Impairment Of Assets

A firm asset, whether fixed or intangible, is said to be impaired when its value is decreased to reflect a loss in the asset's quality, quantity, or market value. An asset shouldn't be carried in your company's financial records at a value greater than the most you might possibly make from selling it, according to this accounting principle. An asset is considered "damaged" when its carrying amount is greater than its fair market value.

How does Impairment of Assets work?

The impairment of assets can be caused by a variety of circumstances. For instance, in addition to inadequate management, technical difficulties, and greater competition, any of the following elements may cause the asset's value to decrease:

  • Market downturn – The fair market value of an item may turn out to be less than its book value if the market declines. For instance, any land or property you possess as an asset may lose value if the real estate market faces a slump.
  • Change in legal climate – A litigation, court action, or some other alteration to the broader business/legal environment could also result in a decline in asset value. You might not be able to use the asset until the legal matter is settled, for instance, if a worker is hurt while using your equipment and sues your business.
  • Escalating costs – A situation where the ongoing expenditures to maintain an asset are higher than you anticipated when you made the initial investment, or when the ongoing costs have merely increased over time, could result in a decline in the asset's overall worth.

Impairment vs. Depreciation

Impairment is unanticipated harm. Wear and tear is called depreciation.

Fixed assets, like machinery and equipment, lose value over time. One of several accelerated depreciation methods or a straight-line method is used to calculate the amount of depreciation that will be taken during each accounting period.

Contrary to impairment, which accounts for an unexpected and significant decline in an asset's fair value, depreciation schedules permit a predetermined distribution of the reduction in value over the asset's lifetime.

For instance: Throughout the course of its useful life, a tractor loses value annually vs. When a tree falls and crushes a tractor, it results in an impairment that needs to be recorded as such.

Example of Impairment

Florida-based ABC Business paid $250,000 historically for a facility many years ago. The building has accrued depreciation of $100,000 after having taken a total of $100,000 in depreciation. On the balance sheet of the corporation, the building's carrying value, or book value, is $150,000.

The building sustains severe damage from a category 5 hurricane. The business decides that the circumstance is appropriate for impairment testing.

ABC Corporation determines the building is now only worth $100,000 after evaluating the damages. Due to the building's impairment, the asset value must be reduced in order to avoid overstating it on the balance sheet.

A debit entry is created for "Loss from Impairment" in the amount of $50,000 ($150,000 book value minus $100,000 determined fair value), which will be shown on the income statement as a reduction of net income.

A $50,000 credit is also made as part of the same entry to the asset account for the building in order to lower the asset's balance or to another balance sheet account known as the "Provision for Impairment Losses."

Conclusion

A unique or one-time occurrence, like a change in the law or the economy, a shift in customer demand, or damage that affects an asset, might result in impairment.

Regular asset impairment testing is necessary to avoid overstating assets on the balance sheet.

When an asset's fair value is lower than its carrying value on the balance sheet, impairment has occurred.

A loss due to impairment should be noted if testing confirms impairment.

The value of the impaired asset is devalued on the balance sheet and the income statement at the same time as an impairment loss is recorded.

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