Last editedNov 20202 min read
When recognising and documenting the value of your company’s assets, their valuation is generally determined by the market. However, the value of assets changes over time, and it’s important that this changing valuation is accurately recorded on your business’s balance sheet. Consequently, it’s a good idea to have a robust understanding of impairment – the mechanism by which you can reduce the carrying amount of an asset to its recoverable amount.
What is Impairment in Accounting?
So, what is meant by impairment of assets? Impairment describes a reduction in the value of a company asset, either fixed or intangible, so as to reflect a decline in the quality, quantity, or market value of the asset. It’s an accounting concept based on the idea that an asset shouldn’t be carried in your business’s financial statements at more than the highest amount that could potentially be recovered from selling it. When the carrying amount does exceed the fair market value of the asset, it’s referred to as an “impaired asset.”
How does impairment of assets work?
Numerous factors can lead to the impairment of assets. For example, aside from poor management, technical invocation, and increased competition, any of the following factors could lead to the value of the asset declining:
Market downturn – If the market takes a dip, then the fair market value of an asset may end up being less than its book value. For example, if the real estate market experiences a downturn, then any land or property that you’re holding as an asset could decline in value.
Change in legal climate – It’s also possible that a lawsuit, court case, or some other change to the general business/legal climate could cause a reduction in value of the asset. For example, if a worker gets injured while using your equipment and sues your company, you may not be able to use the asset until the legal situation is resolved.
Escalating costs – You may experience a situation where the running costs to maintain an asset are more than you were expecting when you made the initial investment, or the running costs have simply escalated over time, leading to a reduction in overall value.
So, how does impairment in accounting work? Essentially, you need to account for impairment losses on your business’s profit and loss account. To do this, you should compare the recoverable amount (i.e. the highest amount that you could get from selling the asset) with the book value of the asset, before writing that figure down as a loss. Fair warning – impairment is subjective, and it can be difficult to work out the fair value of an asset when you’re attempting to carry out impairment.
Example of impairment accounting
To understand what is meant by the impairment of assets in a little more depth, let’s see an example. Imagine that a disposable camera company invested a large amount of capital in their manufacturing equipment and plant. However, the rise of smartphones may have led them to experience a sudden drop in demand for their products, and therefore, the value of their equipment and plant would have declined significantly. That reduction in value may not have been apparent on the company books, which is why impairment accounting is needed to ensure that the book value reflects the fair market value of the asset.
Impairment vs. depreciation and amortization
Impairment of assets may sound similar to the accounting processes of depreciation and amortization (a reduction in the value of an asset over the course of its useful life). While there are some relatively clear similarities between the two concepts, there’s one key distinction: impairment denotes a sudden, irreversible drop in value, whereas depreciation/amortisation reduces the value of the asset over its entire lifetime. So, whereas impairment accounts for unusual drops in an asset’s value, depreciation and amortisation is generally used for standard wear and tear.
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