What Is Asset Impairment in Accounting?

Assets are initially recorded at their acquisition cost on a company’s balance sheet. However, their value can change over time due to market shifts, technological advancements, or physical damage. When an asset’s worth unexpectedly declines below its recorded value, accounting standards require companies to recognize this reduction through impairment. This process ensures financial statements accurately reflect an asset’s current economic value.

Understanding Asset Impairment

Asset impairment refers to a substantial, unexpected reduction in an asset’s value. This occurs when its recorded amount on the balance sheet, known as its carrying value, exceeds the amount that can be recovered from its future use or sale. The carrying value is the asset’s original cost less any accumulated depreciation or amortization. The recoverable amount is determined as the higher of the asset’s fair value less costs to sell, or its value in use, which represents the present value of the future cash flows expected from the asset.

The purpose of recognizing asset impairment is to prevent financial overstatement and ensure a company’s financial statements provide a transparent picture of its economic standing. When an asset becomes impaired, its value on the balance sheet is reduced, and a corresponding impairment loss is recorded. This loss is recognized as an expense on the income statement, impacting profitability. It is a non-cash expense, meaning it does not involve an actual cash outflow, but it reduces net income and affects financial ratios.

Types of Assets Subject to Impairment

Property, plant, and equipment (PP&E) are common examples of tangible assets subject to impairment reviews. This category includes physical assets such as land, buildings, and machinery, which may lose value due to physical damage, obsolescence, or changes in market demand.

Intangible assets with finite lives, like patents, copyrights, and customer lists, are also subject to impairment testing. These assets derive their value from legal or contractual rights and have a limited useful life over which their cost is systematically amortized. While amortization accounts for their gradual decline, unexpected events can lead to a sudden, significant drop, necessitating an impairment review.

In contrast, intangible assets with indefinite lives, such as trademarks and brand names, do not have a foreseeable limit to their useful life and are not amortized. These assets must be tested for impairment at least annually to ensure their carrying value does not exceed their fair value. Goodwill, a unique intangible asset arising from business acquisitions when the purchase price exceeds the fair value of net identifiable assets, also falls into this category. Goodwill is not amortized but is subject to annual impairment testing due to its indefinite life.

Signs of Impairment

Companies perform an impairment test when internal or external factors, known as indicators, suggest an asset’s value may have declined. External indicators often stem from broader economic or market conditions. These include a significant decline in an asset’s market value, adverse changes in the technological, market, economic, or legal environment, or increases in market interest rates that could affect discount rates used in valuation.

Internal indicators relate directly to the company’s operations or the asset itself. Such signs include evidence of physical damage or obsolescence of the asset, or plans to discontinue or restructure operations where the asset is utilized. A significant decline in the asset’s performance, such as lower-than-expected cash flows or consistent operating losses, also serves as a strong internal indicator. Identifying these indicators triggers an assessment of whether an asset’s carrying amount can be recovered through its continued use or sale.

How Impairment is Recognized

Recognizing an impairment loss involves a structured process to determine if an asset’s carrying value exceeds its recoverable amount, and if so, by how much. For property, plant, and equipment (PP&E) and intangible assets with finite lives, a two-step test is generally employed. The first step, a recoverability test, compares the asset’s carrying amount to the undiscounted future cash flows expected from its use and eventual disposal. If the carrying amount is greater than these undiscounted cash flows, the asset is considered not recoverable, and impairment is indicated.

The second step measures the impairment loss. If the asset is deemed not recoverable, the impairment loss is calculated as the amount by which the asset’s carrying amount exceeds its fair value. The fair value is typically determined through market prices or the present value of expected future cash flows.

For goodwill and indefinite-lived intangible assets, the impairment testing process is more direct, often involving a single step. For indefinite-lived intangibles, impairment occurs when the asset’s carrying amount exceeds its fair value. Goodwill impairment testing usually involves comparing the fair value of the reporting unit to which the goodwill is assigned to its carrying amount. If the fair value is less than the carrying amount, an impairment loss is recognized.

Once an impairment loss is identified, it is recorded as an expense on the income statement, reducing net income. Simultaneously, the asset’s value on the balance sheet is reduced to its new, lower recoverable amount. This accounting entry reflects the permanent reduction in the asset’s value and ensures that the financial statements present a more accurate picture of the company’s financial position and profitability. Unlike depreciation, which is a planned expense, impairment represents an unexpected write-down, highlighting a sudden loss in an asset’s economic benefits.