly. After conducting an appraisal, it is determined that the current fair market value of the plant is only $600,000. The company also estimates that the future cash flows that the plant will generate (net of any selling costs) are $550,000.
According to accounting rules, Techtronics should compare the carrying value of the plant ($800,000) to its recoverable amount, which is the higher of the fair value less costs to sell and the value in use. In this case, the recoverable amount is the higher of $550,000 (value in use) and $600,000 (fair value less costs to sell), which is $600,000.
Given that the carrying value of the plant ($800,000) exceeds its recoverable amount ($600,000), an impairment loss should be recognized. The impairment loss would be $200,000 ($800,000 – $600,000). Techtronics would record this $200,000 as an impairment expense on its income statement, reducing its net income for the year. It would also reduce the carrying amount of the plant on its balance sheet from $800,000 to $600,000 to reflect the impairment loss.
This is a simplified example, but it demonstrates how impairment can result in significant adjustments to a company’s financial statements.