An impairment in accounting is when the carrying value of an asset exceeds its recoverable amount. This can happen when the asset's value has declined due to lack of use, physical damage, or economic conditions. In this situation, the asset is written down to its recoverable amount, and a loss is recorded on the company's financial statements.
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An impairment loss is a difference between an asset's book value and its market value. Your books must be updated to reflect the new amount by writing off the difference.
Understanding Impairment with An Example
In accounting, impairment indicates that an asset has become less valuable to a company and may be headed for obsolescence. For example, if a company's factory machinery is more than 50 years old, it is likely to be impaired. When accounting for impairment, companies must write down the asset's value on their balance sheets, and this write-down is an expense that reduces the value of shareholders' equity.
Although impairment in accounting is a relatively new concept, it has quickly become an essential part of financial reporting. Companies must now consider whether their assets are impaired or not and, if so, how to account for the impairment.
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Types of Impairment
There are two types of impairment:
1. Credit impairment:
This is when the value of asset declines due to credit risk. Credit risk is the risk that a borrower will default on their loan payments.
2. Market impairment:
This is when the value of asset declines due to market conditions. Market conditions can include interest rates, economic recession, or changes in consumer demand.
The loss is recorded on the company's income statement when an asset is impaired. It is calculated by subtracting the asset's recoverable amount from its carrying value, and the carrying value is the amount the asset is currently worth.
There are a few reasons why an impaired asset matters:
- When an asset is impaired, it means that it is not able to generate the expected cash flows. This can make it difficult for a company to meet its financial obligations.
- An impaired asset can also lead to a write-down of the asset's value, which can impact the company's financial statements.
- An impaired asset can signal to investors that the company is not in good financial health, which can impact the company's stock price.
Factors Affecting Impairment of Asset
The value of the asset could decline if any of the following factors occur:
1. The Asset may be Overvalued.
This means that the asset's market value may be less than what is stated on the balance sheet. It happens for several reasons, such as if the asset is new and there is not yet a market for it or if the investment is unique and has few comparable assets.
2. The Company may have Financial Problems.
This means that the company may be in debt or may not have enough cash to meet its obligations. It happens for several reasons, such as if the company has taken out loans it cannot afford to repay or has made poor financial decisions.
3. The Company may have Poor Management.
This means that the company may be poorly run and not have good policies or procedures. This happens if the company is new and lacks experienced managers or is in a rapidly changing industry and cannot keep up with the competition.
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Significance of Impairment
Impairment can happen gradually, as when machinery wears out over time, and it can also occur suddenly, as when a natural disaster destroys a factory. In either situation, the key is that the asset is no longer as valuable to the company as it once was.
Accounting for impairment is essential because it provides a more accurate picture of a company's financial condition. When an asset is impaired, its value on the balance sheet should reflect its current value, not its historical cost, and this gives investors a better idea of what the company is worth.
Impairment can majorly impact a company's financial statements. For example, suppose a company has a factory that it bought for ₹8,50,00,000, and the factory is now worth only ₹4,55,00,000. If the company does not account for impairment, it will continue to show the factory on its balance sheet at ₹8,50,00,000, which overstates its assets and equity.
Also, if the company accounts for impairment, it will write down the value of the factory to ₹4,55,00,000, and this will reduce the company's assets and equity by ₹3,95,00,000.
In either case, impairment hurts a company's financial condition, and investors need to be aware of this when evaluating a company.
Indicators of Impairment Test.
The indicators of the impairment test help determine whether an asset is impaired and needs to be written down. An asset is impaired if its carrying value is more significant than its recoverable value.
There are two main types of indicators of impairment:
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Financial Indicators
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Physical Indicators
Economic or Financial indicators include declining sales, declining margins, and increasing debt levels. In contrast, physical indicators include obsolescence, damage, and deterioration.
The company must write down the asset to its recoverable value if an asset is impaired. The recoverable value is the higher the asset's fair value, fewer costs to selling or its value in use.
The indicators of the impairment test are an essential part of accounting because it ensures that assets are not overvalued on the balance sheet. And if not noted in accounts, it gets challenging to sell the asset, or if the company goes bankrupt and the asset needs to be liquidated.
Advantages of Impairment
1. The impairment accounting method provides financial statements that more accurately reflect the total value of an organisation's assets. This is because impairment accounting requires that the value of an asset be reduced to reflect its estimated fair value rather than its historical cost. This helps in the more accurate portrayal of an organisation's financial position.
2. The impairment accounting method allows better matching of expenses to revenues. It is because expenses are recognised when they are incurred rather than when the asset is sold, providing a more accurate picture of an organisation's overall financial performance.
3. The impairment accounting method is more conservative in accounting for assets. It's because the value of an asset is reduced to reflect its estimated fair value rather than its historical cost. This change in accounting methods results in a more accurate portrayal of an organisation's financial position.
4. The impairment accounting method also recognises the actual value of assets in the event of a sale or other disposition. Then the value of an asset is reduced to reflect its estimated fair value rather than its historical cost. The shift in accounting methods has been an accurate outcome for the financial situation of a company.
Also read: What Are Different Types of Accounting Explained With Examples & Importance
Disadvantages of Impairment
1. Impairment can result in overstated assets and income if the impairment charge is not reversed in future periods. This can lead to investors overpaying for the company's stock and creditors demanding higher interest rates.
2. Impairment can create accounting and tax complexities because the tax rules for deducting impairment charges differ from the accounting rules, and this can create confusion and potentially result in errors.
3. Impairment can be challenging to measure, particularly for intangible assets, because there is no clear market value. This can lead to estimation errors and disputes between management and shareholders about the appropriate level of impairment.
Impairment & Depreciation:
Depreciation is an accounting method used to allocate the cost of a fixed asset over its useful life and to account for declines in value. Impairment is a permanent reduction in the value of an asset below its carrying value. An impairment loss is recognised when the asset's carrying value exceeds its fair value. For example, if a company's factory has a carrying value of ₹8,50,00,000, but it's fair value is only ₹4,55,00,000, the factory is considered impaired, and the company would recognise a ₹3,95,00,000 impairment loss.
Impairment & Amortisation
Amortisation spreads a loan into a series of fixed payments over time. You'll pay off the loan's interest and principal in different monthly amounts, although your total cost remains equal each period.
Impairment, on the other hand, is a sudden, one-time loss. An impairment charge is an accounting entry that reduces the value of an asset on a company's balance sheet. This reduction in value is usually due to the asset no longer being able to generate the same amount of revenue as it did in the past. For example, if a company's factory is destroyed in a natural disaster, the company would record an impairment charge for the loss of the factory.
GAAP Requirements for Impairment
Under U.S. GAAP requirements, an impairment charge is required when the carrying value of an asset exceeds its fair value. Fair value can be determined using one or more of the following methods:
1. The market approach uses observable market data to estimate the fair value of an asset.
2. The income approach estimates the fair value of an asset based on its expected future cash flows.
3. The cost approach estimates the fair value of an asset based on its replacement cost.
4. The present value of expected future cash flows method estimates an asset's fair value by discounting its expected future cash flows at a rate that reflects the asset's risk.
GAAP Requirements in India for Impairment
The Companies Act, 2013, and the accounting standards notified that it requires companies to carry out an impairment assessment at the end of every accounting year.
To determine whether an impairment charge is required, companies need to compare the carrying value of an asset with its recoverable amount. The recoverable amount is the higher an asset's fair value, fewer costs to selling, and its value in use.
Value in use is the present value of the future cash flows expected to be generated by the asset. If the asset's carrying value exceeds its recoverable amount, the financial statements must recognise an impairment charge.
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Conclusion
In recent years, several high-profile cases of impairment losses have been recognised by Indian companies. For example, in 2016, Tata Motors recognised an impairment loss of ₹27.58 billion (US$420 million) on its investment in Jaguar Land Rover. In 2017, Reliance Communications recognised an impairment loss of ₹24.55 billion (US$380 million) on its investment in Reliance Jio.
These examples illustrate the potential impairment losses to have a material impact on a company's financial statements. Impairment losses can be difficult to predict and can often come as a surprise to investors. For this reason, it is essential for investors to be aware of the accounting for impairment and to carefully consider the carrying value of goodwill when assessing a company's financial position.
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