Impairment Cost or charge is the drop in the value of an asset on a permanent basis. Whether the asset is tangible or intangible, it is prone to impairment. Tangible assets in a firm could be anything from property to furniture and fixtures. On the other hand, intangible assets would be patents, goodwill, license, etc. The term impairment usually comes in use for fixed assets and mainly for Goodwill.
An accounting manager tests the assets for impairment of the asset by comparing the profit or cash flow that a specific asset generates the same asset’s book value. If, in the comparison, the book value of an asset is more than the cash flow it generates, the difference is written off, resulting in impairment cost or charge. Also, then the value of the asset drops on the balance sheet. Put it simply, the carrying amount (book value) of the asset should not exceed its recoverable amount.
Usually, firms listed on the stock exchange assess impairment on a regular basis. Also, the companies who are in the process of issuing equity or debt securities must also calculate the impairment cost or charge. However, not all companies across the globe assess impairment as it depends on the accounting rules of a country.
Accounting of Impairment Asset
Under the Generally Accepted Accounting Principles (GAAP), all the assets should be impaired when the fair value is less than the book value. Companies should regularly check for their assets and look for indicators of impairment on a regular basis.
As per the standard GAAP practice, a company should perform an impairment test for all the fixed assets at the lowest level, where it gets easy to identify cash flows.
For instance, an auto manufacturer should perform an impairment test on each machine in the plant rather than on the manufacturing plant. In case there are no identifiable cash flows, the company must carry the impairment test at the entity or group level.
Reasons to go for Impairment
There could be specific conditions where an asset becomes unrecoverable. For example, an asset’s high cost to construct or finance, assets could be sold significantly before their useful life ends, or a major change in how the company uses an asset. In such situations as mentioned above, it is only desirable to have the impairment test.
For instance, a sudden drop in economic activity might affect various industries. Therefore, some companies might take it as a hint to start assessing the impairment cost of certain assets. Or there could be a sudden breakdown of machinery, then the accounting manager would not have any option but to write down the asset.
A company should always consider the external environment and indicators to know the right time for the impairment of an asset. Some of the factors leading to impairment are:
- Sudden change in the legal or economic environment affecting the company or the assets.
- A substantial drop in the market price of the asset.
- Slow demand for the product or service in the medium term due to stressful macroeconomic conditions.
- Physical damage to the asset or physical obsolescence.
- Disposal or restructuring of the asset.
- Failed attempt to get post-merger synergy benefits,
- Not up to the mark economic performance.
Benefits of Impairment Cost
- Analysts and investors always want to know the overall health of a company. Whether or not an asset is performing at its full capacity is crucial for a company’s growth. A good understanding of impairment cost helps stakeholders understand the track record and decision-making ability of a company. There could be incidents where managers might have taken a premature decision to write down an asset.
- In the past, there have been incidents where businesses make a wrong decision on impairment and, as a result, falter. Impairment, in a way, always helps investors to understand such warnings.
Drawbacks of Impairment
- Understanding and calculating the cash flow from a specific asset usually gets difficult. There are a few methods that are commonly in use, such as assessing the current market value, calculating the NRV, and the sum of future net cash flows. However, none of the methods are full-proof.
- There is no in-depth explanation or procedure for assessing the impairment cost. So, calculating impairment cost or charge is more of an art than science. This gives companies an opportunity to manipulate numbers in their favor. Also, the process of impairment is usually hidden from investors. This may mislead investors into correctly evaluating the financial health of a company.
Impairment and Depreciation
Often there is confusion between impairment and depreciation. In accounting terms, impairment is writing down an asset owing to an unplanned or sudden drop in the value of an asset.
On the other hand, depreciation is the measure of a drop in the value of an asset due to its normal use. Similarly, Amortization is more of a systematic activity and is done over the course of time.
Just like assets, the capital of a company can also get impaired. This happens when the total capital of a company goes below the par value of the company’s capital stock. However, unlike the asset, the capital can reverse when the total capital stock goes above the par value.
Individuals or investors must be aware of the impairment risks and also factor them into their investing. However, it is not easy to evaluate such risks. So, investors must always look out for warning signs or red flags that hint at such risks.
Also, read – Impairment of Long-Lived Assets.