What Is an Asset Impairment?
An impairment loss takes place when a company makes the judgment call that the carrying value of an asset on the company balance sheet is less than fair value, which is what an unpressured person would pay for the asset in an open marketplace. If the impairment loss isn’t recoverable, under U.S. generally accepted accounting practices (GAAP), the company has to adjust the books to reflect this lessening in value.
Be careful not to confuse asset impairments with the lower of cost or market method for valuing inventory. They are two different accounting events.
Now, you may be wondering about the criteria for measuring recoverability. Good question! In a nutshell, it means the asset’s carrying value isn’t recoverable from its undiscounted cash flows. Now, that’s clear, is it not? Not!
When the carrying value of an asset or group of assets, such as an operating segment, is more than its fair value, the company may have an impairment event on its hands.
U.S. GAAP in Accounting Standards Codification (ASC) 360-10-35 provides guidance to financial accountants on the type of events and circumstances to look for, as the first step in determining whether assets have to be evaluated for recovery and subsequent impairment loss.
Every GAAP guide discusses six biggies. However, this list doesn’t include all the events that can trigger the need to test for impairment:
Market downturn: The market or market price of a long-lived asset experiences a significant downturn. For example, the company is holding a piece of raw land to develop whose fair value is currently less than cost.
Change in use of asset: An event such as a natural disaster causes an adverse change in the manner in which a long-lived asset is used or changes its condition.
Change in business or legal climate: A lawsuit or other adverse change in the general business or legal climate affects the value of the asset. Maybe a factory has been deemed unsafe and can’t be used for production until improvements are made.
Premature disposal of asset: The company plans to dump an asset significantly before the end of its previously estimated useful life.
Escalating costs: Costs to build or acquire an asset start to pile up and are significantly more than the company originally estimates.
Souring investments: History of operating or cash flow losses demonstrates that the company will experience continuing losses from using the asset.
If a company has goodwill, which comes into play during business combinations when one business purchases another for a price greater than the fair market value of the net assets acquired during the sale, there’s an annual requirement to test it for impairment.