What it means
Assets sit on the balance sheet at their carrying amount, which is usually cost less accumulated depreciation or amortisation. That figure assumes the asset will keep earning roughly what was expected when it was bought.
Impairment testing asks whether that assumption still holds. The test compares carrying amount with recoverable amount, which is the higher of what the asset could be sold for after selling costs and what it is worth in continued use.
If the recoverable amount is lower, the shortfall is recorded as an impairment loss in the income statement and the asset's carrying value is reduced. Certain assets, notably goodwill from acquisitions, must be tested at least annually whether or not anything appears to have gone wrong.
Impairment matters in business conversations because it is a loud, non-cash signal. No money leaves the bank when an asset is impaired, but profit falls, net assets fall, and the market reads it as management admitting that a factory, a brand or an acquisition has underperformed.
Loan covenants tied to net assets or earnings can be breached by an impairment even though cash generation is unchanged. Triggers for a test include a sustained fall in demand, a technology that has made equipment obsolete, physical damage, a decision to close a site, or the acquired business missing its plan.
Auditors take a close interest because the calculation rests on management's own forecasts, and optimistic forecasts are the easiest way to avoid an unwelcome write-down. One important variant concerns reversals.
Under international accounting standards most impairments other than those on goodwill can be reversed if conditions genuinely improve, while goodwill impairment is permanent; under United States rules, reversals are generally not permitted at all. The direction of travel is deliberately conservative, so recognising a loss is easier than reinstating value.
In practice
Real-world examples.
Example
A retailer closes 40 underperforming stores. It writes down the fittings and right-of-use assets at those sites, recording an impairment charge that turns a small operating profit into a reported loss for the year.
Example
A technology group acquires a start-up for $90,000,000 and records goodwill. Two years later the acquired product has failed to win customers, and the annual goodwill test results in a $60,000,000 impairment.
Example
A farming company's irrigation equipment is damaged beyond economic repair by flooding. The carrying amount is reduced to the scrap value the equipment would fetch, and the difference is recognised immediately.
Think of it
“Impairment is like realizing your vintage car isn't worth what you thought after getting it appraised. You have to acknowledge the lower value.
Formula
Calculation
The formula is: Impairment loss = Carrying amount - Recoverable amount, where Recoverable amount is the higher of fair value less costs to sell and value in use.
A printing business owns a large press bought for $5,000,000 with accumulated depreciation of $2,000,000, giving a carrying amount of $5,000,000 - $2,000,000 = $3,000,000. Demand for the format has fallen sharply. A dealer would pay $2,350,000 for the press, and selling costs would be $150,000, so fair value less costs to sell is $2,200,000.
Management's forecast of the cash the press will generate over its remaining life, discounted to today, gives a value in use of $2,050,000. The recoverable amount is the higher of the two figures, which is $2,200,000. The impairment loss is $3,000,000 - $2,200,000 = $800,000, charged to the income statement, and the press is carried at $2,200,000 from that point onwards.Case study
Seen in the real world.
Silverbrook Foods is a fictional company invented for this illustrative case. It paid $40,000,000 for a chilled desserts brand, recording $22,000,000 of that as goodwill on the expectation that the brand would grow at 10% a year.
Sales instead fell for two consecutive years as supermarket own-label ranges took shelf space. At the annual test, the discounted cash flows the brand was expected to generate supported a recoverable amount of only $12,000,000 against a carrying amount of $22,000,000, so Silverbrook recognised a $10,000,000 impairment.
The charge wiped out the illustrative group's reported profit for the year and triggered an awkward conversation with its lenders about a net asset covenant. Cash in the bank was unaffected, and management used the episode to rebuild the brand plan around a smaller, more realistic sales base rather than the original growth assumption.
Watch out
Common mistakes.
- Believing an impairment charge means cash has left the business, when it is a non-cash adjustment to the value of an asset already owned.
- Comparing carrying amount only with resale value and ignoring value in use, which understates the recoverable amount for assets that still earn well in the business.
- Confusing impairment with depreciation; depreciation spreads a known cost over an asset's expected life, while impairment corrects a value that has fallen unexpectedly.
Questions
People also ask.
How often must goodwill be tested for impairment?
At least annually, and immediately whenever there is an indication that the acquired business is underperforming.
Can an impairment loss be reversed later?
Under international standards many asset impairments can be reversed if the reasons for them cease to apply, but goodwill impairment cannot be, and United States rules generally prohibit reversals.
Does an impairment affect the tax bill?
Usually not directly, because tax authorities normally rely on their own rules for deductions rather than the accounting write-down, though deferred tax entries often change.
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