Impairment of assets occurs when the recoverable amount of an asset falls below its carrying value on the balance sheet. This means that the asset has lost value and must be written down to reflect its fair market worth. Recognizing and accounting for impairment is crucial to ensure financial statements present an accurate picture of a company’s assets and financial health.
An asset is impaired when its market value or the benefits it can generate in the future are less than its recorded book value. Impairment can happen due to:
🔹 Changes in market conditions (e.g., a decline in demand for a company’s products)
🔹 Physical damage to the asset (e.g., fire, accidents, or obsolescence)
🔹 Regulatory changes (e.g., new laws making certain assets unusable)
🔹 Declining business performance (e.g., cash flows from an asset are lower than expected)
Companies must regularly assess whether their assets have lost value. Under accounting standards like GAAP and IFRS, impairment testing is usually required when there is an indicator of impairment, such as:
✅ A significant drop in market value
✅ A major change in business operations
✅ A decline in profitability from the asset
✅ Evidence of damage or obsolescence
To determine if an asset is impaired, companies compare its carrying value (book value on the balance sheet) to its recoverable amount.
📌 Recoverable Amount = Higher of:
Fair Value Minus Selling Costs → The price the asset would fetch in the market, minus selling expenses.
Value in Use → The present value of expected future cash flows from the asset.
If the recoverable amount is lower than the carrying value, the company must recognize an impairment loss.
When impairment is confirmed, the company reduces the asset's value and records a loss on the income statement.
📌 Journal Entry for Impairment Loss:
Dr. Impairment Loss $10,000
Cr. Asset Account $10,000
This entry reduces the asset’s value by $10,000 and recognizes the loss in financial statements.
Under IFRS, if an asset's value later recovers, the impairment loss can be partially or fully reversed (except for goodwill).
Under GAAP, impairment losses cannot be reversed once recorded.
📌 Reversal Entry (IFRS Only):
Dr. Asset Account $5,000
Cr. Impairment Recovery $5,000
This restores part of the asset’s value and increases earnings.
💡 Example 1: Machinery Impairment
A company purchases machinery for $50,000, but due to technological advancements, it can only be sold for $30,000. If its value in use is $28,000, the recoverable amount is $30,000. Since the book value is higher than $30,000, the company records an impairment loss of $20,000.
💡 Example 2: Goodwill Impairment
A company acquires a competitor and records $1 million in goodwill. However, if the acquired business underperforms, goodwill must be tested for impairment. If the business is now worth $700,000, an impairment loss of $300,000 is recorded.
✔ Ensures financial statements are accurate and assets are not overstated
✔ Prevents misleading investors by reducing overvalued assets
✔ Complies with accounting standards (GAAP and IFRS)
✔ Helps management make better business decisions based on real asset values
Impairment of assets is a crucial accounting process that ensures a company's balance sheet reflects the true economic value of its assets. By conducting regular impairment tests, businesses can avoid overstating assets, comply with financial regulations, and make informed strategic decisions.