Asset impairment refers to a situation where the carrying amount of a fixed asset on a company’s balance sheet exceeds its recoverable amount. The recoverable amount is the higher of an asset’s fair value (selling price) less costs to sell or its value in use (present value of expected future cash flows generated by the asset). When the carrying amount of an asset is higher than its recoverable amount, the asset is considered impaired, and the company needs to adjust its value on the balance sheet accordingly.
Asset impairment can occur due to various reasons, including changes in market conditions, technological advancements that render assets obsolete, legal or regulatory changes, economic downturns, or changes in the company’s operations.
Here’s how the process of recognizing and accounting for asset impairment generally works:
- Identification of Impairment: Companies need to regularly assess their fixed assets for potential impairment. If events or circumstances suggest that an asset’s carrying amount might not be recoverable, the company needs to perform an impairment test.
- Impairment Test: The company compares the asset’s carrying amount with its recoverable amount. If the recoverable amount is lower than the carrying amount, the asset is considered impaired.
- Measuring Impairment Loss: The impairment loss is the amount by which the carrying amount of the asset exceeds its recoverable amount. This loss is recognized as an expense on the income statement, reducing the asset’s value on the balance sheet.
- Updated Carrying Amount: After recognizing the impairment loss, the asset’s carrying amount on the balance sheet is adjusted to its recoverable amount. The adjusted carrying amount becomes the new basis for subsequent depreciation or amortization calculations.
- Disclosure: Companies need to disclose information about impaired assets in their financial statements. This includes details about the impairment loss, the circumstances leading to impairment, and any subsequent changes in recoverable amounts.
It’s important to note that not all assets are tested for impairment annually. Impairment tests are typically conducted when there are indications that the value of an asset may have been impaired. Additionally, companies need to consider the potential impairment of goodwill and intangible assets with indefinite useful lives, among other types of assets.
Asset impairment is an essential aspect of financial reporting because it ensures that a company’s balance sheet accurately reflects the current value of its assets. Noncompliance with impairment testing and reporting can lead to misrepresentation of financial statements and inaccurate assessment of a company’s financial health. Companies should follow relevant accounting standards, such as those provided by the International Financial Reporting Standards (IFRS) or Generally Accepted Accounting Principles (GAAP), to properly account for and disclose asset impairment.