What it means
Assets are recorded at a carrying amount, which is their cost less accumulated depreciation or amortisation. If an event damages the asset's earning power, that carrying amount may no longer be believable.
Impairment is the rule that forces the accounts to catch up with reality. Typical triggers include a sharp fall in demand for the products an asset makes, physical damage, a change in law, plans to close a factory, or a competitor launching a better product.
Businesses review for such warning signs at each reporting date. Goodwill and some other assets must be tested at least once a year, even when nothing obviously has gone wrong.
The test compares the carrying amount with the recoverable amount. Under international standards, recoverable amount is the higher of the asset's fair value less costs of disposal (what it could be sold for, after selling costs) and its value in use (the present value of the cash it is expected to generate).
If the carrying amount is higher, the difference is an impairment loss. An impairment loss is charged to the income statement and reduces the asset on the balance sheet, which lowers profit and equity.
It is a non-cash charge, since the money was spent earlier. After the write-down, future depreciation is lower because the asset's base is smaller.
Rules for reversing impairments differ. Under international standards, a loss can be reversed for most assets if conditions improve, though never for goodwill, while other frameworks prohibit reversals.
Investors often treat large impairments as a sign that past acquisitions or investments were overpriced. Impairment decisions involve judgement, which is why auditors and regulators scrutinise them.
Management must forecast cash flows and choose a discount rate, and optimistic assumptions can delay or shrink a write-down. Clear disclosure of those assumptions helps readers see how sensitive the result is to small changes.
In practice
Real-world examples
Example 1
A retailer closes a group of underperforming stores. The finance team tests the fittings and leasehold improvements, finds they are worth $1,200,000 less than their book value, and records an impairment loss in that amount.
Example 2
A technology group acquired a smaller company two years ago and recorded $5,000,000 of goodwill. After the acquired product loses market share, an annual test shows the goodwill is only supported to the extent of $3,500,000, so a $1,500,000 impairment is booked.
Example 3
A farm owner finds that a drought has damaged irrigation equipment that cost $90,000 and has a carrying amount of $60,000. Its recoverable amount is estimated at $25,000, so the business records a $35,000 impairment. The farm's insurer later pays $15,000 towards the damage, which is recorded separately as a recovery.
Think of it
Impairment means an asset is worth less than the books show-you have to write it down.
Formula
Calculation
Impairment loss = Carrying amount - Recoverable amount
Recoverable amount = Higher of (Fair value less costs of disposal) and (Value in use)
Suppose a plastics manufacturer has a moulding line with a carrying amount of $800,000. Following a loss of its main customer, the line could be sold for $540,000, with $20,000 of selling costs, so fair value less costs of disposal = 540,000 - 20,000 = $520,000. The present value of the cash it is expected to generate is $560,000.
Recoverable amount = higher of 520,000 and 560,000 = $560,000. Impairment loss = 800,000 - 560,000 = $240,000. The line is written down to $560,000.Case study
Seen in the real world
Kestrel Aviation Services is an illustrative, fictional company that maintains regional aircraft. It bought a specialised engine-testing rig for $3,000,000 and, after two years of depreciation, carried it at $2,400,000.
When its biggest airline customer announced it was retiring the aircraft type the rig serviced, the finance director arranged an impairment test. The rig could only be sold for about $900,000 after costs, and the cash flows from the few remaining customers had a present value of $1,100,000.
The recoverable amount was therefore $1,100,000, and the company recorded an impairment loss of 2,400,000 - 1,100,000 = $1,300,000. The illustrative lesson is that one customer decision can change an asset's value overnight, and the accounts must reflect it promptly. The board also asked the audit committee to review the assumptions behind the cash flow forecast, since a small change in the discount rate would have altered the loss materially.
Watch out
Common mistakes
- Treating impairment as the same thing as depreciation, when depreciation is a planned spreading of cost and impairment is an unplanned write-down for lost value.
- Assuming impairment is a cash cost, when it is a non-cash charge and the money was spent when the asset was bought.
- Delaying the test until there is a crisis, when warning signs such as falling demand or underused plant should prompt a review earlier.
Questions
People also ask
How often should assets be tested for impairment?
Most assets are tested when there is an indication of a problem, while goodwill and certain intangible assets must be tested at least once a year.
Can an impairment loss be reversed?
Under some frameworks, including international standards, reversal is allowed for most assets but not for goodwill, while other frameworks prohibit reversal altogether.
Does impairment affect tax?
The tax treatment varies by country, and a write-down for accounting purposes is often not deductible until the asset is sold or scrapped.
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