Definition
An impaired asset is a company’s asset that has a market value lower than its carrying value on the balance sheet. The impairment may result from factors such as obsolescence, damage, or a decline in overall market demand. Businesses typically conduct an impairment test, comparing the asset’s carrying value to its recoverable amount, and if impaired, they adjust the carrying value by recording an impairment loss in the financial statements.
Phonetic
Impaired Asset: /ɪmˈpeɪrd ˈæsɛt/ Meaning: /ˈmiːnɪŋ/,Causes: /ˈkɔːzɪz/,How To Test: /haʊ tuː tɛst/,How To Record: /haʊ tuː rɪˈkɔːrd/
Key Takeaways
- Meaning: An impaired asset is an asset that has a market value less than the value listed on the company’s balance sheet. In other words, it is an asset that has either become damaged or its value has decreased due to changes in market conditions, affecting the company’s overall net worth.
- Causes: Assets can become impaired for various reasons, including technological changes, changes in market demand, regulatory changes, or physical damage to the asset. For example, if a new technology makes a company’s equipment obsolete or if a regulatory change decreases the demand for a company’s product, the value of the related assets can become impaired.
- How to Test and Record: To test for impaired assets, companies must periodically assess the recoverable value of their assets. If the recoverable value is less than the carrying amount on the balance sheet, the asset is considered impaired. When impairment is identified, a company must record an impairment loss on their financial statements. This loss reduces the carrying value of the impaired asset on the balance sheet and is also charged as an expense on the income statement, ultimately affecting the company’s net income.
Importance
The business/finance term “Impaired Asset” is crucial as it refers to an asset that has lost a significant portion of its value or potential to generate income, which directly impacts a company’s financial health. Understanding the causes of impairment, such as technological changes, economic downturns, and obsolescence, enables management to identify underperforming assets, take corrective measures, and make informed decisions for future investments. Performing impairment tests on assets ensures accurate financial reporting, resulting in an objective valuation of the asset and a true representation of the company’s financial performance. Furthermore, proper recording of impaired assets in the financial statements enhances transparency, boosts investor confidence, and ensures compliance with relevant accounting standards, ultimately contributing to the financial stability and integrity of a business.
Explanation
An impaired asset serves as an indicator of reduced value and diminished profitability within an organization. It reflects a fundamental change in a company’s business environment, specifically highlighting the assets that are no longer anticipated to generate economic benefits essential for organizational growth. Through the identification and recording of impaired assets, businesses can take proactive measures in their financial management, such as the reallocation of resources, renegotiation of long-term debt, or even asset disposal. By monitoring and addressing these impaired assets, companies can better adapt to changing market conditions and produce more streamlined and efficient operations.
The process of testing and recording an impaired asset is crucial for providing an accurate picture of a business’s financial status. Firstly, causes of impairment, such as technological obsolescence, legal or regulatory changes, or a drastic decline in market value, should be identified. This is followed by performing an impairment test, which compares the asset’s carrying value (book value) with its recoverable amount (the higher of its fair market value and value-in-use). If the carrying value exceeds the recoverable amount, the asset is considered to be impaired. To record this change in financial statements, the difference between the carrying value and recoverable amount is declared as an impairment loss, which is then charged to the income statement for the reporting period. This process enables businesses to reflect a more realistic representation of an asset’s value in their financial statements, fostering improved decision-making and stakeholder communication.
Examples
Example 1: Retail StoreMeaning: An impaired asset occurs when the book value (where it appears on the balance sheet) of an asset exceeds its recoverable amount, which is the higher of its fair market value or the cash flows derived from it.Causes: A retail store may have acquired commercial property at a high price with the intention to expand its business. The property values decline in that area due to an economic downturn or other factors, making it worth less than what the store paid for it.
How to Test: The store needs to regularly review the fair market value of the property and compare that value to its book value. If the fair market value is lower than the book value, impairment needs to be recognized.
How to Record: The store must first record an impairment loss on their income statement to account for the difference between the asset’s book value and its recoverable amount. Then, the property’s book value on the balance sheet must be reduced to reflect the impaired value.
Example 2: Manufacturing CompanyMeaning: Impaired asset occurs when the carrying amount of the asset is higher than its expected future cash flows or fair market value.Causes: A manufacturing company has machinery and equipment for production, but due to technological advancements, the machinery becomes obsolete, and its fair market value reduces significantly.
How to Test: The company reviews the future cash flows expected from the machinery and compares them with the carrying amount. If the value is lower, an impairment test is necessary.
How to Record: A manufacturing company recognizes an impairment loss and adjusts the machinery’s book value to the impaired value. This loss is recorded on the income statement, while the balance sheet reflects the updated value of the machinery.
Example 3: Software Development CompanyMeaning: An impaired asset occurs when the value of the intangible assets, like software, decreases below its book value or carrying amount.Causes: A software development company invests in creating proprietary software for their clients. Over time, a competitor develops more advanced technology, rendering the company’s software less valuable and less profitable than anticipated.
How to Test: The company needs to re-evaluate the estimated future cash flows from the software and compare it with the current carrying amount. If lower, an impairment test is required.
How to Record: The software development company records an impairment loss in their income statement, reflecting the difference between the software’s carrying amount and its recoverable amount. The company also needs to adjust the software’s book value on the balance sheet accordingly.
Frequently Asked Questions(FAQ)
What is the meaning of an Impaired Asset?
An impaired asset is a company’s asset that has a market value less than the value listed on the company’s balance sheet. It occurs when the carrying amount of an asset exceeds its recoverable amount, which is the value the company can expect to receive from using the asset or selling it.
What are the common causes of asset impairment?
Asset impairment can be due to several factors, such as significant changes in market conditions, technological advancements, changes in legal or regulatory environments, or natural disasters. These factors can lead to reduced market value or diminished usefulness of an asset, making it less economically viable for a company.
What is the process of testing an asset for impairment?
The process of testing an asset for impairment typically involves these steps:1. Identify the asset that may be impaired.2. Determine the asset’s recoverable amount (the higher of its fair value or value in use).3. Compare the carrying amount of the asset to its recoverable amount.4. If the carrying amount is greater than the recoverable amount, then the asset is considered impaired.Note that, according to accounting standards, companies are required to perform impairment tests on their assets on an annual basis or when there is an indication that the assets may be impaired.
How does a company record asset impairment?
When an asset is identified as impaired, the company has to record the impairment in its financial statements. The impairment loss is calculated as the difference between the carrying amount and the recoverable amount. The company records the impairment loss by debiting an impairment loss expense account and crediting the related asset account. This reduces the carrying amount of the asset to its recoverable amount, reflecting the actual market value of the asset. Additionally, the company should disclose the impairment loss in the notes to the financial statements.
Can an impaired asset be reversed?
Depending on the accounting standards followed by the company, the reversal of an impaired asset may or may not be allowed. Generally, under the International Financial Reporting Standards (IFRS), the reversal of an impaired asset is permitted if there is a change in the estimates used to determine the asset’s recoverable amount. However, under US Generally Accepted Accounting Principles (GAAP), the reversal of an impairment loss for long-lived assets is not allowed. Always consult your local accounting standards and guidelines to determine the appropriate treatment for impairment reversals.
Related Finance Terms
- Impaired Asset: An asset that has a market value lower than its carrying value on the balance sheet, leading to a potential loss for the company.
- Causes of Impairment: Factors such as obsolescence, physical damage, significant changes in market demand or legal regulations that negatively impact the asset’s value.
- Impairment Testing: A process of assessing whether the carrying value of an asset is recoverable through its future cash flows, by comparing the carrying value to the higher of either the fair market value less selling costs or the asset’s expected future cash flows (undiscounted).
- Impairment Loss Recording: If the carrying value of an asset is not recoverable, the difference between the carrying value and recoverable amount should be recorded as an impairment loss in the income statement.
- FASB & IASB Guidelines: The Financial Accounting Standards Board (FASB) and International Accounting Standards Board (IASB) provide guidelines on how to identify, test, and record impairments for financial reporting purposes, ensuring accurate and consistent financial statements.
