Understand what impairment is, how it differs from depreciation and amortization, and how to calculate and report it.
An impairment in accounting means that the value of a company asset has diminished to less than its book value. Recording impairment on financial statements is a requirement under the US Generally Accepted Accounting Principles (GAAP). Accounting for impairment in the financial statements ensures the accurate valuation of a company’s fixed and intangible assets.
Small businesses and nonprofits that don’t follow GAAP rules aren’t required to adhere to impairment rules. For tax and other book basis accounting, it doesn't apply. For companies that do follow GAAP rules, here’s a primer on what impairment of assets is, how it differs from depreciation and amortization, and how to calculate and report it on financial statements.
Impairment is the permanent reduction in the value of a fixed asset or intangible asset to the point that its market value is less than the value recorded on the financial statements. Under GAAP, impairments are entered as a loss on the income statement.
Impairments are not the same as depreciation or amortization. In the case of depreciation or amortization, the loss of value of the asset is anticipated and planned for. With impairment, the loss in value is unexpected. One example of why an asset might decrease in value unexpectedly is a patent for a suddenly obsolete item. Businesses must assess their assets for impairment annually. An auditor makes sure they comply with GAAP rules.
Some assets lose value over time. Sometimes, an asset gets recorded on the financial statements as generating a certain amount of income, but it is really costing a company money. Impairment is a way to ensure accurate recording of the value of assets.
Long-lived assets are more likely to show impairment because of their longevity. This is especially true if depreciation or amortization is underestimated. Patents are a good example. A patent is an intangible asset, but it has value. Companies capitalize the costs of obtaining a patent. Any such costs are recorded as an asset on the balance sheet and amortized each year to reduce the book value of the patent over time.
Sometimes, a patent may be impaired and not worth the amount shown on the balance sheet. Perhaps a competitor has developed a similar product. If this is the case, an impairment test identifies the loss, and the loss is recorded on the balance sheet. If the patent is sold or disposed of, it is removed from the balance sheet, or derecognized.
Impairment can have a negative impact on a business’s balance sheet and financial ratios because the market value is less than the book value. GAAP rules under the Financial Accounting Standards Board (FASB) are designed to ensure fair and transparent accounting of a business’s financials. With accurate financial information, investors can make sound investing decisions. If impairment is not recorded, the balance sheet and financial ratios will be inaccurate.
The GAAP rules call for annual recoverability tests for businesses. These tests consider the effects of economic downturns and events like pandemics or natural disasters on asset values.
To calculate impairment, the asset’s book value is compared to the net income it generates or its fair market value. The reason for impairment is important because this affects the calculation of fair market value.
The fair market value is the amount the asset could be sold for in the current market. Another way to describe this is the future cash flow of the asset or how much cash it could generate in ongoing business operations.
You also check if the book value exceeds the undiscounted cash flows the asset is expected to generate. The book value is non-recoverable. If holding the asset costs more than the fair market value, it indicates an impairment cost. The amount of the write-down amount is equal to the difference in asset book value and the discounted future cash flows.