Impairment

Impairment Carrying Amount Fair Market Value Accounting Principles Financial Reporting Asset Valuation Diminution of Value Financial Statements
Impairment is an accounting principle that outlines the process of reducing the book value of an asset when its fair market value drops below the asset's carrying amount on the balance sheet. It is a critical concept in financial reporting that ensures that the value of assets is not overstated in an organization's balance sheet.
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Impairment in Detail

Impairment refers to the recognition that an asset’s market value has fallen below its recorded book value. This may occur due to various factors, including obsolescence, market changes, or physical damage. Impairment helps to maintain the accuracy and reliability of financial statements by ensuring assets are not overstated.

Examples

  1. Goodwill Impairment: If a company acquires another business and the acquired business underperforms, causing its projected earnings to be lower than expected, the goodwill might need to be written down to reflect the new reality.
  2. Asset Impairment: A manufacturing plant’s machinery might be impaired if it becomes obsolete due to new technology or if it’s damaged in an unforeseen event like a fire or flood.
  3. Intangible Asset Impairment: A company holds a patent for a product that was anticipated to generate revenue, but due to new market competition, the product no longer meets sales expectations. The patent would need to be impaired to reflect its diminished value.

Frequently Asked Questions

1. How is impairment different from depreciation?

  • Impairment is a sudden decrease in the recoverable amount of an asset below its carrying value, whereas depreciation is a systematic allocation of the cost of an asset over its useful life.

2. What triggers an impairment test?

  • Events such as market declines, adverse changes in the business climate, legal changes, or physical damage to an asset can trigger an impairment test.

3. How is the impairment loss measured?

  • The impairment loss is measured as the amount by which the carrying amount of an asset exceeds its recoverable amount. The recoverable amount is the higher of the fair value less costs of disposal and its value in use.

4. Can impairment losses be reversed?

  • Under IFRS, impairment losses (other than goodwill) can be reversed if there’s an indication that the impairment no longer exists or has decreased. Under US GAAP, reversal of impairment losses is generally prohibited.

5. What is the impact of impairment on financial statements?

  • Impairment losses are typically recognized as an expense on the income statement, which reduces net income. On the balance sheet, the asset’s book value is reduced by the amount of the impairment loss.
  • Carrying Amount: The amount at which an asset is recognized on the balance sheet, after deducting accumulated depreciation and accumulated impairment losses.
  • Fair Market Value: The estimated price at which an asset would trade in a competitive auction setting.
  • Depreciation: The systematic allocation of an asset’s cost over its useful life.
  • Goodwill: An intangible asset that arises when a buyer acquires an existing business, representing the value of the business’s reputation, customer base, and other non-physical assets.

Online Resources

Suggested Books for Further Studies

  • “Intermediate Accounting” by Donald E. Kieso, Jerry J. Weygandt, and Terry D. Warfield: Offers in-depth explanations and examples related to impairment and other complex accounting topics.
  • “Financial Reporting and Analysis” by Charles H. Gibson: Provides comprehensive insights into financial reporting practices, including impairment.
  • “Wiley GAAP 2021” by Joanne M. Flood: A guide to Generally Accepted Accounting Principles with detailed sections on impairment and other relevant standards.

Accounting Basics: “Impairment” Fundamentals Quiz

### What does impairment indicate in accounting? - [x] A decrease in the recoverable amount of an asset below its carrying value - [ ] The systematic allocation of an asset's cost - [ ] An increase in the value of an asset - [ ] Annual maintenance of the asset > **Explanation:** Impairment in accounting indicates that the recoverable amount of an asset has fallen below its carrying value and thus, needs to be adjusted on the financial statements. ### Can impairment losses be reversed under US GAAP? - [ ] Yes, always - [ ] Only for intangible assets - [x] Generally not reversible - [ ] Reversible with regulatory permission > **Explanation:** Under US GAAP, impairment losses are generally not allowed to be reversed in later periods. ### Which financial statement is directly impacted by recognizing an impairment loss? - [x] Income Statement - [ ] Cash Flow Statement - [ ] Statement of Retained Earnings - [ ] Statement of Changes in Equity > **Explanation:** Recognizing an impairment loss impacts the income statement because it is recorded as an expense, reducing net income. ### What triggers an impairment test? - [ ] Receiving a new business loan - [ ] Positive market changes - [x] Adverse business climate changes - [ ] Quarterly earnings report > **Explanation:** An impairment test is typically triggered by adverse changes in the business climate, market declines, or damage to an asset, among other factors. ### What is used to measure the impairment loss? - [ ] The initial purchase price of the asset - [ ] The historical cost minus accumulated depreciation - [x] The amount by which the carrying amount exceeds the recoverable amount - [ ] The original estimated useful life > **Explanation:** Impairment loss is measured as the excess of the carrying amount of an asset over its recoverable amount. ### What are the two components used to determine the recoverable amount? - [ ] Fair market value and original cost - [x] Fair value less costs of disposal and value in use - [ ] Net book value and replacement cost - [ ] Historical cost and amortized cost > **Explanation:** The recoverable amount is determined by the higher of fair value less costs of disposal and value in use. ### How often must assets be tested for impairment according to IFRS? - [x] At least annually and whenever there is an indication of potential impairment - [ ] Every six months - [ ] Only upon acquisition - [ ] Only at the end of each fiscal year > **Explanation:** According to IFRS, assets must be tested for impairment at least annually or whenever there is an indication that the asset might be impaired. ### How is impairment recorded in financial statements? - [ ] As an increase in asset value - [x] As an expense reducing net income - [ ] By adjusting the asset's original purchase price - [ ] As other comprehensive income > **Explanation:** Impairment is recorded as an expense in the income statement, which reduces net income. ### What is the primary difference between impairment and depreciation? - [ ] Impairment occurs systematically, whereas depreciation does not - [ ] Depreciation increases the book value of an asset - [x] Impairment is a sudden decrease below book value, while depreciation is systematic over time - [ ] Impairment applies to land only > **Explanation:** Impairment is a sudden decrease in the recoverable amount of an asset below its carrying amount, whereas depreciation is a systematic allocation of an asset's cost over its useful life. ### When would an impairment test not be necessary? - [x] When there are no indications of impairment and the asset has not decreased in value - [ ] When the asset is fully depreciated - [ ] After selling part of the asset - [ ] When market values are rising > **Explanation:** An impairment test is generally not necessary if there are no indications of impairment and there is no evidence suggesting that the asset's carrying amount exceeds its recoverable amount.
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