Impairment Loss: What It Is and How It’s Calculated

What Is Impairment Loss?

Impairment loss occurs when a business asset suffers an unexpected, permanent depreciation in fair market value in excess of the book value of the asset on a company’s financial statements.

Assets can experience this decrease in value for a variety of reasons. These can include changes in market conditions, new government legislation, the enforcement of regulations, new technologies, and more.

Under U.S. generally accepted accounting principles, or GAAP, assets that are considered impaired must be recognized as a loss on an income statement.

Key Takeaways

• Impairment occurs when a business asset suffers a depreciation in fair market value in excess of the book value of the asset on a company’s financial statements.
• If the calculated costs of holding the asset exceed the calculated fair market value, the asset is considered to be impaired.
• Under GAAP, assets considered impaired must be recognized as a loss on an income statement.
• The technical definition of impairment loss is a decrease in net carrying value of an asset greater than the asset’s future undisclosed cash flow.

Understanding Impairment Loss

The technical definition of impairment loss is a decrease in net carrying value, the acquisition cost minus depreciation, of an asset that is greater than the future undisclosed cash flow of the same asset.

Impairment occurs when assets are sold or abandoned because the company no longer expects them to benefit long-run operations.

This is different from a write-down, though impairment losses often result in a tax deferral for the asset.

Depending on the type of asset impaired, stockholders of a publicly held company may also lose equity in their shares. This results in a lower debt-to-equity (D/E) ratio.

Important

Even when impairment results in a small tax benefit for the company, the realization of impairment is bad for the company as a whole. It usually represents the need for reinvestment.

Calculating Impairment Loss

1. The first step is to identify the factors that lead to an asset’s impairment. Some factors may include changes in market conditions, new legislation or regulatory enforcement, turnover in the workforce, or decreased asset functionality due to aging.

In some circumstances, the asset itself may be functioning as well as ever, but new technology or new techniques may cause the fair market value of the asset to drop significantly.

2. A fair market calculation is key; asset impairment cannot be recognized without a good approximation of fair market value. Fair market value is the price that the asset would fetch if it was sold on the market.

This is sometimes described as the future cash flow that the asset would expect to generate in continued business operations. Another term for this value is “recoverable amount.”

3. Once the fair market value is assigned, it is then compared with the carrying value of the asset as represented on the company’s financial statements.

Carrying value does not need to be recalculated at this time since it exists in previous accounting records.

4. If the calculated costs of holding the asset exceed the calculated fair market value, the asset is considered to be impaired.

If the asset in question is going to be disposed of, the costs associated with the disposal must be added back into the net of the future net value less the carrying value.

Impairment losses are either recognized through the cost model or the revaluation model, depending on whether the debited amount was changed through the new, adjusted fair market valuation described above.

What Does Impairment Mean?

In accounting, impairment refers to an unexpected and permanent drop in a fixed or intangible asset’s value to a market value that’s less than what’s recorded on a company’s balance sheet. The amount is recorded as a loss on the income statement.

How Does Impairment Loss Differ from a Write-Down?

A write-down leads to impairment loss. “Write-down” is an accounting term for the reduction in the book value of an asset when its fair market value (FMV) has fallen below the carrying book value, and thus becomes an impaired asset. Impairment loss often results in a tax deferral for the asset.

How Do I Start to Determine Impairment Loss?

Begin by identifying the factors that lead to an asset’s impairment. Factors may include:

• Changes in market conditions
• Decreased asset functionality due to aging
• New legislation or regulatory enforcement
• New technology or new techniques that may cause the asset’s fair market value to drop significantly
• Turnover in the workforce

The Bottom Line

Impairment occurs when a business asset suffers a permanent reduction in fair market value in excess of the book value of the asset on a company’s financial statements.

Under U.S. generally accepted accounting principles (GAAP), assets that are considered impaired must be recognized as a loss on an income statement.