IMPAIRMENT

Definition

Impairment is a reduction in the recoverable value of an asset below its carrying amount on the balance sheet. When an asset's fair value falls below its book value and is unlikely to recover, the company must write down the asset, recognizing an impairment loss in its financial statements.

Origins

The term "impairment" comes from the Latin impedire, meaning "to hinder or diminish." In financial accounting, it gained traction through international standards like IFRS and US GAAP, where strict guidelines were introduced to prevent overstating asset values.

Usage

Impairment is relevant in:

• Financial Reporting: Required under IFRS (IAS 36) and US GAAP (ASC 360, ASC 350).

• Mergers & Acquisitions: Especially for testing goodwill after business combinations.

• Auditing: Auditors check whether impairments are properly recognized and disclosed.

• Credit Analysis: Analysts look at impairment losses to assess asset quality and risk.
  
  

How Impairment Works

1. Asset Evaluation

At each reporting date, the company assesses whether there are indicators of impairment, such as:

• A significant decline in market value.

• Adverse changes in the economic or legal environment.

• Physical damage or obsolescence.

• Poor performance of the asset or associated cash-generating unit (CGU).

2. Recoverable Amount

Impairment is recognized when:

$$\text{Carrying Amount}>\text{Recoverable Amount}$$

Where:

• Carrying Amount is the asset’s net book value.

• Recoverable Amount is the higher of:

• Fair value less costs to sell (FVLCTS)

• Value in use (VIU) – the present value of expected future cash flows.
  
  

3. Recording the Loss

If the asset is impaired, an impairment loss is recognized:

• Debit: Impairment Loss (Income Statement)

• Credit: Asset (Balance Sheet reduction)
  
  

Key Takeaway

• Impairment reflects a permanent decline in an asset's value.

• It ensures that assets are not overstated on the balance sheet.

• Required by IFRS (IAS 36) and US GAAP (ASC 360, 350).

• Affects profitability, equity, and investor perception.

• Common in sectors like energy, manufacturing, and M&A-heavy industries.

Types & Variations

1. Goodwill Impairment

• Only tested for impairment, not amortized.

• Must be tested annually and upon triggering events.

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2. Asset Impairment (PP&E)

• Only tested for impairment, not amortized.

• Must be tested annually and upon triggering events.
  
  

3. Intangible Asset Impairment

• Patents, trademarks, software licenses, etc.

• Amortized over time, but subject to impairment if circumstances change.

$$\frac{\text{<br>}}{}$$$$\text{Debt Ratio} = \frac{\text{Total Liabilities}}{\text{Total Assets}}$$4. Financial Asset Impairment$$\text{DSO} = \left( \frac{\text{Accounts Receivable}}{\text{Net Sales}} \right) \times 365$$

• Occurs when expected future cash flows decline.

• Modeled using Expected Credit Loss (ECL) under IFRS 9.

Context in Financial Modeling

Impairment is modeled as a non-cash expense that affects:

• Net income (reduces profits).

• EBITDA remains unaffected (since impairment is non-operating).

• Balance sheet, through a reduction in asset value.

• Cash flow statement, reflected only in indirect method under operating activities.
  
  

It can also reduce goodwill in DCF or M&A models, affecting:

• Terminal value estimates

• Adjusted book value in asset-based valuations

Nuances & Complexities

• Judgment-based: Determining value in use involves estimating cash flows and discount rates.

• Volatile impact: Sudden large impairments may spook investors.

• Regulatory scrutiny: Companies can be penalized for delayed recognition.

• Reversal policies vary: Under IFRS, some impairments (excluding goodwill) can be reversed if conditions improve; under US GAAP, impairment losses on long-lived assets cannot be reversed.

Mathematical Formulas

Impairment Loss: 

$$\text{Impairment Loss}=\text{Carrying Amount}-\text{Recoverable Amount}$$

Value in Use (VIU):$$\text{VIU}=\sum _{t=1}^n\frac{C{F}_t}{(1+r{)}^t}$$

 
Where:

• $CF_t$ = Expected future cash flows in year $t$

• $r$ = Discount rate

• $n$ = Asset’s remaining useful life

Related Terms

• Depreciation

• Amortization

• Write-off

• Fair Value

• Carrying Value

• Goodwill

• Cash-Generating Unit (CGU)
  
  

Real-World Applications

Example 1: Goodwill Impairment in M&A

In 2020, General Electric took a $22 billion goodwill impairment charge on its power division after future cash flows declined significantly, impacting investor sentiment and share price.

Example 2: Retail Sector Asset Write-down

During the pandemic, many retailers impaired store assets due to permanent closures and loss of expected revenue, reducing balance sheet strength.

Example 3: Oil & Gas Sector

Firms like ExxonMobil and Shell recorded impairments due to declining oil prices, writing down the value of exploration assets.
 

References & Sources

• Investopedia: What Does Impairment Mean in Accounting?