when testing an asset for impairment the total profit cash flow or other benefits that can be generated by the asset is periodically compared with its current book value if the book value of the asset exceeds the future cash flow or other benefits of the asset the difference between the two is written off and the value of the asset declines on the company s balance sheet 1
investopedia xiaojie liuunderstanding impairmentimpairment is most commonly used to describe a drastic reduction in the recoverable value of a fixed asset the impairment may be caused by a change in the company s legal or economic circumstances or by a casualty loss from an unforeseeable disaster for example a construction company may face extensive damage to its outdoor machinery and equipment due to a natural disaster this will appear on its books as a sudden and large decline in the fair value of these assets to below their carrying value an asset s carrying value also known as its book value is the value of the asset net of accumulated depreciation that is recorded on a company s balance sheet 2an accountant tests assets for potential impairment periodically if any impairment exists the accountant writes off the difference between the fair value and the carrying value fair value is normally derived as the sum of an asset s undiscounted expected future cash flows and its expected salvage value which is what the company expects to receive from selling or disposing of the asset at the end of its life 3other accounts that may be impaired and thus need to be reviewed and written down are the company s goodwill and its accounts receivable a company s capital can also become impaired an impaired capital event occurs when a company s total capital becomes less than the par value of the company s capital stock unlike impairment of an asset impaired capital can naturally reverse when the company s total capital increases back above the par value of its capital stock 4impairment vs depreciationimpairment is unexpected damage depreciation is expected wear and tear the value of fixed assets such as machinery and equipment depreciates over time the amount of depreciation taken in each accounting period is based on a predetermined schedule using either a straight line method or one of a number of accelerated depreciation methods depreciation schedules allow for a set distribution of the reduction of an asset s value over its lifetime unlike impairment which accounts for an unusual and drastic drop in the fair value of an asset for instance gaap requirements for impairmentunder generally accepted accounting principles gaap assets are considered to be impaired when their fair value falls below their book value 6any write off due to an impairment loss can have adverse effects on a company s balance sheet and its resulting financial ratios it is therefore important for a company to test its assets for impairment periodically certain assets such as intangible goodwill must be tested for impairment on an annual basis in order to ensure that the value of assets is not inflated on the balance sheet gaap also recommends that companies take into consideration events and economic circumstances that occur between annual impairment tests in order to determine if it is more likely than not that the fair value of an asset has dropped below its carrying value 7causes of impairmentspecific situations in which an asset might become impaired and unrecoverable include when a significant change occurs to an asset s intended use when there is a decrease in consumer demand for the asset damage to the asset or adverse changes to legal factors that affect the asset if these types of situations arise mid year it s important to test for impairment immediately standard gaap practice is to test fixed assets for impairment at the lowest level where there are identifiable cash flows for example an auto manufacturer should test for impairment for each of the machines in a manufacturing plant rather than for the high level manufacturing plant itself if there are no identifiable cash flows at this low level it s allowable to test for impairment at the asset group or entity level 8example of impairmentabc company based in florida purchased a building many years ago at a historical cost of 250 000 it has taken a total of 100 000 in depreciation on the building and therefore has 100 000 in accumulated depreciation the building s carrying value or book value is 150 000 on the company s balance sheet a category 5 hurricane damages the structure significantly the company determines that the situation qualifies for impairment testing after assessing the damages abc company determines the building is now only worth 100 000 the building is therefore impaired and the asset value must be written down to prevent overstatement on the balance sheet a debit entry is made to loss from impairment which will appear on the income statement as a reduction of net income in the amount of 50 000 150 000 book value 100 000 calculated fair value as part of the same entry a 50 000 credit is also made to the building s asset account to reduce the asset s balance or to another balance sheet account called the provision for impairment losses 