What is Impairment?
Impairment is a permanent decrease in the value of an asset that represents the difference between an asset’s book value and its fair value.
Impairment is a permanent decrease in the value of an asset. Impairments occur because assets have book values that do not change, while their actual worth may increase or decrease over time. When the market value of an asset permanently drops below its book value, an impairment occurs –- Companies need to reduce the asset's value on their balance sheet to reflect the new situation. The most commonly impaired assets are fixed assets and intangible assets. Fixed assets such as property, plants, and equipment, are frequently subject to impairment. Intangible assets, such as intellectual property (like patents or trademarks), are also subject to impairment.
Let’s imagine a trade war breaks out between two countries. A hypothetical company that manufactures cars in one country and imports them into the other sees the price of importing those cars rise. As a result, the factory’s profitability falls. Since it doesn’t generate as much profit, it’s worth less. As a result, there’s a discrepancy between its book value and its market value, which results in impairment.
Impairment is like an ice cream cart that’s moved from the desert to Antarctica...
The ice cream may be just as good as it was in the desert, but because of the new location, the cart is not going to sell as much ice cream, and its value will be far lower.
In this sense, an impairment loss is an expense. However, impairment expense doesn’t mean that the company lost any money in the period –- It’s merely reflecting that the value of the company has decreased since one of its assets is no longer worth what it once was.
Intangible assets like copyrights or patents also can be impaired. If intellectual property moves into the public domain or loses its protected status as a result of a lawsuit, then it becomes impaired. The company would recognize an expense for this on its income statement, even though it’s not related to a direct cost.
It’s important to note that under the US Generally Accepted Accounting Principles (GAAP) rules, once an asset has been impaired, its value cannot later be increased. That means companies should be sure that an asset’s decrease in value is permanent before they markdown an asset.
An impairment loss is calculated by taking an asset’s book value and subtracting it from the asset’s fair market value. Book value is also sometimes called carrying value, while the asset’s fair market value is called the market value.
Impairment Loss = Market Value - Book Value
Market value is typically the value that someone would pay for the asset in question. In other situations, the market value may be the recoverable value of an asset — If an asset is damaged but can still be sold, the recoverable worth should be used.
For example, a company vehicle totaled in an accident could still be sold for scrap. In that case, the impairment loss would be the difference between the book value and the value for which the vehicle can be sold.
In some situations, the impairment could represent an asset losing its value completely.
Different companies use different methods of organizing their financial statements. In finance, this is called the basis of accounting. One of the most common bases of accounting in the United States is GAAP (Generally Accepted Accounting Principles) –- All publicly traded and regulated companies in the US are required by the SEC (Securities and Exchange Commission) to follow GAAP.
GAAP features a three-step process for calculating impairment:
Step 1: Companies must regularly test all assets for indicators of impairment, such as a significant decrease in the asset’s market value.
Step 2: If a significant decrease in market value exists, companies must calculate the asset’s recoverable value. This number is calculated by determining the undiscounted cash flow that would stem from the asset’s continuous use. If the value provided by the cash flow is lower than the book value, then the company should report an impairment loss.
Step 3: Companies must determine the value of the impairment loss by identifying the asset’s market value. This value is determined by estimating what the asset would be worth if it were to be sold immediately in its current condition to an unpressured buyer. The market value estimated in this step is used to calculate the impairment loss.
Impairment and depreciation are similar in that they both deal with assets losing value. However, depreciation differs in that it deals with predictable and expected loss in value over time. For example, factory machines wear down over time, becoming less efficient. Depreciation reflects how those machines lose value over time.
Impairment is typically sudden and unexpected relative to depreciation. For example, a factory losing value because its equipment is aging would be deprecation. The loss of profit in question is slow and expected.
The same factory losing value because it caught on fire would be impairment. Unlike the previous example, the factory fire would be a relatively sudden and unexpected situation.
A significant difference to note is that deprecation is typically calculated from the beginning of an asset’s life. Companies project how long they will use an asset and determine how much they will be able to sell it for when it has reached the end of that calculated life. That loss in value is then recorded over the length of the asset’s expected life.
One way of determining depreciation is called the “straight-line method.” For example, a machine that was worth $100K when it was purchased is expected to be worth $20K after five years. The company would first calculate the total depreciation by subtracting the price for which they sell the used equipment from the price they paid ($100K - $20K = $80K). It then divides that over five years ($80K / 5 years) to determine that the machine should depreciate at $16K per year –- This expense is then recorded every year for five years.
Accounts receivable is a blanket term for payments due to a company for goods or services it has provided but for which it has not yet been paid. An important aspect of accounts receivable is that the company expects to be paid for its products or services in the future.
Because of this expectation, accounts receivable is listed as an asset on a balance sheet. However, the company doesn’t yet have the money it is owed in its possession.
People and companies don’t always pay the money they owe. That means that the value in accounts receivable isn’t guaranteed. Companies deal with this problem, to some extent, by making an allowance on their balance sheet for “bad debt” or “doubtful accounts.” Based on trends of payment and non-payment in the past, companies can project how much money they will ultimately receive.
The company eventually has to write off the bad debt it wasn’t able to recover. In this situation, it is often called accounts receivable impairment.
Different companies use different standards for determining when they should write off bad debt. Many companies require their customers to pay within 30, 90, or 120 days of the bill being sent. A general standard for determining if a debt is bad or not is based on the length of time given for repayment.
Generally, if a debt is owed for more than twice the length of the standard pay period, it is considered bad debt. For example, if a bill allows for 30 days to pay, and the payment hasn’t been made by 60 days from when the bill is sent, then the debt is considered “bad.”
Another situation in which the debt is considered “bad” is when the company with the liability goes bankrupt. While the company is going through bankruptcy, it is legally shielded from paying many of its debts. Sometimes a company can recover some or all of its debts from a bankrupt company — and sometimes not.
One final scenario where debt can go wrong is when the client disputes the quality of the goods or services it was delivered. While this can sometimes be resolved amicably, these disputes sometimes end up in court and can take a long time to resolve.
Goodwill is often recorded when one company purchases another for more than the market thinks it’s worth –- It represents the difference between the company’s fair market value and purchase price.
You can calculate the fair value of a company by subtracting its liabilities from its assets. The difference between this and the purchase price is then recorded on the balance sheet as goodwill (an intangible asset).
A company’s value fluctuates based on intrinsic factors, such as revenue and extrinsic factors such as market conditions –- A company purchased by another is unlikely to remain at the same value forever.
If the purchased company’s value permanently drops below its book value, then the goodwill value on the balance sheet is the first to be impacted. So, when the purchased company’s value permanently drops, a goodwill impairment is recorded.
What is a Limited Liability Company (LLC)?
A limited liability company (LLC) is a business entity that provides a business owner with the tax benefits of a partnership or sole proprietorship, and the limited liability of a corporation.
What are Articles of Incorporation?
A company’s articles of incorporation are a legal document that establishes a corporation and provides the government with relevant information to allow it to do business.
What is Comparative Advantage?
A comparative advantage is something that a person, business, or country can do at a lower opportunity cost than another.
What is a Bond?
A bond is like an IOU that’s issued by a company, government, or institution in exchange for cash, and it’s tradable in financial markets, similar to a stock.
What is Inventory Turnover?
Inventory turnover is a ratio that shows the number of times that a company can sell through its inventory in a given period of time.