Impairment: Overview, definition, and example
What is impairment?
Impairment refers to a reduction in the value of an asset, typically due to unforeseen changes in market conditions, physical damage, or other factors that cause the asset to lose its original value. In accounting, impairment is recognized when the carrying value of an asset exceeds its recoverable amount, meaning the asset is no longer worth as much as it was originally recorded. Impairment can apply to various types of assets, including property, equipment, goodwill, and financial assets. When impairment occurs, businesses are required to write down the value of the asset to reflect its lower market or recoverable value.
Why is impairment important?
Impairment is important because it ensures that financial statements accurately reflect the current value of a company's assets. Without recognizing impairment, a company could overstate its asset values, which could mislead investors, creditors, or regulators. Recognizing impairment helps to ensure transparency and financial accuracy, making it easier for stakeholders to assess the financial health of a business. Additionally, identifying and addressing impairment can prevent companies from holding onto non-performing or overvalued assets, encouraging better decision-making and financial management.
Understanding impairment through an example
For example, a company owns a piece of machinery that was originally purchased for $100,000. Over time, due to technological advances, the machinery becomes outdated and less efficient, reducing its market value. If the company determines that the recoverable value of the machinery is now only $60,000, it would recognize an impairment loss of $40,000, adjusting the asset’s carrying value on its balance sheet to reflect the current market conditions.
In another example, a company has a patent (intangible asset) that it purchased for $500,000. However, after a new competitor enters the market with a better technology, the company’s patent loses its value. The company must assess the recoverable amount of the patent and may find that it is now only worth $200,000. The company would then recognize an impairment loss of $300,000, reducing the carrying value of the patent.
An example of an impairment clause
Here’s how an impairment clause might appear in a contract or financial statement:
“The Company shall assess the carrying value of its assets at the end of each fiscal year. If any asset is determined to be impaired, the Company shall record an impairment loss in accordance with applicable accounting standards and reduce the carrying value of the asset accordingly.”
Conclusion
Impairment is a key concept in accounting and financial reporting, ensuring that assets are accurately valued and financial statements reflect the true worth of a company’s holdings. Recognizing impairment helps maintain the integrity of financial reporting, preventing overstatements of asset values that could mislead stakeholders. It also encourages companies to reassess and adjust their asset portfolios, ensuring that non-performing or underperforming assets are properly valued.
This article contains general legal information and does not contain legal advice. Cobrief is not a law firm or a substitute for an attorney or law firm. The law is complex and changes often. For legal advice, please ask a lawyer.