What Is Impairment?
Impairment is a condition that occurs when the carrying amount of an asset on a company's balance sheet exceeds its fair value or its estimated future undiscounted cash flows. This accounting event falls under the broader category of Financial Accounting and signals that an asset's economic benefits have diminished, requiring a write-down of its value. An impairment charge reduces the asset's book value and is recognized as an expense on the income statement, impacting a company's reported profitability and overall financial statements.
History and Origin
The concept of asset impairment in U.S. generally accepted accounting principles (GAAP) gained prominence with the issuance of specific accounting standards. The Financial Accounting Standards Board (FASB) provides detailed guidance, primarily within Accounting Standards Codification (ASC) Topic 360, "Property, Plant, and Equipment," for the impairment of long-lived assets. This standard outlines the conditions under which a company must test for impairment and how to measure any resulting loss. The need for such standards arose to ensure that financial statements accurately reflect the economic reality of a company's assets, especially as market conditions or operational circumstances change. For example, the Securities and Exchange Commission (SEC) requires public companies to disclose material impairment charges, providing specific guidelines on reporting such events to investors.8 The guidance in ASC 360-10 addresses how to assess, measure, and recognize impairment for tangible assets and intangible assets subject to amortization.7
Key Takeaways
- Impairment occurs when an asset's carrying amount exceeds its fair value or its recoverable amount.
- It requires a write-down of the asset's value on the balance sheet and recognition of a loss on the income statement.
- Impairment testing for long-lived assets is triggered by specific events or changes in circumstances, not necessarily annually.
- The recoverability test compares the asset's carrying amount to its undiscounted future cash flows.
- The measurement of an impairment loss is the amount by which the carrying value exceeds the asset's fair value.
Formula and Calculation
The calculation of an impairment loss generally involves a two-step process for long-lived assets held and used:
Step 1: Recoverability Test
Determine if the asset is recoverable by comparing its carrying amount to the sum of the undiscounted future cash flows expected from its use and eventual disposition. If the carrying amount is greater than the undiscounted cash flows, the asset is considered not recoverable, and impairment may exist. This comparison helps establish if a potential impairment needs to be recognized.6
Step 2: Measurement of Impairment Loss
If the asset is deemed not recoverable, an impairment loss is recognized. The loss is measured as the amount by which the carrying amount of the asset exceeds its fair value. The fair value is typically determined using market-based approaches or discounted cash flow analysis.
The impairment loss reduces the asset's carrying amount on the balance sheet, and this reduced amount then becomes the new cost basis for future depreciation calculations.
Interpreting the Impairment
An impairment charge indicates that an asset's future economic benefits are no longer expected to be as high as originally anticipated when the asset was acquired or developed. From an investor's perspective, a significant impairment can signal underlying operational issues, adverse market conditions, or poor strategic decisions that have eroded the value of a company's assets. For instance, a decline in demand for a product, obsolescence of technology, or a sharp drop in market prices for a specific asset type can all trigger an impairment. The charge directly impacts reported earnings, and while it is a non-cash expense, it reflects a real economic loss in asset value. Understanding impairment requires assessing the factors leading to the write-down and evaluating the company's prospects for recoverability in the future.
Hypothetical Example
Consider "Tech Innovations Inc.," a company that purchased specialized manufacturing equipment for $5 million. After two years, its carrying amount on the balance sheet is $4 million, net of depreciation. Due to a sudden shift in technology, the demand for products made by this equipment significantly declines.
Management projects that the undiscounted future cash flows from the equipment over its remaining useful life will only be $3.5 million. Since the $4 million carrying amount exceeds the $3.5 million undiscounted future cash flows, the equipment is deemed not recoverable.
Tech Innovations Inc. then estimates the fair value of the equipment, perhaps by looking at sales prices for similar used equipment, and determines it to be $2.8 million.
The impairment loss is calculated as:
$4,000,000 (Carrying Amount) - $2,800,000 (Fair Value) = $1,200,000.
Tech Innovations Inc. would recognize a $1,200,000 impairment loss on its income statement, reducing the equipment's carrying amount on the balance sheet to $2.8 million.
Practical Applications
Impairment testing is a critical part of financial reporting and asset management, ensuring that a company's assets are not overstated on its balance sheet. It appears in several areas:
- Corporate Financial Reporting: Companies regularly assess their long-lived assets, including property, plant, equipment, and certain intangible assets, for potential impairment. This is especially true when there are "triggering events" such as a significant decline in an asset's market price, adverse changes in the business climate, or a history of losses associated with the asset.5 Public companies are required to disclose material impairment charges, often detailed in their quarterly and annual financial filings.4 For instance, in 2020, Shell announced a significant impairment charge of up to $22 billion on its assets, reflecting a warning on long-term oil prices.3
- Mergers and Acquisitions: After an acquisition, the purchased company's assets are revalued. If the acquisition includes significant goodwill or other intangible assets, these must be tested for impairment annually or more frequently if triggering events occur within the relevant reporting unit.
- Asset Disposition: When a company plans to dispose of assets by sale, these assets are reclassified as "held for sale" and are measured at the lower of their carrying amount or fair value less cost to sell, potentially leading to an impairment recognition.
Limitations and Criticisms
While impairment accounting aims to present a true and fair view of assets, it faces several limitations and criticisms:
- Subjectivity in Estimates: A significant drawback of impairment testing lies in the highly subjective nature of the estimates involved. Determining future cash flows and fair value requires considerable judgment and assumptions, which can be influenced by management's outlook. Different assumptions could lead to varying impairment charges, making comparisons between companies challenging.2
- Timing of Recognition: Impairment is often recognized when "events or changes in circumstances indicate" that an asset's carrying amount may not be recoverable. This event-driven approach means that impairment charges might be delayed, potentially leading to asset values being overstated for a period until a clear triggering event occurs.
- No Reversal of Impairment: Under U.S. GAAP, once an impairment loss is recognized for assets held and used, the written-down carrying amount becomes the new cost basis. Companies are generally not permitted to reverse a previously recognized impairment loss, even if market conditions improve and the asset's value recovers. This can be seen as a conservative approach but may not always reflect the asset's true economic recovery.
- Impact on Earnings Volatility: Impairment charges can be substantial and non-recurring, leading to significant volatility in reported earnings. While this reflects economic reality, it can sometimes obscure underlying operational performance for analysts and investors.
Impairment vs. Depreciation
Both impairment and depreciation reduce the book value of assets, but they serve different accounting purposes and are triggered by different events.
| Feature | Impairment | Depreciation |
|---|---|---|
| Purpose | To recognize a sudden, material loss in an asset's value due to unforeseen events. | To systematically allocate the cost of a tangible asset over its useful life. |
| Trigger | Specific "triggering events" (e.g., market decline, technological obsolescence). | Passage of time or usage of the asset. |
| Frequency | Only when triggering events indicate a potential loss. | Typically recorded annually or periodically (e.g., monthly). |
| Nature of Loss | Reflects an unexpected economic loss of value. | Reflects the normal wear and tear or obsolescence over time. |
| Reversibility | Generally not reversible under U.S. GAAP for assets held and used. | Not applicable; it's a systematic allocation. |
While depreciation systematically reduces an asset's value over its life, impairment is a more immediate, event-driven recognition that the asset's value has fallen below its recorded amount due to specific adverse conditions. Depreciation is a routine accounting process, whereas impairment is an exceptional adjustment.
FAQs
What types of assets are subject to impairment testing?
Impairment testing primarily applies to long-lived assets, such as property, plant, and equipment (PP&E), and certain intangible assets with finite useful lives. Indefinite-lived intangible assets (like trademarks) and goodwill are also tested for impairment, though under slightly different accounting standards (ASC 350 for goodwill).
How does impairment affect a company's financial statements?
An impairment charge reduces the asset's value on the balance sheet, leading to a decrease in total assets and potentially shareholder equity. It is also recognized as a non-cash expense on the income statement, reducing net income and earnings per share.
Is impairment a cash expense?
No, impairment is a non-cash expense. While it reduces reported earnings, it does not involve an outflow of cash. It is an accounting adjustment reflecting a decline in the economic value of an asset.
What are some common indicators that an asset might be impaired?
Common indicators (or "triggering events") include a significant decrease in the market price of an asset, a significant adverse change in its physical condition or how it's being used, a major adverse change in legal factors or the business environment, or a history of operating or cash flow losses associated with the asset.1
Can an impaired asset's value be written back up later?
Under U.S. GAAP, for assets held and used, a previously recognized impairment loss generally cannot be reversed, even if market conditions improve. The new, lower carrying amount becomes the asset's new cost basis for future accounting.