Readers would likely agree that understanding asset impairment is an important yet complex aspect of accounting.
This article clearly explains what asset impairment is, how to identify and measure it, and provides real-world examples to demonstrate the key concepts.
You'll learn the definition of asset impairment, its difference from depreciation, how to calculate and record impairment losses and reversals, and review case studies that put the methods into practice.
Introduction to Impairment of Assets
Impairment of assets refers to when an asset on a company's balance sheet decreases in fair value below its carrying value. Recognizing and properly accounting for impairment losses is an important concept in financial reporting.
What is Impairment of Assets in Accounting?
Impairment of assets in accounting occurs when the book value of an asset exceeds its recoverable amount. The recoverable amount is the higher of the asset's fair value less costs to sell and its value in use. If the carrying value is higher than these amounts, the company must recognize an impairment loss to reduce the asset's book value to the recoverable amount. This adjustment is recorded as an expense on the income statement.
Why is Impairment of Assets Important?
Properly recognizing asset impairment losses is important for two main reasons:
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It provides a more accurate representation of a company's financial position. If assets are overvalued on the balance sheet, it can mislead investors and stakeholders. Recording impairment losses reduces assets to their fair or usable value.
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It impacts net income and earnings per share. Impairment losses directly reduce net profit and EPS. Analysts and investors may view unexpected losses as a red flag.
Key Topics Covered in this Article
This article will provide an in-depth look at impairment accounting, including:
- Examples of common impairment triggers
- The asset impairment testing process
- Impairment loss measurement methods
- Journal entries for recording impairment
- Differences between impairment and depreciation
- Reversing previously recognized impairment losses
Understanding these concepts is key for proper financial reporting of impaired assets.
What is meant by impairment of assets?
An asset is considered impaired when its carrying value on the balance sheet exceeds its recoverable amount. The recoverable amount is defined as the higher of the asset's fair value less costs to sell and its value in use.
A few key points about asset impairment:
- Impairment results when an asset declines in utility and value. Common reasons include obsolescence, damage, market changes, poor performance, etc.
- Impairment is different from normal depreciation which is a systematic allocation of asset cost over its useful life. Impairment recognizes an abnormal, accelerated decline in asset value.
- Entities are required to test assets periodically for impairment. When impairment occurs, the carrying value is written down to the recoverable value via an impairment loss.
- The impairment loss is recorded as an expense on the income statement, reducing net income for the period.
- After impairment, the adjusted carrying value of the asset becomes its new cost basis going forward.
- Impairment can be reversed in future periods if the recoverable value increases and the impairment conditions no longer exist.
In summary, asset impairment is an accounting mechanism to reflect an abnormal decline in asset value on the balance sheet and recognize an associated loss/expense on the income statement in the current period. It is different from normal depreciation and can be reversed if asset utility/value improves.
What is an example of impairment of financial assets?
For example, a construction company may face extensive damage to its outdoor machinery and equipment due to a natural disaster. This will appear on its books as a sudden and large decline in the fair value of these assets to below their carrying value.
On July 8, 2023, a major hurricane caused significant damage to the construction equipment of BuildCo Inc. As a result, the fair value of the equipment declined substantially compared to its carrying value on BuildCo's balance sheet.
Specifically, BuildCo was carrying $2 million in equipment at cost. After assessing the damage, it was determined that the fair value of the equipment declined to $1.2 million. This $800,000 decline represents an impairment loss that must be recognized by BuildCo.
To record this, BuildCo would make the following impairment of assets journal entry:
| Account | Debit | Credit |
|---|---|---|
| Impairment Loss | $800,000 | |
| Equipment | $800,000 |
This entry reduces the equipment account to its new fair value of $1.2 million and recognizes an impairment loss of $800,000 on the income statement.
The impairment of assets accounting treatment requires companies to write-down impaired assets to fair value and recognize an impairment charge. This matches the updated value of assets on the balance sheet with their declining economic reality.
Overall, this example illustrates the impact of an event that causes asset impairment. By recording the loss in value, the financial statements reflect the diminished utility of the equipment.
What is the difference between impairment and depreciation?
Impairment and depreciation are two different concepts in accounting that reduce the book value of assets. However, there are some key differences:
Impairment
- An impairment is an unexpected, significant decline in the value of an asset. It is usually caused by an external event outside of the company's control, such as:
- A market crash or economic downturn
- A natural disaster that damages the asset
- New technology making the asset obsolete
- Impairment results in a write-down of the asset's book value to reflect its new lower fair market value.
- Impairments can potentially be reversed in the future if conditions improve and the asset regains its lost value.
Depreciation
- Depreciation is the systematic allocation of an asset's cost over its estimated useful life. It reflects the expected decrease in value over time due to normal wear and tear from using the asset.
- Depreciation is accounted for on a scheduled basis every year, following a depreciation method like straight-line or double declining balance.
- Depreciation expenses cannot be reversed under normal circumstances. The depreciated value reflects the asset's expected residual value at the end of its useful life.
In summary, impairment is an unexpected loss in asset value, while depreciation is an expected decrease in value over time. Impairments may be reversed, but normal depreciation will not be.
How do you deal with impairment of assets?
When an asset's carrying value on the books is higher than its fair market value, it is considered impaired. Here are the main steps to deal with asset impairment:
Record the Impairment Loss
Calculate the difference between the asset's carrying value and its current fair market value. This difference is the impairment loss that must be recorded. Make a journal entry debiting Impairment Loss and crediting the specific asset account for the calculated impairment amount.
Update the Asset's Value
Reduce the asset's carrying value on the balance sheet to its new fair market value. The asset can no longer be valued on the books higher than what it is actually worth based on market conditions.
Recalculate Depreciation
With the asset now valued lower, recalculate its future depreciation expense accordingly. This will result in lower depreciation being recorded going forward.
The key is to bring the asset's book value in line with its actual market value once impairment has occurred. This impacts financial reporting as well as future depreciation calculations. Recording the impairment loss and writing down the asset right away is important for accurate financial statements.
Identifying Signs of Asset Impairment
Asset impairment can be indicated by various events or changes in circumstances. Some key signs that an asset may be impaired include:
Decline in Market Value as an Impairment Indicator
A significant or prolonged decline in the fair market value of an asset below its carrying value on the books is one of the most common triggers for impairment testing. For example, if the market value of a piece of machinery declines due to technological advancements that make it less productive compared to newer models, impairment may need to be recognized.
Changes in Technological or Legal Environment Leading to Impairment
Changes in technology or regulations that impact the utility of an asset can also lead to impairment. Examples include new industry standards that make equipment obsolete, bans on certain product components, or other legal/regulatory changes that decrease usefulness or value. If such changes mean an asset cannot generate the previously expected economic benefits, impairment losses may need to be recorded.
Asset Abandonment Plans and Impairment Considerations
Plans to abandon or decommission an asset before the end of its useful life often necessitate writing down the asset to its “recoverable value” - the higher of either its fair value or value in use with immediate disposal. Since abandoned assets cannot generate future cash flows, their carrying value is impaired.
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Measuring and Recognizing Impairment Losses
Fair Value vs. Value In Use: Core Valuation Approaches
There are two main approaches for valuing assets to test for impairment:
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Fair Value: This estimates the price that would be received when selling the asset in an orderly transaction between market participants. Fair value uses observable market prices and data when available.
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Value In Use: This calculates the present value of estimated future cash flows expected to arise from the asset's continued use and eventual disposal. Value in use incorporates assumptions about growth rates, profit margins, useful life, and discount rates.
The approach used depends on which method better reflects the recoverable amount for that specific asset. Value in use is more commonly applied for assets used internally, while fair value works better for assets with active markets.
Impairment of Assets Formula: Calculating Recoverable Value
The impairment formula compares an asset's carrying value to its recoverable value:
- Carrying Value = Original Cost - Accumulated Depreciation
- Recoverable Value = Higher of Fair Value or Value In Use
If the asset's carrying value exceeds recoverable value, an impairment loss exists.
The impairment loss is calculated as:
Impairment Loss = Carrying Value - Recoverable Value
The asset's carrying value on the balance sheet is then reduced by the impairment amount, either directly or through an impairment allowance account.
Impairment of Assets Journal Entry: Recording and Reporting Losses
The journal entry to record an impairment loss is a debit to Impairment Expense and a credit to the asset account:
Debit: Impairment Expense $100,000
Credit: Asset $100,000
The impairment loss is reported on the income statement under operating expenses. Notes to the financial statements should disclose the events and circumstances leading to impairment, plus the valuation methods used to determine fair value or value in use.
Reversing Impairment Losses: Criteria and Accounting
Criteria for When Reversal of Impairment Loss is Permitted
According to accounting standards, a previously recognized impairment loss can only be reversed if there has been a change in the estimates used to determine the asset's recoverable amount since the last impairment loss was recognized. Specifically, the reversal can only occur when:
- There is an external indicator that the impairment loss recognized in prior years no longer exists or has decreased, such as an increase in market prices or a significant improvement in industry conditions.
- The asset's recoverable amount exceeds its current carrying value, meaning the prior impairment testing led to too pessimistic an outcome.
Essentially, if the factors that led to recognizing an impairment have been fully or partially reversed, accounting rules permit the impairment to correspondingly reverse as well.
Process of Calculating and Recording Impairment Reversals
If the impairment reversal criteria are met, the carrying amount of the asset must be increased to its newly calculated recoverable amount. However, the reversal is limited so that the increased carrying amount cannot exceed what the depreciated historical cost would have been if the impairment had not been recognized in prior years.
Here is an example of the accounting to record a reversal of an impairment loss:
- A machine is carried at $100,000 (cost of $150,000 minus accumulated depreciation of $50,000)
- Due to decreased factory output levels, an impairment of $20,000 was recognized last year, reducing the carrying value to $80,000
- Output has recovered this year and the machine's recoverable amount is estimated to be $110,000
- The impairment can therefore be reversed by $20,000, limited to its depreciated historical cost of $100,000
- The journal entry would be:
Dr. Impairment Losses 20,000
Cr. Machine 20,000
Financial Reporting and Disclosures for Reversals
A reversal of an impairment loss is recognized in income and increases net profit in the period it occurs. The carrying amount adjustment is made on the balance sheet.
Notes to the financial statements must include the amount of impairment reversals recognized during the period and the line item in the income statement that includes the reversals (often “Other Income”). Details should also be disclosed regarding the nature events and circumstances leading to the reversal.
Understanding Impairment vs Depreciation
Defining Depreciation and its Purpose
Depreciation is an accounting method of allocating the cost of a tangible or physical asset over its estimated useful life. The purpose of depreciation is to match the cost of the asset to the revenue it generates over its lifespan. It allows a business to gradually expense the cost of the asset rather than taking a large one-time charge. Some common examples of assets that are depreciated include buildings, machinery, equipment, furniture, and vehicles. Depreciation calculations involve estimates of the asset's useful life, residual value, and depreciation method.
Contrasting Impairment Loss and Depreciation
While depreciation is the gradual expensing of an asset's historical cost, an impairment loss recognizes a sudden decrease in the recoverable amount of an asset below its carrying value on the balance sheet. Impairment occurs when there are indicators that the utility of the asset has significantly diminished for reasons such as obsolescence, damage, or changes in market conditions. The key difference is that depreciation is systematic and expected, while impairment is irregular and often unexpected.
Additionally, depreciation is calculated based on an asset's historical cost, while impairment testing involves estimates of the asset's fair or recoverable value. Impairment also requires a test to be performed to determine if a loss needs to be recognized, whereas depreciation does not require any special test.
Accounting Treatment: Impairment of Assets vs Depreciation
On the income statement, depreciation is recorded as a non-cash operating expense that reduces net income. Impairment losses are also non-cash expenses, but are treated as non-operating expenses below the operating income line.
For tax purposes, depreciation is a deductible expense that can provide a tax shield by reducing taxable income. An impairment loss may or may not be tax deductible depending on local regulations. For example, in the US impairment is generally tax deductible while in some countries it may not be deductible.
On the balance sheet, depreciation reduces the net book value of the asset over time. An impairment write-down also reduces the carrying amount of the asset. However, depreciation is based on the initially expected decline in value, while impairment recognizes an accelerated, unexpected decline in value.
Impairment of Assets Accounting Treatment and Standards
Impairment of Assets Accounting Standard Overview
The key accounting standards that govern asset impairment are IAS 36 Impairment of Assets under IFRS, and ASC 360 Property, Plant, and Equipment under US GAAP. These standards provide guidance on when and how entities should test assets for impairment, how to measure impaired assets, and how to account for impairment losses.
The core principle under both standards is that assets should not be carried at more than their recoverable amount, which is the higher of the asset's fair value less costs to sell and its value in use. If the carrying value exceeds the recoverable amount, the asset is impaired and an impairment loss must be recognized.
Detailed Accounting Treatment for Impaired Assets
The step-by-step accounting treatment for impaired assets is:
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Identify indicators of impairment - These can include obsolescence, physical damage, worse economic performance than expected, etc.
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Test asset for impairment - Compare asset's carrying value to its recoverable amount per above standard.
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Measure impairment loss - The impairment loss is measured as the difference between the carrying value and recoverable amount.
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Recognize impairment loss - Debit impairment loss expense on the income statement, credit the impaired asset account to reduce its book value.
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Disclose details in financial statements - Disclose description of impaired asset, amount of impairment loss, line item under which loss is included.
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Review annually for reversal - If conditions improve in later years resulting in increased recoverable value, some or all of impairment loss may be reversed.
Special Considerations Under IFRS vs. GAAP
Some key differences in impairment rules between IFRS and GAAP include:
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Frequency of impairment testing - IFRS uses specific "trigger" events, while GAAP requires annual testing regardless.
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Reversal of losses - IFRS allows reversal in future years if conditions improve. GAAP prohibits reversal even if value recovers.
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Cash flow estimation - IFRS uses pre-tax cash flows and risk-adjusted discount rates. GAAP uses post-tax cash flows and risk-free rates.
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Goodwill - IFRS does not amortize goodwill but tests annually for impairment. GAAP amortizes goodwill over 10 years and also requires impairment testing.
So in summary, IFRS impairment testing relies more on specific impairment indicators, while GAAP requires routine annual testing even absent indicators of impairment.
Real-World Impairment of Assets Example
Impairment of assets occurs when an asset's carrying value on the balance sheet exceeds its recoverable amount. Here are some real-world examples of impairment losses and reversals:
Case Studies of Impairment Loss Recognition
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In 2020, Boeing recognized a $6.5 billion impairment charge on several aircraft programs due to reduced demand from the COVID-19 pandemic. This reduced the carrying value of these assets to reflect their decreased recoverable amount.
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During the 2008 financial crisis, major banks like Citigroup, Bank of America and Wells Fargo recorded billions in impairment losses on loans and mortgage-backed securities as borrowers defaulted and collateral values plunged.
Analysis of Impairment Reversals in Practice
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Chipmaker Intel reversed some impairment charges in 2021 as the demand and pricing for semiconductors improved. This increased the recoverable value of some previously impaired manufacturing assets.
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After impairing stores in 2020 due to COVID-19, retailer Best Buy saw sales rebound in 2021. They tested and reversed some of those impairment charges as stores became profitable again.
Lessons Learned from High-Profile Asset Impairments
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Market changes can rapidly impact asset values, underscoring the need for regular impairment testing. Boeing and the banks were caught off guard by sudden swings.
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Impairment charges directly hit net income but cash flow remains unchanged. Investors should separate one-time accounting hits from business fundamentals.
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Reversals indicate management's impairment testing process works. Intel and Best Buy reacted quickly when conditions improved after their conservative write-downs.
Conclusion and Key Takeaways
Impairment of assets is an important concept in accounting that refers to when an asset declines in value below its carrying value on the balance sheet. Properly accounting for asset impairment allows businesses to reflect the true economic value of their assets.
Summary of Impairment of Assets Key Concepts
- Impairment occurs when an asset's market value drops below its carrying value
- Impairment losses are recorded as expenses to reduce the asset's value
- Impairment testing helps identify and measure decline in asset values
- Common reasons for impairment include obsolescence, damage, market changes
Reiterating the Importance of Impairment Accounting for Businesses
Properly accounting for impaired assets is crucial for accurate financial reporting. Impairment losses directly impact net income and equity. Reflecting economic reality supports better business decision making. Staying compliant with accounting standards avoids penalties and builds investor trust.
Final Thoughts on Asset Impairment
While impairment reduces asset values and profits, transparently recording these losses strengthens financial reporting. Businesses should continuously monitor assets for impairment to enable timely loss recognition and informed strategy changes when declines occur. With diligent impairment testing, companies can make the most of available information to drive decisions.
