What is disability?
In accounting, impairment is a permanent reduction in the value of a business asset. It can be a fixed asset or an intangible asset.
When an asset is tested for impairment, the total profit, cash flow or other benefit that the asset can generate is periodically compared to its current carrying amount. If the asset’s book value exceeds the asset’s future cash flow or other benefit, the difference between the two is written off and the asset’s value decreases on the company’s balance sheet.
- Impairment can occur as a result of an unusual or unique event, such as a change in legal or economic conditions, a change in consumer demand, or damage affecting an asset.
- Assets should be regularly tested for impairment to avoid overstating the balance sheet.
- Impairment exists when the fair value of an asset is less than its book value on the balance sheet.
- If the impairment is confirmed as a result of the tests, an impairment loss should be recorded.
- An impairment loss records an expense in the current period that appears in the income statement and simultaneously reduces the value of the impaired asset on the balance sheet.
Impairment is most commonly used to describe a drastic reduction in the recoverable value of a fixed asset. Impairment can be caused by a change in the company’s legal or economic circumstances or by a casualty loss from an unforeseen disaster.
For example, a construction company may face extensive damage to its outdoor machinery and equipment due to a natural disaster. This will show up on your books as a sudden and large drop in the fair value of these assets below their book value.
The book value of an asset, also known as its book value, is the net asset value of accumulated depreciation that is recorded on a company’s balance sheet.
Periodic evaluation for impairment
An accountant periodically tests assets for possible impairments. If there is any impairment, the accountant cancels the difference between the fair value and the book value. Fair value is normally obtained as the sum of an asset’s expected undiscounted future cash flows and its expected salvage value, which is what the company expects to receive from the sale or disposal of the asset at the end of its useful life.
Other accounts that may be impaired and, therefore, should be reviewed and noted, are the company’s goodwill and its accounts receivable.
The capital of a company can also deteriorate. An impaired capital event occurs when the total capital of a company is less than the by value of the capital stock of the company.
Unlike the impairment of an asset, impaired capital can naturally reverse when the total capital of the company increases again above the nominal value of its capital stock.
Impairment vs. Depreciation
Deterioration 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 that uses a straight-line method or one of several accelerated depreciation methods.
Depreciation schedules allow for an established distribution of an asset’s reduction in value over its useful life.
Unlike impairment, which represents an unusual and drastic drop in the fair value of an asset, depreciation is used to account for the typical wear and tear of fixed assets over time.
GAAP requirements for impairment
Under generally accepted accounting principles (GAAP), assets are considered impaired when their fair value falls below their book value.
Any write-off due to an impairment loss can have adverse effects on a company’s balance sheet and its resulting financial ratios. Therefore, it is important for a company to periodically test its assets for impairment.
Certain assets, such as intangible goodwill, must be tested for impairment annually to ensure that the value of the assets does not inflate on the balance sheet.
GAAP also recommends that companies consider economic events and circumstances that occur between annual impairment tests to determine whether it is “more likely than not” that the fair value of an asset has fallen below its carrying amount.
Causes of deterioration
Specific situations in which an asset may deteriorate and become irrecoverable include when a significant change occurs in the intended use of an asset, when there is a decrease in consumer demand for the asset, damage to the asset, or adverse changes in legal factors. that affect the asset. .
If these types of situations arise in the middle of the year, it is important to carry out an impairment test immediately.
Standard GAAP practice is to test fixed assets for impairment at the lowest level where there are identifiable cash flows. For example, an automobile manufacturer must perform deterioration tests for each of the machines in a manufacturing plant rather than for the high-end manufacturing plant itself. If there are no identifiable cash flows at this low level, it is allowed to test for impairment at the asset group or entity level.
Example of impairment
Florida-based ABC Company purchased a building many years ago at a historic cost of $ 250,000. You have had a total of $ 100,000 in depreciation on the building and therefore have $ 100,000 in accumulated depreciation. The building’s book 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 the impairment test.
After assessing the damage, ABC Company determines that the building is now only worth $ 100,000. Therefore, the building is impaired and the value of the asset must be written off to avoid an overstatement on the balance sheet.
A debit entry is made in “Impairment loss”, which will appear in the income statement as a reduction in net income, in the amount of $ 50,000 (book value of $ 150,000 – fair value calculated of $ 100 000).
As part of the same entry, a credit of $ 50,000 is also made to the building’s asset account, to reduce the asset balance, or to another account on the balance sheet called “Provision for impairment losses.”
How is disability determined?
Under generally accepted accounting principles (GAAP), an asset is considered impaired when its fair value falls below its carrying amount.
When an asset is tested for impairment, the total profit, cash flow or other benefit that the asset is expected to generate is compared to its current carrying amount.
If it is determined that the asset’s carrying amount exceeds the asset’s future cash flow or profit, an impairment is recorded.
What is the difference between depreciation and impairment?
Impairment represents an unexpected and drastic drop in the fair value of an asset.
Depreciation represents the typical and expected wear and tear of assets over time. It is routinely accounted for using a predetermined schedule and methodology.
- A tractor depreciates in value from year to year throughout its useful life.
- A tractor that is crushed by a falling tree has experienced deterioration that must be recorded in the books as such.
How is impairment accounted for?
If there is impairment, an accountant cancels the difference between the fair value and the book value, and the asset’s value decreases on the company’s balance sheet.
Fair value is normally obtained as the sum of an asset’s expected undiscounted future cash flows and its expected salvage value, which is what the company would expect to receive from the sale or disposal of the asset at the end of its useful life.