What Is Tangible Asset Impairment and How Is It Tested?

Tangible asset impairment is an accounting concept for a permanent decline in the value of a company’s physical assets, also known as property, plant, and equipment (PP&E). These include items like buildings, machinery, and vehicles. Impairment occurs when an asset’s carrying value on the balance sheet—its original cost minus accumulated depreciation—is higher than its recoverable amount. Recognizing this loss ensures financial statements are accurate and prevents the overstatement of assets.

The principle behind impairment is to reflect that an asset may no longer generate its anticipated economic benefits. This value reduction is recorded as an expense on the income statement, impacting the company’s profitability. U.S. Generally Accepted Accounting Principles (GAAP), under Accounting Standards Codification (ASC) Topic 360, provide the framework for recognizing these losses to ensure consistency in financial reporting.

Indicators of Potential Impairment

Companies do not test every tangible asset for impairment in every reporting period. Instead, a test is required whenever events or changes in circumstances suggest an asset’s carrying amount may not be recoverable. These indicators are categorized as external or internal, helping management identify issues from the market or internal operations.

External indicators arise from the broader business environment. Examples include a significant decrease in an asset’s market price, adverse changes in the legal or regulatory landscape, or a downturn in the economy affecting the company’s industry. An increase in market interest rates can also be a trigger, as it alters the value of an asset’s future cash flows.

Internal indicators relate to the asset’s condition or use. These include physical damage, technological obsolescence, or a change in how an asset is used, such as idling a manufacturing line. A history of operating losses associated with an asset or a forecast of continued losses also signals that its carrying value may be overstated.

The Impairment Test for Assets Held for Use

When an indicator suggests potential impairment for an asset a company plans to continue using, U.S. GAAP prescribes a two-step test. This process ensures a loss is recognized only when the asset’s value is unrecoverable through its future use.

The first step is the recoverability test, which compares the asset’s carrying amount to the undiscounted future cash flows it is expected to generate. These cash flows include revenue from the asset’s use and its eventual disposal. If the undiscounted cash flows are greater than the carrying amount, the asset is recoverable, and no impairment is recorded.

If the asset fails the recoverability test, an impairment loss must be measured by comparing the asset’s carrying amount to its fair value. Fair value is the price that would be received to sell the asset in an orderly transaction.

In practice, the test is usually applied at the “asset group” level, not to a single asset. An asset group is the lowest level of assets for which identifiable cash flows are largely independent of other assets. For example, a production line in a factory, with all its machinery, would be an asset group since its cash flows can be tracked separately.

Calculating and Recording the Impairment Loss

If an asset fails the recoverability test, the company must calculate and record the impairment loss. This involves a specific calculation and accounting entry to adjust the company’s financial statements. This ensures the balance sheet is not overstated and the income statement reflects the loss.

The impairment loss is the difference between the asset’s carrying amount and its fair value. For instance, if machinery with a carrying value of $100,000 has a fair value of only $70,000, the impairment loss is $30,000. Fair value can be determined using a market, income, or cost approach.

To record this loss, a journal entry is made. The company debits an “Impairment Loss” account and credits the asset’s accumulated depreciation or the asset account directly. The debit creates an expense on the income statement, reducing net income, while the credit reduces the asset’s book value on the balance sheet.

After an impairment loss, the asset’s lower fair value becomes its new cost basis for calculating future depreciation. Under U.S. GAAP, an impairment loss for an asset held for use cannot be reversed in future periods, even if the asset’s fair value recovers. The write-down is a permanent adjustment.

Impairment of Assets Held for Sale

The rules for impairment differ for assets a company intends to sell rather than use. These assets are reclassified as “held for sale” on the balance sheet and have a distinct impairment test. The goal is to value the asset at what it is expected to be sold for.

An asset held for sale is measured at the lower of its carrying amount or its fair value less costs to sell. This conservative approach anticipates expenses associated with the sale. An impairment loss is recognized if the fair value less costs to sell is lower than the asset’s book value.

“Costs to sell” are the direct costs required to complete the transaction, such as broker commissions and legal fees. Normal operating expenses incurred while the asset is on the market are not included in this calculation.

Once an asset is classified as held for sale, depreciation stops. Unlike assets held for use, a subsequent increase in the fair value less costs to sell can be recognized as a gain. However, this gain is limited to the amount of any cumulative impairment losses previously recorded for that asset.

Financial Statement Disclosure Requirements

When a company records an impairment loss, it must provide specific information in the notes to its financial statements. These disclosures give investors and creditors a clear understanding of the impairment’s circumstances and financial impact, ensuring transparency.

Required disclosures include:

• A description of the impaired asset or asset group.
• The facts and circumstances that led to the impairment.
• The amount of the impairment loss and the line item on the income statement where it is included.
• The method used to determine the asset’s fair value, such as the market, income, or cost approach.