Definition
Impairment in finance refers to a permanent decrease in the value of a company’s asset, such as equipment, inventory, or good will, to a point where it is below its carried cost or book value. It usually occurs when the future earnings from the asset are expected to be less than its current value. Impairments can be triggered by incidences such as changes in market value, physical damage to the asset, or adverse changes in the laws or business environment.
Key Takeaways
- Impairment refers to the diminishing in quality, strength amount, or value of an asset. It is generally the result of a sudden and unexpected damage or lessening in the worth of a particular resource.
- In financial accounting, an impairment is recognized when the carrying amount of an asset exceeds its recoverable amount. The carrying amount is the cost of the asset minus depreciation, and the recoverable amount is the present value of the expected future cash flows of the asset, or the amount that could be obtained from the sale of the asset.
- Once an impairment has been recognized, it cannot be reversed for that particular asset. This rule aims to prevent organizations from misusing the process to manipulate their financial statements and thus distort the true financial position of the organization.
Importance
Impairment in finance is a crucial concept because it helps to maintain accuracy and transparency in a company’s balance sheet.
It is a term used when the market value of an asset drops below the book value or carrying cost.
If an asset is deemed ‘impaired’, it may not generate enough income or cash flow in the future to cover its carrying cost, thereby overstating the company’s actual value.
Recognizing impairment losses aligns the reported value of assets with their realistic economic benefits, enabling better decision-making for management, investors, and other stakeholders.
It further ensures compliance with financial reporting standards and reflects the economic reality of assets, preventing misleading overstatements.
Explanation
Impairment is a critical concept in the financial world because of its core purpose: to ensure that companies accurately value their assets and report their financial condition. It is an accounting principle that guides organizations in evaluating their assets for unexpected value reductions. This is significant because businesses often have substantial investments in different kinds of assets, from physical ones like property and equipment, to intangible ones like goodwill and patents.
Over time, various factors might reduce these assets’ worth, affecting the company’s overall financial health. If these value drops are not identified and reported, it could lead to an inflated portrayal of a company’s financial stature, misleading investors and stakeholders. Impairment is primarily used for avoiding this misrepresentation.
It allows businesses to identify and write down the reduced values of their assets, ensuring that their financial statements provide a realistic and accurate picture of their financial status. By recognizing the reduced value of an asset, the process of impairment effectively decreases a company’s earnings in the income statement and overall asset values in the balance sheet. This helps in enhancing the transparency and fairness of the financial statements, thus promoting credibility and trust among investors, creditors, and other stakeholders.
In turn, this helps these parties make more informed financial and investment decisions.
Examples of Impairment
British Telecom’s Italian Scandal: In 2017, British Telecom (BT) took a pre-tax impairment hit of a whopping £530 million. This was following an accounting scandal at their Italian subsidiary, where revenues had been over-stated for several years. The impairment loss recognized by BT reflected the reduced recoverable amount of the Italian unit, given the impact of the scandal on its projected future cash flows.
General Electric (GE) goodwill impairment: In 2018, General Electric incurred a massive $23 billion impairment expense. The loss came from devaluing goodwill (an intangible asset that arises when one company acquires another for a price higher than the fair market value of its assets and liabilities) associated with its power business, which had been struggling with structural and market challenges.
HSBC’s Impairment Due to Coronavirus: In 2020, amidst the coronavirus pandemic, HSBC bank set aside up to $11 billion for loan losses, reflecting expectations of a steep rise in bad loans. This anticipated impairment was a direct result of the financial fallout from the COVID-19 pandemic, as many borrowers struggled to ensure repayment of the loans due to economic instability.
FAQs on Impairment
1. What is Impairment?
Impairment refers to a significant reduction in the recoverable amount of a fixed asset or group of assets that management has determined to be below its carrying amount on the balance sheet.
2. What causes Impairment?
Impairment can occur as a result of a variety of factors, such as significant changes in the market, technology changes, increase in market interest rates, physical damage, legal restrictions, and bad management decisions.
3. How is Impairment recognized?
Impairment is recognized by reducing the carrying amount of the asset on the balance sheet and recognizing the impairment loss in the income statement.
4. What is the impact of Impairment?
Impairment reduces the value of assets in a company’s balance sheet and this reduction is also recognized as an expense in the income statement, which directly reduces net income for the period.
5. Is Impairment a non cash expense?
Yes, impairment is a non cash expense as it does not result in any cash outflow. However, it reduces the company’s net income and therefore the earnings available to its shareholders.
6. What is impairment loss?
Impairment loss is the amount by which the carrying amount of an asset exceeds its recoverable amount. It is recognized in the income statement and directly reduces net income for the period.
Related Entrepreneurship Terms
- Amortization
- Depreciation
- Asset Valuation
- Non-Performing Assets
- Write-down
Sources for More Information
- Investopedia: A trusted online resource offering definitions of financial terms including Impairment.
- IAS Plus: A comprehensive source of information about international financial and accounting standards.
- Accounting Tools: This site provides free information and resources on accounting, finance, and operations topics including Impairment.
- Financial Accounting Standards Board (FASB): The official site of the organization that establishes financial accounting and reporting standards for public and private companies and non-profit organizations in the United States.
