Impaired Asset: Meaning; Causes; How To Test; and How To Record

Introduction

Impaired assets are a common concern in the world of finance. They can have a significant impact on a company's financial health and can even lead to bankruptcy in extreme cases. In this article, we will explore the meaning of impaired assets, the causes behind their impairment, how to test for impairment, and how to record them. By understanding these concepts, individuals and businesses can make informed decisions to mitigate the risks associated with impaired assets.

What is an Impaired Asset?

An impaired asset refers to an asset that has a reduced value compared to its original cost or carrying amount. This reduction in value can occur due to various factors, such as changes in market conditions, technological advancements, legal issues, or poor asset management. When an asset is impaired, its future cash flows are expected to be lower than initially anticipated.

Impaired assets can be tangible, such as buildings, machinery, or inventory, or intangible, such as patents, trademarks, or goodwill. Regardless of the type of asset, impairment can have a significant impact on a company's financial statements and overall financial performance.

Causes of Asset Impairment

There are several causes that can lead to asset impairment. Understanding these causes is crucial for identifying potential risks and taking appropriate measures to mitigate them. Some common causes of asset impairment include:

• Changes in market conditions: Fluctuations in supply and demand, changes in consumer preferences, or economic downturns can all lead to a decrease in the value of assets.
• Technological advancements: Assets that become obsolete due to technological advancements can quickly lose their value. For example, a company manufacturing VHS tapes would face impairment as consumers shift to digital streaming.
• Legal issues: Lawsuits, regulatory changes, or changes in intellectual property rights can all impact the value of assets. For instance, a patent infringement lawsuit can lead to the impairment of a company's intellectual property.
• Poor asset management: Inadequate maintenance, improper utilization, or inefficient operations can all contribute to asset impairment. For example, a company that fails to maintain its machinery may experience a decrease in its value over time.

Testing for Asset Impairment

Testing for asset impairment is a crucial step in identifying and quantifying the impairment loss. Companies typically follow a systematic approach to assess the recoverability of their assets. The most common method used is the impairment test, which involves comparing the carrying amount of the asset with its recoverable amount.

The recoverable amount is the higher of an asset's fair value less costs to sell or its value in use. Fair value refers to the price that would be received to sell the asset in an orderly transaction between market participants. Value in use, on the other hand, is the present value of the asset's expected future cash flows.

If the carrying amount of the asset exceeds its recoverable amount, the asset is considered impaired, and an impairment loss must be recognized. The impairment loss is calculated as the difference between the carrying amount and the recoverable amount.

Recording Impairment Loss

Once an asset is deemed impaired, it is necessary to record the impairment loss in the financial statements. The impairment loss is recognized as an expense in the income statement and reduces the carrying amount of the asset in the balance sheet.

The impairment loss is typically recorded as a separate line item in the income statement, below operating profit. This allows stakeholders to understand the impact of impaired assets on the company's financial performance.

It is important to note that impaired assets cannot be subsequently revalued upwards. Once an impairment loss is recognized, the carrying amount of the asset cannot be increased in the future, even if its value recovers.

Example Case Study: Impairment of Goodwill

Let's consider a case study to illustrate the impairment of goodwill, an intangible asset. Company XYZ acquired Company ABC for $10 million, which included $2 million of goodwill. However, due to changes in market conditions and poor financial performance, Company XYZ determines that the goodwill is impaired.

Company XYZ performs an impairment test and determines that the recoverable amount of the goodwill is only $1.5 million. As a result, an impairment loss of $0.5 million ($2 million – $1.5 million) is recognized in the income statement. The carrying amount of the goodwill is reduced to $1.5 million in the balance sheet.

Summary

Impaired assets can have a significant impact on a company's financial health and performance. Understanding the meaning of impaired assets, the causes behind their impairment, how to test for impairment, and how to record them is crucial for individuals and businesses alike.

By identifying potential risks and taking appropriate measures to mitigate them, companies can minimize the impact of impaired assets on their financial statements. Regularly testing for impairment and recognizing impairment losses in a timely manner ensures that financial statements accurately reflect the true value of assets.

Remember, impaired assets cannot be subsequently revalued upwards, so it is essential to stay vigilant and proactive in managing and monitoring assets to avoid potential impairment.