What Is an Impairment in Accounting?

Asset impairment in accounting refers to a permanent reduction in the value of a company’s asset, meaning its market value has fallen below the value recorded on the financial statements. This concept is a fundamental part of financial reporting under generally accepted accounting principles (GAAP) in the United States. Its primary purpose is to ensure that assets listed on a company’s balance sheet accurately reflect their true economic value, preventing overstatement and providing a more transparent view of the company’s financial health. This accounting requirement ensures that stakeholders receive reliable information about a company’s assets.

Recognizing Impairment

Companies must regularly assess their assets for indicators that suggest a potential impairment. These indicators can stem from external or internal sources.

External indicators include a significant decline in an asset’s market value. Adverse shifts in the technological, market, economic, or legal environment can also signal impairment, as can increases in market interest rates. Technological obsolescence, where new advancements render an asset less valuable, is an external factor.

Internal indicators of potential impairment include physical damage to the asset or its obsolescence. Changes in how an asset is used, such as an asset becoming idle or part of a restructuring plan, can also trigger an impairment review. A decline in the asset’s performance, such as lower-than-expected cash flows generated by the asset, also suggests that its value may be overstated.

Calculating Impairment Loss

Once indicators suggest an asset might be impaired, the next step involves quantifying any potential loss. Calculating an impairment loss involves comparing the asset’s carrying value, which is its book value on the balance sheet, to its recoverable amount. If the carrying value exceeds the recoverable amount, an impairment loss is recognized.

The recoverable amount is the higher of two values: the asset’s fair value less costs to sell, and its value in use. Fair value less costs to sell is the amount obtained from selling the asset in an orderly transaction, minus direct costs. Value in use is the present value of future cash flows expected from the asset’s continued operation and eventual disposal. This calculation involves discounting estimated future cash flows.

For most long-lived assets under US GAAP, a two-step process is used for impairment testing. First, the asset’s carrying amount is compared to the undiscounted future cash flows it is expected to generate. If the carrying amount is greater than these undiscounted cash flows, the asset is considered potentially impaired, and the second step is performed. The impairment loss is then measured as the amount by which the asset’s carrying value exceeds its fair value.

Reporting Impairment

When an asset is determined to be impaired, the resulting loss must be recorded and presented in the company’s financial statements. The impairment loss is recognized as an expense on the income statement, reducing the company’s net income for the period.

On the balance sheet, the carrying value of the impaired asset is reduced to its new recoverable amount. This write-down ensures that the asset is no longer overstated and accurately reflects its diminished value.

Companies are also required to provide detailed disclosures about recognized impairment losses in the notes to their financial statements. These disclosures include a description of the impaired asset, the events or circumstances that led to the impairment, and the amount of the impairment loss. Companies must also disclose the methods and assumptions used to determine the asset’s fair value or recoverable amount. This detailed reporting provides transparency to investors and other stakeholders, enabling them to understand the nature and impact of the impairment.