What Does Impairment Mean in Accounting?

Asset impairment in accounting refers to the reduction in the value of an asset on a company’s balance sheet. This accounting principle ensures that a company’s assets are not overstated, reflecting their true economic worth. When an asset’s market value or ability to generate future cash flows falls below its recorded cost, an impairment charge becomes necessary. It signifies an unexpected decline in an asset’s utility or worth, requiring a write-down of its book value.

Defining Asset Impairment

Asset impairment occurs when an asset’s carrying amount (book value) on a company’s balance sheet exceeds its recoverable amount. The carrying amount represents the asset’s original cost less any accumulated depreciation or amortization. The recoverable amount is the higher of the asset’s fair value less costs to sell or its value in use, which is the present value of the future cash flows expected from the asset. This adjustment aligns the asset’s recorded value with its current economic reality. The concept ensures financial reports are conservative and present a faithful representation of a company’s financial health. It is a fundamental aspect of U.S. Generally Accepted Accounting Principles (GAAP) to maintain transparency and reliability in financial reporting.

Assets Subject to Impairment

Various types of assets are subject to impairment accounting under U.S. GAAP, including tangible assets like property, plant, and equipment (PP&E), and intangible assets such as patents, copyrights, and trademarks. Goodwill, an intangible asset from business acquisitions, also undergoes impairment testing. The rules and frequency of testing differ by asset type. Long-lived assets, including tangible and finite-lived intangible assets, are tested when circumstances indicate their carrying amount may not be recoverable. Indefinite-lived intangible assets and goodwill are generally tested at least annually.

Identifying and Measuring Impairment

Companies must identify specific indicators, often called “triggering events,” that suggest an asset’s carrying value may not be recoverable. These events can include a significant decrease in an asset’s market price, adverse changes in its physical condition or how it is being used, or a significant adverse change in legal or business conditions. Other indicators might involve an accumulation of costs significantly exceeding original expectations or a history of operating or cash flow losses associated with the asset. If such indicators are present, an impairment test is performed.

For long-lived assets held and used, U.S. GAAP requires a two-step impairment test. The first step, the recoverability test, compares the asset’s (or asset group’s) carrying amount to the sum of its undiscounted future cash flows. If the carrying amount exceeds these undiscounted cash flows, the asset is considered not recoverable, and the second step is performed.

The second step involves measuring the impairment loss. This loss is calculated as the amount by which the asset’s carrying amount exceeds its fair value. Fair value is generally determined by quoted market prices, if available, or through valuation techniques like discounted cash flow analysis.

For goodwill, the impairment test has been simplified; it generally involves comparing the fair value of a reporting unit to its carrying amount. If the reporting unit’s carrying amount exceeds its fair value, an impairment loss is recognized for that excess, limited to the amount of goodwill allocated to that reporting unit.

Financial Statement Impact of Impairment

Recognizing an impairment loss significantly affects a company’s financial statements. On the income statement, the impairment loss is recorded as an expense, which directly reduces net income. This reduction in net income subsequently lowers earnings per share (EPS), impacting a company’s reported profitability. The charge is typically presented as a separate line item or disclosed in the notes to the financial statements.

On the balance sheet, the carrying amount of the impaired asset is reduced to its new fair value. This write-down decreases the total assets reported by the company. Since total assets decrease while liabilities remain unchanged, a corresponding reduction occurs in equity. An impairment charge is a non-cash expense, meaning it does not involve an outflow of cash; instead, it reflects a revaluation of an asset’s worth. This revaluation can also influence key financial ratios, such as return on assets or debt-to-equity ratios.