What is impairment in accounting? (Plus pros and cons)
By Indeed Editorial Team
Published 4 June 2022
The Indeed Editorial Team comprises a diverse and talented team of writers, researchers and subject matter experts equipped with Indeed's data and insights to deliver useful tips to help guide your career journey.
The concept of impairment helps accountants manage a business's balance sheet. Impairment is the permanent value reduction of an organisation's assets that often occurs over time, although it's distinct from depreciation which is a similar concept. Impairment can affect both fixed assets and intangible assets. In this article, we explore what impairment in accounting is, how it differs from depreciation, the pros and cons of impairment on a balance sheet and provide examples of using impairment to account for the loss in value of certain assets in different situations.
What is impairment in accounting?
Impairment in accounting refers to a permanent reduction in the value of an asset on an organisation's financial records. This includes both fixed assets and tangible assets. Impairment can occur as the result of a one-off event, such as a storm or even a change in consumer demand. It's essential that you test assets for impairment regularly to ensure that their values are accurate on the balance sheet. Impairment occurs when you decide that the fair value of an asset is less than its carrying value.
It's possible to test for impairment by comparing an asset's total profit, cash flow or other generated benefits against its book value. If the current book value exceeds the forecasted cash flow or profit of the asset in the future, you write off the difference between these numbers, and impairment occurs. This causes a permanent reduction in the asset's value, and this reduction presents itself on the balance sheet as an impairment loss.
Impairment vs depreciation
Impairment and depreciation might seem like similar concepts because both of these terms refer to the reduction value of an organisation's assets over time. Impairment is generally unexpected damage to an asset, while depreciation results from expected wear and tear. For example, if you run an agricultural business, the value of heavy machinery, tractors and other equipment depreciate over time due to wear and tear. If an unexpected storm damages your machinery, this is impairment rather than depreciation.
What are the requirements for impairment?
The generally accepted accounting principles (GAAP) set out the primary requirement of impairment, this being when the fair value of an asset falls below its book value. It's important that companies test their assets for impairment regularly because any impairment that takes place can have a negative effect on the company's balance sheet and create a larger discrepancy between assets and debts. GAAP recommends that companies test particular assets, including intangible goodwill, for impairment on at least an annual basis, plus taking into consideration one-off events (such as storms or market changes) that might cause impairment.
Causes of impairment in accounting
There can be many different causes of impairment, some of which are avoidable and others which are not. Impairment most often occurs due to an unexpected event or change, but in some cases, the market conditions that cause impairment are possible to predict and avoid. It's important that organisations know the common causes of impairment so that, if any of these causes occur mid-year, they can carry out an impairment test immediately. Some of the most typical causes of impairment to a company's assets include:
a change to an asset's intended use
decrease in consumer demand for the asset
damage to the asset caused by a natural disaster or an accident
changes in regulations that may cause an asset to drop in value
It's standard GAAP practice to carry out impairment testing at the lowest level when there are recognisable cash flows. For example, an electronics manufacturer might test each television it produces in a plant for impairment rather than the plant itself. If there are no identifiable cash flows at this level, the company might then carry out impairment testing at the entity level.
Pros and cons of impairment
If you're considering noting down impairment on your organisation's balance sheet, it's vital that you understand the advantages and disadvantages of this concept. If your organisation's assets have suffered from an impairment, your accountant can carry out an impairment test and include this drop in value on your balance sheet as soon as possible. Some of the pros and cons of impairments are below:
Pros of impairment
There are advantages to listing impairments on your organisation's balance sheet. These advantages affect both organisations and investors:
Highlighting company management
Impairment can benefit organisations by highlighting the importance of asset awareness when preparing balance sheets. If a company handles impairments properly, it can create opportunities to gain support from investors by not only following correct accounting principles but also demonstrating successful management within a challenging market. Investors are more likely to invest in companies that have experienced difficult market conditions and succeeded in spite of them rather than backing untested businesses.
For investors, impairments are an important part of understanding the financial position that a company's in. Impairments cause a real reduction in the value of a company's assets, which affects the company's financial health. Significant impairments might also indicate to investors that a company doesn't have good business practices or is operating in a declining market. Impairments on a company's balance sheet also highlight issues such as overspending and overinflation.
Cons of impairments
There are also disadvantages to the concept of impairments. These can make it difficult to accurately reflect real-life changes on the balance sheet both for organisations and investors:
When impairments affect the value of a company's assets, it can be difficult to measure the exact value of the loss to accurately adjust the balance sheet. For example, when an impairment occurs because of a natural disaster such as a flood or a fire, it takes time to assess the extent of the damage and price up the actual loss of value to the company's assets. If this damage occurs near the end of the fiscal year, it's difficult to reflect an accurate loss in value on that year's balance sheet.
Difficulty recognising impairment
Most organisations carry out impairment checks on an annual basis, alongside additional checks in the wake of natural disasters, break-ins and other one-off events. When assets lose their value for intangible reasons, because of a drop in market demand or something else less clear, it can be hard to identify the signs of impairment. This means that many organisations encounter unexplained losses on their balance sheet even though they've carried out checks for impairment during the year.
To better understand the concept of impairment, observe the examples below. These examples demonstrate how a company's assets might lose value after significant one-off events or unexpected changes in market demand for a product:
Example 1: impairment after a natural disaster
Pecan Bakery is a bakery based in York that holds several assets amounting to a current book value of £50,000. Flooding in the York area breaches the kitchen at Pecan Bakery and causes significant amounts of damage to kitchen equipment, so the company conducts impairment testing to reassess the value of the bakery's assets.
After the impairment tests, Pecan Bakery reduces the book value of its assets to £35,000. Due to this impairment, the owner of Pecan Bakery writes the loss amount in the balance sheet for that fiscal year to accurately reflect the reduction in the value of the company's assets. This involves including a debit entry of £15,000 due to loss from an impairment, which reduces the company's overall net income that year.
Example 2: impairment due to market changes
Cooper's Computers is an independent computer retailer based in Newcastle. The company buys a large supply of computers and peripherals worth approximately £100,000 to restock the backroom of the shop. Over the next six months, the value of these assets depreciates as the computers age, causing a loss of around £10,000 in depreciation and resulting in a current book value of £90,000.
An unexpected development in computer chip technology results in a drop in demand for much of Cooper's Computers' existing stock, as consumers turn to alternative computer models. This results in a sudden drop in the value of the assets held by Cooper's Computers, which prompts the company to perform impairment testing. After the tests, Cooper's Computers reports an asset value of £70,000, reflecting a further drop of £20,000 due to impairment. The owner of the company records this on the company's balance sheet as a debit entry of £20,000, which reduced the company's net income for the year.
Please note that none of the companies, institutions or organisations mentioned in this article are affiliated with Indeed.
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