Impairment Loss Meaning
An impairment loss is a drop in an asset’s net carrying amount (cost of acquisition minus depreciation), which is more than that asset’s future undisclosed cash flow. This permanent decrease in value occurs when a company abandons or sells the asset, expecting it not further to benefit the long-run operations. Calculating it helps businesses to reduce their losses.
Businesses must test an asset’s impairment value to determine the loss. They can do this from time to time by comparing an asset’s projected worth or fair market value against its present book value. Businesses can subtract the difference if the latter is more than the former. As a result, the asset’s value will decrease on their financial statements.
Table of contents
- The impairment loss definition refers to a permanent decrease in an asset’s fair market value due to various reasons like a change in the legal climate, escalating costs, etc.
- The main goal of computing this loss is to ensure that the overall value of assets is not overstated.
- Individuals can calculate impairment loss by finding the difference between an asset’s book value and fair value.
- A noteworthy difference between depreciation and impairment loss in accounting is that the former applies to only fixed assets, for example, plant and machinery, unlike the latter.
Impairment Loss Explained
The impairment loss definition refers to a recognized reduction in a fixed or an intangible asset’s carrying value triggered by a decrease in the fair value. A business writes off that amount when an asset’s fair value falls below the carrying value. Companies must put this loss on an income statement to track their financial accuracy. This helps them avoid mistakes, such as overstatements.
Let us say there is any sign of inaccuracy. For example, an overestimation of the estimated revenue gain. Periodically testing the value of assets for impairment can help companies make the right financial plans. Besides increased competition and poor management, numerous factors can lead to impairment losses. Let us look at these aspects:
#1 – Escalating Costs
Businesses may face a situation where the running costs incurred to maintain an asset are higher than the projected cost at the time of the initial investment. Alternatively, the running costs can increase over time, resulting in a decrease in the overall value.
#2 – Market Downturn
In the case of a market downturn, an asset’s fair market value may decrease than the book value. For example, if the real estate market faces a downturn, the value of a property held by a company could decrease.
#3 – Changes In Existing Laws
A lawsuit or a change in the legal or business climate could reduce an asset’s fair market value. For instance, if a worker suffers an injury while using equipment owned by the business, the company cannot use the asset until the legal situation gets resolved.
An impairment loss in accounting is not common for low-cost assets. This is because it is not worthwhile for a company’s accounting department to conduct an impairment analysis. Hence, impairment losses are usually applicable in the case of high-cost assets.
One can use the following formula to calculate impairment loss:
Impairment Cost = Book Value – Fair Value
Let us look at this impairment loss calculation example to understand the concept better.
Suppose Amacon Company manufactures equipment for the automotive service industry. It bought a new set of automated machines to develop the latest devices. The expected lifespan of such machines was five years. Keeping this in mind, the company’s owner purchased 30 machines. Each machine’s price was $200. As a result, the overall purchase price was $6,000.
Within a year from the date of purchase, 20 machines started malfunctioning. As a result, Amacon Company decided to test the assets for impairment. After analyzing the issues, the company concluded that the present estimated worth or fair value of the malfunctioning machines was $100.
The business can use the above formula to compute the impairment cost.
Impairment Cost = ($200 x 20) – ($100 x 20) i.e., $2,000
When the balance sheet date is approaching, companies must assess whether the impairment losses recorded in the preceding accounting periods have decreased or do not exist. In either case, businesses must estimate the asset’s recoverable amount.
Suppose the projected recoverable cost is higher than the asset’s carrying cost. In that case, organizations must reverse the previously recognized loss to the extent that the projected recoverable cost is more than the asset’s carrying cost.
Once the reversal is complete, the asset’s carrying value must not be more than the following:
- The carrying cost that businesses would determine if they did not recognize any impairment loss for the asset in previous accounting periods.
- Projected recoverable cost.
The recoverable amount is the asset’s net selling price or the value in use, whichever is higher. Calculating the loss amount to be reversed depends on whether the recoverable amount is more or less than the asset’s historical net book value.
When the recoverable amount is more, one can compute the reversal amount by subtracting the net book value from the historical net book value. In contrast, individuals must subtract the net book value from the recoverable amount if the recoverable amount is less.
Generally, tax authorities try to tax business income as close to the cash base as possible instead of the accrual base. This means that the tax authorities do not allow companies to claim a deduction against an impairment loss as the expense does not relate to a sale or purchase in the accounting period.
Impairment Loss vs Depreciation
Individuals often find impairment loss and depreciation confusing, leading to inaccurate preparation of financial statements. One must understand the critical differences between these two concepts to eliminate such confusion. So, let us look at their distinct features.
|This loss usually refers to a sudden drop value of an asset. Natural disasters and market crashes are a few unexpected sources resulting in a decreased value.
|Depreciation refers to the expected drop in the value of an asset owing to regular wear and tear.
|Impairment applies to both intangible and fixed assets.
|Depreciation applies to fixed assets only.
|Impairment losses are not tax-deductible.
|Depreciation is tax-deductible.
Frequently Asked Questions (FAQs)
Goodwill impairment occurs if the goodwill associated with an acquisition exceeds the implied fair market value. A company records the earnings charge on its financial statement once it identifies enough evidence that shows the asset related to the goodwill can no longer deliver the financial results the company expected from it on the date of purchase.
An organization must record this loss as an expense on its income statement. At the same time, it must reduce the impaired asset’s value on the balance sheet.
One can find this charge under the operating expenses section on a corporate income statement.
Yes, it may have an impact on equity. When a company’s asset is impaired, the organization writes it down to the present market value. If the fair value is less than the price paid at the time of purchase, the net income falls, and the shareholders’ equity decreases.
This article has been a guide to Impairment Loss and its meaning. We explain its formula, calculation, example, tax treatment, and comparison with depreciation. You may also find some useful articles here –