An impairment in accounting means that the value of a company asset has diminished to less than its book value. Recording impairment on financial statements is a requirement under the US Generally Accepted Accounting Principles (GAAP). Accounting for impairment in the financial statements ensures the accurate valuation of a company’s fixed and intangible assets.
Small businesses and nonprofits that don’t follow GAAP rules aren’t required to adhere to impairment rules. For tax and other book basis accounting, it doesn't apply. For companies that do follow GAAP rules, here’s a primer on what impairment of assets is, how it differs from depreciation and amortization, and how to calculate and report it on financial statements.
What is impairment?
Impairments are not the same as depreciation or amortization. In the case of depreciation or amortization, the loss of value of the asset is anticipated and planned for. With impairment, the loss in value is unexpected. One example of why an asset might decrease in value unexpectedly is a patent for a suddenly obsolete item. Businesses must assess their assets for impairment annually. An auditor makes sure they comply with GAAP rules.
What is the purpose of asset impairment?
Some assets lose value over time. Sometimes, an asset gets recorded on the financial statements as generating a certain amount of income, but it is really costing a company money. Impairment is a way to ensure accurate recording of the value of assets.
Long-lived assets are more likely to show impairment because of their longevity. This is especially true if depreciation or amortization is underestimated. Patents are a good example. A patent is an intangible asset, but it has value. Companies capitalize the costs of obtaining a patent. Any such costs are recorded as an asset on the balance sheet and amortized each year to reduce the book value of the patent over time.
Sometimes, a patent may be impaired and not worth the amount shown on the balance sheet. Perhaps a competitor has developed a similar product. If this is the case, an impairment test identifies the loss, and the loss is recorded on the balance sheet. If the patent is sold or disposed of, it is removed from the balance sheet, or derecognized.
How impairment is calculated
Impairment can have a negative impact on a business’s balance sheet and financial ratios because the market value is less than the book value. GAAP rules under the Financial Accounting Standards Board (FASB) are designed to ensure fair and transparent accounting of a business’s financials. With accurate financial information, investors can make sound investing decisions. If impairment is not recorded, the balance sheet and financial ratios will be inaccurate.
The GAAP rules call for annual recoverability tests for businesses. These tests consider the effects of economic downturns and events like pandemics or natural disasters on asset values.
To calculate impairment, the asset’s book value is compared to the net income it generates or its fair market value. The reason for impairment is important because this affects the calculation of fair market value.
The fair market value is the amount the asset could be sold for in the current market. Another way to describe this is the future cash flow of the asset or how much cash it could generate in ongoing business operations.
You also check if the book value exceeds the undiscounted cash flows the asset is expected to generate. The book value is non-recoverable. If holding the asset costs more than the fair market value, it indicates an impairment cost. The amount of the write-down amount is equal to the difference in asset book value and the discounted future cash flows.
Where is impairment recorded?
Impairment charges are recorded on two financial statements: the balance sheet and the income statement:
- An impairment loss results in a write-off. It’s entered as an expense on the income statement. This reduces the value of the impaired asset on the balance sheet.
- Double-entry bookkeeping requires two entries: a debit to impairment loss (or the expense account) and a credit to impaired assets.
Here’s an example of an impairment and how it’s recorded under GAAP rules.
Assets are impaired when their market value drops below their book value.
Lakestar Machinery conducts an impairment assessment for one of its machines that was idle for two years due to the devastating effects of a hurricane. The total carrying value (book value) for the machine is $30,000, and the market value is $25,000. Thus, the impairment loss is $5,000 ($30,000 – $25,000).
The impairment loss is entered as a write-off so that the asset's real value is reflected on the balance sheet and it’s not overvalued.
The impairment loss of $5,000 is entered on the debit side of the income statement, which reduces the net income. There’s also an entry to reduce the asset’s balance on the balance sheet by $5,000, and the asset's account or an impairment loss account is credited $5,000.
How is impairment different from depreciation and amortization?
Amortization, depreciation, and impairment are treated differently under GAAP.
- Depreciation refers to fixed assets, such as vehicles, equipment, and computers, and the value they lose each year. The amount of depreciation is anticipated, calculated, and reported each financial reporting period.
- Amortization refers to intangible assets, such as patents, goodwill, trademarks, and copyrights, which also lose value over time. The amount of amortization is also anticipated, calculated, and recorded over the asset’s expected life.
- Impairment is not planned; it is an unexpected loss in an asset’s book value.
Impairment of intangible assets
As stated, under GAAP, companies must report the impairment of intangible assets and fixed assets. Intangible assets include patents, goodwill, trademarks, and copyrights. Intangible assets are impaired when the fair value of an asset is assessed to be less than the value on the balance sheet after amortization.
Xero does not provide accounting, tax, business or legal advice. This guide has been provided for information purposes only. You should consult your own professional advisors for advice directly relating to your business or before taking action in relation to any of the content provided.
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