Impairment

Impairment is an accounting principle that describes a permanent reduction in the value of a company's asset, normally a fixed asset. When testing for impairment, the total profit, cash flow, or other benefit that's expected to be generated by a specific asset is periodically compared with that same asset's book value. If it's found that the book value of the asset exceeds the cash flow or benefit of the asset, the difference between the two is written off and the value of the asset declines on the company's balance sheet.

Impairment is specifically used to describe a reduction in the recoverable amount of a fixed asset below its book value. Impairment normally occurs when there is a sudden and large decline in the fair value of an asset below its carrying amount, or the amount recorded on a company's balance sheet. An accountant tests assets for impairment periodically; if any impairment exists, the accountant writes off the difference in the fair value and the book value. Fair value is normally derived as the sum of an asset's undiscounted expected future cash flows plus the expected salvage value.

Accounts that are likely to be written down are the company's goodwill, accounts receivable, and long-term assets because the carrying value has a longer span of time for impairment. Assets, such as machinery and equipment, depreciate in value over time. This depreciation is distributed over the asset's entire lifetime using methods such as the straight line depreciation method and the declining-balance method.

The impairment of an asset only occurs when the difference between fair value and the carrying amount is deemed to be unrecoverable. Under Generally Accepted Accounting Principles (GAAP), all assets are considered to be impaired when the fair value falls below the book value.

Any write-off due to an impairment loss can have adverse affects on a company's balance sheet and its resulting financial ratios. It's therefore very important for a company to test all fixed assets for impairment periodically. Standard GAAP practice is to test assets for impairment at the lowest asset 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.

Specific situations where an asset might become impaired and unrecoverable include such scenarios as assets with excessive costs to finance or construct, assets that are expected to be sold well before the end of their useful life, and when there is a significant change to an asset's intended use. Additionally, adverse changes to legal factors that affect an asset may be a signal of impairment. If any of these situations arise, it's important to test for impairment immediately.

Similar to an impaired asset, a company's capital can also become impaired. Impaired capital event occurs when a company's total capital becomes less than the par value of the company's capital stock. However, unlike the 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.