What is Impairment?

Impairment describes a reduction in the value of a company asset, either fixed or intangible, so as to reflect a decline in the quality, quantity, or market value of the asset. It’s an accounting concept based on the idea that an asset shouldn’t be carried in your business’s financial statements at more than the highest amount that could potentially be recovered from selling it. 

What is Impairment?

The impairment of a fixed asset can be described as an abrupt decrease in fair value due to physical damage, changes in existing laws creating a permanent decrease, increased competition, poor management, obsolescence of technology, etc. In the case of a fixed-asset impairment, the company needs to decrease its book value on the balance sheet and recognize a loss in the income statement.

Impairment

The Good

If done correctly, impairment charges provide investors with really valuable information. Balance sheets are bloated with goodwill that result from acquisitions during the bubble years when companies overpaid for assets by buying overpriced stock.

Over-inflated financial statements distort not only the analysis of a company but also what investors should pay for its shares. The new rules force companies to revalue these bad investments, much like what the stock market did to individual stocks.

The impairment charge also provides investors with a way to evaluate corporate management and its decision-making track record. Companies that have to write off billions of dollars due to the impairment have not made good investment decisions. Management teams that bite the bullet and take an honest all-encompassing charge should be viewed more favorably than those who slowly bleed a company to death by deciding to take a series of recurring impairment charges, thereby manipulating reality.

Goodwill and impairment

The asset of goodwill does not exist in a vacuum; rather, it arises in the group financial statements because it is not separable from the net assets of the subsidiary that has just been acquired.

The impairment review of goodwill, therefore, takes place at the level of a cash-generating unit, that is to say, a collection of assets that together create an independent stream of cash. The cash-generating unit will normally be assumed to be the subsidiary. In this way, when conducting the impairment review, the carrying amount will be that of the net assets and the goodwill of the subsidiary compared with the recoverable amount of the subsidiary.

When looking to assign the impairment loss to particular assets within the cash-generating unit, unless there is an asset that is specifically impaired, it is goodwill that is written off first, with any further balance being assigned on a pro-rata basis.

The goodwill arising from the acquisition of a subsidiary is subject to an annual impairment review. This requirement ensures that the asset of goodwill is not being overstated in the group’s financial statements. Goodwill is a peculiar asset in that it cannot be revalued so any impairment loss will automatically be charged against income. Goodwill is not deemed to be systematically consumed or worn out thus there is no requirement for a systematic amortization.

Goodwill and impairment

GAAP Requirements for Impairment

Under generally accepted accounting principles (GAAP), assets are considered to be impaired when their fair value falls below their book value.

Any write-off due to an impairment loss can have adverse effects on a company’s balance sheet and its resulting financial ratios. It is, therefore, important for a company to test its assets for impairment periodically.

Certain assets, such as intangible goodwill, must be tested for impairment on an annual basis in order to ensure that the value of assets is not inflated on the balance sheet.

GAAP also recommends that companies take into consideration events and economic circumstances that occur between annual impairment tests in order to determine if it is “more likely than not” that the fair value of an asset has dropped below its carrying value.

GAAP Requirements for Impairment

KEY TAKEAWAYS

  • Impairment can occur as the result of an unusual or one-time event, such as a change in legal or economic conditions, a change in consumer demand, or damage that impacts an asset.
  • Assets should be tested for impairment regularly to prevent overstatement on the balance sheet.
  • Impairment exists when an asset’s fair value is less than its carrying value on the balance sheet.
  • If impairment is confirmed as a result of testing, an impairment loss should be recorded.
  • An impairment loss records an expense in the current period that appears on the income statement and simultaneously reduces the value of the impaired asset on the balance sheet.

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