How to Account for the Impairment of Capital Assets

Capital assets, like buildings and machinery, are recorded at their historical cost and reduced over time through depreciation. However, certain events can cause a sudden drop in an asset’s utility or market value. When this happens, accounting principles require a business to write down the asset’s value in a process called impairment, which ensures that financial statements present a realistic picture of the company’s financial health.

Identifying Potential Impairment

Capital asset impairment is a permanent reduction in the value of a long-lived asset, recognized when its carrying amount on the balance sheet is deemed unrecoverable. Instead of requiring an annual test, U.S. Generally Accepted Accounting Principles (GAAP) mandate that a company assess for impairment indicators at the end of each reporting period. These indicators signal the need for a formal impairment test and are categorized as external or internal.

External indicators originate from the business environment and include a significant adverse change in the legal or business climate, a substantial decrease in the asset’s market price, or an economic downturn.

Internal indicators arise from the company’s operations. These include physical damage to an asset, a change in how an asset is used, or a history of operating losses associated with the asset. A forecast projecting continued losses from its use also suggests its carrying value may be overstated and requires testing.

The Impairment Testing Process

When an indicator suggests a possible impairment, a company must perform a formal test. For capital assets held for use, U.S. GAAP prescribes a two-step process to determine if a write-down is necessary. The process compares the asset’s recorded value to the economic benefit it is expected to generate.

The first step is the recoverability test, which compares the asset’s carrying value to the sum of the undiscounted future cash flows from its use and sale. If these future cash flows are greater than the asset’s carrying amount, the asset is recoverable, no impairment has occurred, and the process stops. For example, if a machine with a $100,000 carrying amount is projected to generate $105,000 in future cash flows, it passes the test.

If an asset fails the recoverability test, the company proceeds to the second step to measure the impairment loss. In this stage, the impairment is confirmed if the asset’s carrying amount is higher than its fair value. This step moves from a cash flow projection to a more precise valuation.

Measuring and Recording the Impairment Loss

The impairment loss is measured as the difference between the asset’s carrying amount and its fair value. Fair value is the price that would be received to sell an asset in an orderly transaction between market participants. This reflects what the market would pay, not what the company believes the asset is worth for its own use.

If an active market with quoted prices is not available, a company must use other valuation techniques. A common method is to calculate the present value of the asset’s expected future cash flows, using an appropriate interest rate. This differs from the undiscounted cash flows used in the recoverability test.

For instance, if the machine with a $100,000 carrying amount failed the recoverability test and its fair value was determined to be $60,000, the impairment loss is $40,000. To record this, the company debits “Impairment Loss” for $40,000 and credits the asset’s “Accumulated Depreciation” or the asset account directly.

This journal entry recognizes the loss as an expense on the income statement and reduces the asset’s carrying amount on the balance sheet to its new fair value. Under U.S. GAAP, an impairment loss cannot be reversed if the asset’s value later recovers.

Financial Statement Presentation and Disclosures

On the income statement, the impairment loss is reported as a separate line item within income from continuing operations. This presentation shows the loss is part of the company’s primary business activities but is not a typical operating expense. On the balance sheet, the capital asset is reported at its new, lower carrying amount.

U.S. GAAP also requires specific disclosures in the financial statement footnotes to provide context for the impairment. The company must describe the impaired asset and the facts and circumstances that led to recording the loss, such as technological obsolescence, a market downturn, or physical damage.

The company must also disclose the amount of the impairment loss and the income statement line item where it is included. A part of the disclosure is explaining how fair value was determined. If based on a quoted market price, that should be stated. If another valuation technique was used, the company must disclose the method and the assumptions used, like the discount rate and cash flow projections.