In a business, the value of an asset doesn’t remain constant. Due to market fluctuations, it either goes up or down. The assets help in making the business profitable. However, these assets may depreciate over time and cause impairments. Impaired asset gives managers, investors, and financial institutions more accurate information about the financial health of a company.
Therefore, you can manage a company’s financial statements more effectively if you comprehend impairment in accounting and its standards. In the following post, we will talk about impairment in accounting, cover its working, benefits, and much more.
What is an Impaired Asset?
The asset can be tangible or intangible. To understand the impairing of an asset, you must first know the market value and book value.
- Market value is the selling price of an asset presently in the market.
- On the contrary, the book value is the amount you are paying for an asset after subtracting the depreciation.
So, when the market value of an asset falls below the book value, it will be considered an impaired asset. Thus, it will be sold at a lower price than its actual worth.
It is alternatively known as “writing off” an asset. The company must book the new amount in its balance sheet by calculating the difference. For the business prospect, it becomes important to record the asset impairment if you are expecting that the asset value is not going to recover.
Impairment in accounting states that an asset whose value is severely crashing and the business cannot recover the initial value even after selling it should not be carried forward in your financial statements.
The impairment losses in your business help in keeping track of profit and loss. To account for impairment losses, the accounting team should compare the highest selling amount and a book value of an asset before declaring it an impaired asset.
Signs of Asset Impairment
Financial asset impairment might be difficult to identify. Here are a few indicators of asset impairment
- There is a notable decline in the market value.
- Change in market trends.
- Lesser use of assets.
- The particular asset causes losses in cash flow.
- New innovations cause a reduction in the value of the asset.
Why is it Important?
Assets are represented on the balance sheet at their fair market value. The approach provides stakeholders with a more accurate financial representation of a company’s assets.
The loss of sales when an asset is sold can also be mitigated through asset impairment. According to generally accepted accounting principles (GAAP) in the United States, the impairment limit is generally reached when the owner cannot recover the net carrying amount or book value.
So, when an asset is continuously depreciated at a rate that is too low, its book value will be higher than its market value, and over time, this discrepancy will widen. Therefore, the company will gain a large loss when the asset is sold at the market value after several years.
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Asset Depreciation vs. Asset Impairment
Depreciation and impaired asset are very much similar. However, there is a key difference. Basically, impairment is an irreversible drop in the value of an asset.
- Impairment typically involves a sudden and sharp decline in value, whereas depreciation is the decrease in market value brought on by everyday wear and tear. You can anticipate depreciation.
- The impairment concept applies to tangible and intangible assets. On the other hand, depreciation applies to fixed assets only.
- Businesses record both differently on the balance sheet. Impairment doesn’t count as tax-deductible expenses, whereas depreciation is.
How to Calculate Impairment Loss?
Step 1: Calculate the asset’s depreciation
- Firstly, you have to calculate the depreciation cost of an asset. So, if you have an asset whose purchase value is $50000 and it can last for 10 years.
- The depreciation cost will be equal to the purchase price divided by the number of years. Then the depreciation rate will be $5000 per year.
- Now, if you want to calculate depreciation cost after 4 years, then it will be 20,000.
Step 2: Calculate the asset’s carrying cost
The carrying cost will be equal to purchasing cost minus the total depreciation.
Therefore, according to our example,
Carrying cost = $50,000 – $20,000 = $30,000.
The carrying cost is $30,000.
Step 3: Calculate the asset’s recoverable value
In the next step, you have to determine the recoverable amount after selling the asset.
Recoverable value = fair market value – cost to sell.
Let’s say it will cost $10,000 to sell the car.
Therefore, the recoverable value = $30,000 – 10,000 = $20,000.
Step 4: Calculate the impairment loss
Finally, calculate the impairment loss.
Impairment loss = carrying cost – recoverable amount.
$30,000 – 20,000 = 10,000
It is what you write in your balance sheet as your impairment.
Advantages and Disadvantages of Asset Impairment
Here are some advantages of asset impairment.
- Impaired asset accounting provides investors and analysts with a method to evaluate the business. It helps them in decision-making.
- If you accurately record your books with asset impairment, you will save a big chunk of money.
- It can serve as early warning signs for investment research.
Here are some disadvantages of impairment of asset
- Mostly, it can be challenging to spot the symptoms of impairment when assets lose value for illogical causes, such as a decline in market demand or something else less obvious.
- Moreover, it can be challenging to determine the precise loss amount when impairments affect a company’s assets.
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Frequently Asked Questions
What is impairment of assets?
The impairment of an asset occurs when the market value of an asset suddenly drops below the book value, and it is not recoverable anymore. It is different from depreciation
How does the asset impairment work?
The asset impairment arises due to the following reasons:
● When you are unable to use the asset.
● There is a decrease in the demand for the asset.
● There are changes in the trend.
● When you are facing legal challenges.
How to record an impairment of assets?
To determine whether an asset is impaired, subtract its fair market value from the asset’s carrying value. Here, the carrying value is equal to its historical cost minus accumulated depreciation. You must record an impairment loss to reflect the discrepancy if the asset’s fair market value is less than its book value.
How accounting for the impairment of assets is beneficial?
Impaired asset accounting provides a wider picture of business performance to the stakeholders and prevents the business from making bigger losses. It helps the stakeholders to make more strong and more accurate decisions.