What it means
Assets normally sit on the balance sheet at cost less accumulated depreciation, a figure called the carrying amount. Impairment asks a different question: if we tried to get value out of this asset today, either by using it or by selling it, how much would we actually get?
The comparison is between the carrying amount and the recoverable amount, and the recoverable amount is the higher of two measures. One is the fair value less costs of disposal, meaning the net sale proceeds; the other is the value in use, meaning the present value of the cash the asset will generate if the business keeps it.
Impairment is triggered by events rather than by the calendar. A factory losing its main customer, technology becoming obsolete, a brand that stopped selling, or an acquisition that failed to deliver are all signals that a review is needed.
The effect on the accounts is immediate and visible. The asset's carrying value falls, an impairment loss appears in the income statement, and future depreciation is calculated on the lower figure, so profits are hit once and then relieved slightly thereafter.
Two nuances matter in practice. Impairment is a non-cash charge, so it does not drain the bank account, and under international rules some impairments can be reversed if circumstances improve, though goodwill impairment never can.
In practice
Real-world examples.
Example
A retailer closes a chain of twenty stores and writes down the fixtures and fittings in those units. The equipment has little second-hand value, so the carrying amount is reduced almost to zero and the loss appears as a separate line in the accounts.
Example
A software company capitalised $1,500,000 of development costs on a product that later failed to win customers. With no realistic future cash flows, the asset is impaired in full and the charge is disclosed in the notes.
Example
A mining group tests a licence area after commodity prices fall by 40%. The value in use of the site drops below its carrying amount, and the group books a partial impairment while keeping the licence for a possible price recovery.
Formula
Calculation
Impairment loss = Carrying amount - Recoverable amount, where Recoverable amount = the higher of fair value less costs of disposal and value in use.
A bottling company bought a filling line for $2,000,000 with an expected useful life of 10 years and no residual value, so straight-line depreciation is $2,000,000 / 10 = $200,000 a year. After 4 years, accumulated depreciation is 4 x $200,000 = $800,000 and the carrying amount is $2,000,000 - $800,000 = $1,200,000.
The main customer for that line then moves to a different bottle format. The finance team estimates the line could be sold for $700,000 with $40,000 of dismantling costs, giving fair value less costs of disposal of $660,000. The present value of the cash flows from continuing to run the line at reduced volumes is $720,000.
The recoverable amount is the higher of $660,000 and $720,000, so it is $720,000. The impairment loss is $1,200,000 - $720,000 = $480,000, charged to the income statement this year.
Depreciation is then recalculated over the remaining 6 years of life: $720,000 / 6 = $120,000 a year, down from $200,000.Case study
Seen in the real world.
This is an illustrative and entirely fictional example. Calderhaven Print acquired a smaller competitor for $9,000,000, recognising $3,400,000 of goodwill on the basis that the target's contract book would keep renewing. Two years later, three of the four largest contracts had moved to digital suppliers and the acquired division's revenue had halved.
The annual goodwill test compared the division's recoverable amount, based on a discounted forecast of the remaining contracts, with its carrying amount including goodwill. The recoverable amount came out $2,100,000 lower, so Calderhaven recognised a $2,100,000 impairment loss, which turned a small reported profit into a reported loss for the year.
No cash left the business, and the bank covenants had been written on earnings before impairment, so the operating position was unchanged. The illustrative point is that impairment communicates information rather than consuming cash: it told investors the acquisition case had not held, which the cash flow statement alone would not have shown.
Watch out
Common mistakes.
- Treating an impairment charge as a cash outflow, when it is a write-down of a book value and no money moves.
- Confusing impairment with depreciation; depreciation spreads a known cost over time, while impairment corrects a value that has fallen unexpectedly.
- Assuming the recoverable amount is the sale price, when it is the higher of net sale proceeds and the value from continuing to use the asset.
Questions
People also ask.
When does a business have to test for impairment?
Whenever there is an indicator such as a lost contract, physical damage, obsolescence or a sharp fall in market value, and annually for goodwill and indefinite-life intangibles.
Can an impairment be reversed later?
Under international standards most impairments can be reversed if the recoverable amount recovers, but an impairment of goodwill can never be reversed.
Does an impairment affect the cash flow statement?
Only as an add-back; it is removed from profit when calculating operating cash flow because it never involved cash.
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