Typically, impairment will happen to a company’s fixed assets or intangible assets. In accounting, the term “impairment” refers to a situation where the value of an asset has reduced permanently. People will usually use this term to describe that a fixed asset’s recoverable amount has reduced drastically.
If an accountant from an accounting firm in Singapore wants to conduct an impairment testing on an asset, he needs to periodically compare the cash flow, total profit or other benefits that he expects a particular asset would generate with its present book value. If he found out that the asset’s book value is higher than that of its benefit or future cash flow, he needs to write off the difference between these two amounts. As a result, the asset’s value will decrease on the balance sheet of the company.
When economical or legal situations that surround a company has changed, or when the company suffers from a loss due to any unexpected devastation, an impairment may happen. As an instance, the equipment of a manufacturing company may experience an impairment in the aftermath of a flood. When this happens, the fair value of an asset will experience a large and sudden decrease, and it will become lower than that of its carrying value. Also known as book value, the carrying value of an asset is the asset’s value after deducting its accumulated depreciation that one has recorded on the balance sheet of his company.
As we mentioned above, the accountants will test the assets for any potential impairment regularly. In the case where any impairment happens, they will write off the difference between the carrying value and the fair value of that asset. Normally, the accountants will derive fair value as the amount of the undiscounted future cash flow as well as the predicted salvage value of an asset. The salvage value is the amount of money the company expects to obtain when it disposes of or sells an asset when the useful life of that asset has come to an end.
Some other accounts may experience impairment too. Thus, the accountants need to review and write them down. Some of the examples include the company’s accounts receivable as well as goodwill (Also see What is Impairment Testing for Goodwill?). Compared to current assets, long-term assets have higher risks of impairment as they have a longer useful life. Thus, their carrying value has a longer period to become impaired.
Some may confuse between depreciation and impairment. As time passes, depreciation will happen on fixed assets like equipment and machinery. In each accounting period, the depreciation will happen according to a schedule that the accountants have made in advance. The methods that they can use to account for depreciation include the accelerated depreciation method or the straight-line depreciation method. Depreciation and impairment are different from each other in a way that people would use the former to deal with the normal wear and tear that the fixed assets would experience as time passes. On the other hand, the latter is related to the drastic and unexpected decrease in an asset’s fair value.