A complete guide to impairment charge? (With example)
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An impairment charge is an accounting term that accounts for assets whose value decreases or is lost completely. It typically occurs when a company experiences unanticipated challenges that have a negative impact on the company's health. These charges can help management, investors and creditors make suitable investment decisions while considering the business's financial well-being. In this article, we explain what an impairment charge is and the pros and cons of impairments and provide an example of an impairment in accounting.
What is an impairment charge?
An impairment charge, or simply an impairment, is a process businesses use to write off goodwill on a balance sheet. These are assets that no longer have any value or whose value declines. This can occur when the value of an asset surpasses its fair market value, according to the Generally Accepted Accounting Practice (GAAP) standards, which come from the Financial Reporting Council (FRC).
Though any asset can experience impairment, the typically impaired assets include intangible assets, capital, inventory and goodwill. A capital impairment occurs when a company's total capital falls under the face value or stated value. Nevertheless, impaired capital may rebound if the total capital rises to more than the face value, which isn't the case with asset impairment.
What is goodwill?
Goodwill refers to intangible assets that a company holds. It's related to the purchase of one company by another. It symbolises the part of the purchase price that surpasses the combined total fair value of any assets purchased and liabilities accepted. A company typically tests goodwill a minimum of once per year to establish if its recorded value exceeds its fair market value. Impaired goodwill arises if they find the fair market value is lower than the recorded value.
Many investors believe that goodwill is one the most challenging assets to value as there are multiple conceivable justifications for goodwill in the form of intangible assets. This can include strong customer relations, proprietary technology, intellectual property brand awareness and employee relations are just some of the factors that can contribute to goodwill.
Related: How to become an accountant
Impairment vs. depreciation
Asset impairment is sometimes confused with asset depreciation. Though both terms refer to a decline in the value of assets, impairment and depreciation are two different concepts. The main difference is that depreciation accounts for typical wear and tear on fixed assets over time, while impairment accounts for an unforeseen and drastic drop in the fair value of an asset.
Depreciation accounts for the value of fixed assets such as machinery and equipment that depreciates or declines over time. A company records the amount of depreciation in each accounting period based on a fixed schedule. A depreciation schedule allows for a set distribution of the reduction of an asset's value over its lifetime.
What is an impairment test?
Impairment testing is the process of checking the values of assets displayed in the balance sheet of a company, known as the 'carrying amount'. A company can conduct an impairment test to determine if the asset's carrying amount exceeds the recoverable value. This involves making a comparison between the profit a particular asset generates and its book value.
The book value of an asset refers to its total cost minus any depreciation. If the book value exceeds the profit it generates, the discrepancy cancels to become an impairment. It may be necessary for the majority of companies worldwide to calculate the impairment of their assets when they issue debt or equity. Though, this can vary according to the accounting principles of their country.
Factors that impact an impairment
Internal and external factors can both affect impairment:
These are events or activities that occur within an organisation. Examples of internal factors that can influence impairments include:
damage to assets physically or because of non-use
proposing no advantages for merging the organisation with another business
retaining assets for disposal or restructuring
declining financial results that don't align with business projections
These are exterior forces that impact or influence an organisation. Examples of external factors that can influence impairments include:
shifts in economics, laws and regulations or political factors that affect the organisation or its assets
shifts in the market price for a particular asset
shifts in the market price of a company's entities due to global macroeconomic conditions
When can you use an impairment?
Impairment typically relates to goodwill or the discrepancy between a company's acquisition price and its true value. There are some circumstances in business in which it's useful to test for goodwill impairment. For instance, an unforeseen fall in economic activity can impact numerous industries. Some companies can employ a goodwill impairment to evaluate the impairment cost of their assets and aim to establish their financial status. Many companies may experience loss by paying too much for assets if they neglect to calculate impairment costs before purchase.
A lender may also use a company's impairment to determine if they're going to invest in a particular organisation. Before a lending organisation loans money to a particular company, they may require that the borrower guarantees to maintain certain ratios of operations, known as loan covenants. This is considered a default if a company cannot meet the operating ratios stated in the agreement. The impairment can aid a lender when tracking the company's progress and making decisions, particularly if they require additional financing.
Pros of impairments
Impairment can have several benefits for an organisation, such as:
assists companies, investors and creditors to make decisions
signals devaluation of assets employing its value shifts
helps to write off goodwill
provides investors and analysts with a way to evaluate a company's judgment and leadership
Cons of impairments
There are some cons to using impairment for an organisation, such as:
can be challenging to determine a company's total value and different experts may offer different valuations
organisations may manipulate figures in their favour and conceal the impairment process
can potentially dissuade investors and creditors if the results are always unfavourable
Example of an impairment
Here is an example of an impairment in accounting:
Proud & Co is an oil and gas company. The company decides to assess an impairment for their assets, particularly concerning goodwill. Proud & Co recently purchased Jones Energies, now a subsidiary, which might cause an impairment which could affect the company's balance sheet. Proud & Co records they bought the company for £55 million, but its actual value was £49 million. This means the company recognised £6 million in goodwill because of factors including its track record of success, brand reputation and clientele in the energy field.
After the acquisition, Jones Energies' revenue and total value declined, which is currently at £46 million. As the owner of Jones Energies, the assets of Proud & Co also decline by £3 million. Proud & Co records an impairment of £3 million due to its Jones Energies assets. This demonstrates a fall in goodwill value as the difference in the current actual value of Jones Energies, and the purchase price has risen. Proud & Co records this on their accounting balance sheet and uses it to form educated judgments concerning how they govern Jones Energies to boost profitability.
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