What is an impaired asset?
An impaired asset is an asset whose market value is less than the value reported on the company’s balance sheet. When an asset is considered to be impaired, it must be written down to its current market value on the company’s balance sheet.
The central theses
- Assets should be reviewed regularly for impairment to avoid overvaluing them on the balance sheet.
- The assets that are most likely to be impaired include trade receivables and non-current assets such as intangible assets and property, plant and equipment.
- When the value of an impaired asset is written down on the balance sheet, a loss is also recorded in the income statement.
How impaired assets work
An asset is impaired when its projected future cash flows are less than its current book value. An asset may be depreciated due to materially adverse changes in legal factors that have changed the value of the asset, material changes in the market price of the asset due to a change in consumer demand or damage to its physical condition. Another indicator of potential impairment is when an asset is likely to be sold before the originally estimated sale date. Assets that are likely to be impaired are the company’s receivables, goodwill and fixed assets.
Long-term assets such as intangible assets and property, plant and equipment are particularly at risk because the book value is depreciated over a longer period of time.
Assets are regularly tested for impairment to ensure that the company’s total asset value is not overestimated on the balance sheet. In accordance with generally accepted accounting principles (GAAP), certain assets, such as goodwill, should be audited annually. GAAP also recommends that companies consider events and economic circumstances that occur between annual impairment tests to determine whether the fair value of an asset is “more than likely” to have fallen below its carrying amount.
An impairment should only be recognized if the expected future cash flows are irrecoverable. When the carrying amount of an impaired asset is written down to market value, the loss is recognized in the company’s income statement for the same accounting period.
Accounting for impaired assets
The total value of an impairment loss in dollars is the difference between the asset’s book cost and the lower fair market value of the item. The journal entry used to record an impairment is a debit to a loss or expense account and a credit to the related asset. For the credit, a countervalue reduction account can be used, which has a balance against the associated asset account, in order to keep the historical acquisition costs of the asset in a separate item. In this situation, the net of the asset, its accumulated depreciation and the countervalue adjustment account will reflect the new book cost.
When the impairment is recognized, the asset has reduced book costs. In future periods the asset will be accounted for at its lower book cost. Even if the fair value of the impaired asset returns to its original level, GAAP requires that the impaired asset be recognized at the lower, adjusted dollar amount. This corresponds to conservative accounting principles. Any increase in value is recognized when the asset is sold.
Standard GAAP practice is to test fixed assets for impairment at the lowest possible level when there are identifiable cash flows. For example, an automobile manufacturer should test for impairment on each of the machines in a manufacturing facility, not the parent facility itself. However, if there are no identifiable cash flows at this low level, it is acceptable to test for impairment at the asset class or company level. If an asset group experiences a decrease in value, the adjustment is spread across all assets within the group. This breakdown is based on the current book cost of the assets.
Depreciation of assets vs. depreciation of assets
Fixed assets are regularly depreciated in order to take into account the typical wear and tear of the object over time. The depreciation amount in each accounting period is based on a predetermined schedule, using either straight-line depreciation or one of several accelerated depreciation methods. Depreciation is different from depreciation, which is recognized as a result of a one-off or unusual decrease in the market value of an asset.
If a fixed asset is impaired, the periodic depreciation amount will be adjusted in future. Retrospective changes are not required to adjust the previous depreciation that has already been carried out. However, depreciation expenses are recalculated for the remaining useful life of the asset based on the new carrying amount of the impaired asset at the time of the impairment.
Real-world example of an impaired asset
In 2015, Microsoft recognized impairment losses on goodwill and other intangible assets related to the acquisition of Nokia in 2013. Microsoft initially recorded goodwill related to the acquisition of Nokia of $ 5.5 billion. The book value of this goodwill, and thus all of the assets shown on Microsoft’s balance sheet, was overestimated compared to the actual market value. Unable to take advantage of the potential benefits in the wireless business, Microsoft made an impairment loss.