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Home > Accountancy Checklists > Understanding Impairment Accounting: What It Is and When It Is Used

Accountancy Checklists

Understanding Impairment Accounting: What It Is and When It Is Used


Checklist Description

This checklist outlines ways to understand impairment accounting: what it is and when it is used.

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Definition

Impairment of assets is the diminishing in quality, strength, amount, or value of an asset. The term “long-lived asset” refers to such properties as a business organization’s buildings, land, machinery, and equipment. These assets may be susceptible to an impairment (decline) of their value, which may be caused by factors such as poor management, new competition, and technological innovations. Impairment losses are stated in the profit-and-loss account. The impairment value is measured by comparing the value of the fixed asset or income-generating unit with its recoverable amount. The recoverable amount is the highest value that can be obtained from selling the fixed asset or income-generating unit.

As with most generally accepted accounting principles (GAAP), the definition of impairment is often in the eye of the beholder. Determining fair value has always been problematic, with different professionals arriving at different valuations. There is limited guidance as to how or when to recognize impairments, how impairments should be measured, and how impairments should be disclosed.

The impairment of assets provides investors with a way to evaluate corporate management and its decision-making track record. Investors, creditors, and financial analysts who have not kept their eye on the ball are often surprised when asset write-downs are reported.

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Advantages

  • Impairment charges, if applied correctly, provide investors and analysts with ways to assess company management and its decision-making track record. Managers that must write down or write off assets due to impairment have not made first-class investment choices.

  • Many business failures are preceded by a decline in the impairment value of assets. Such revelations could serve as early warning signals to investors and creditors.

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Disadvantages

  • It can be difficult to determine which measure of value should be used when assessing impairment. Options include current cost (replacement cost), current market value (selling price), net realizable value (selling price minus disposal costs), or the sum of the future net cash flows from the income-generating unit.

  • There is little detailed guidance on accounting for asset impairments, when to recognize impairments, how impairments should be measured, and how impairments should be disclosed. The definition of impairment is often, therefore, just a matter of individual judgment.

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Action Checklist

  • Study carefully the impairment of assets of any business in which you have an interest. Obtain as much information from as many different sources as possible to confirm the findings before making decisions.

  • Check which measure of value was used when assessing impairment: Current cost (replacement cost), current market value (selling price), net realizable value (selling price minus disposal costs), or the sum of the future net cash flows from the income-generating unit.

  • Don’t take shortcuts because hidden potential write-downs may cost more in the long run.

  • Check which GAAP are used in the specific enterprise, business area, or country in which you are interested.

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Dos and Don’ts

Do

  • Make sure that you have checked the financial ratios used in the impairment analysis in detail. If in doubt, consult an expert analyst.

  • Involve accountants and industry experts in your evaluation of the financial impairment of a company.

  • When comparing a business’s impairment valuations with other firms in an industry, allow for any material differences in accounting policies between the compared company and industry norms.

Don’t

  • Don’t take for granted goodwill valuations that have sometimes come from acquisitions during the “bubble” years, when companies overpaid for assets by using overpriced stock.

  • Don’t rely solely on ratios when making decisions. Use market research to confirm the results.

  • Don’t fall into the trap of thinking that financial ratios are infallible.

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Further reading

Books:

  • Horngren, Charles T., Gary L. Sundem, John A. Elliott, and Donna Philbrick. Introduction to Financial Accounting. 10th ed. Upper Saddle River, NJ: Prentice Hall, 2010.
  • Nikolai, Loren A., John D. Bazley, and Jefferson P. Jones. Intermediate Accounting. 11th ed. Mason, OH: South-Western Cengage Learning, 2009.
  • Rolfe, Tom. Financial Accounting and Tax Principles: Managerial Level. Oxford: Butterworth-Heinemann, 2007.

Websites:

  • American Accounting Association (AAA): aaahq.org
  • Financial Accounting Standards Board (FASB): www.fasb.org
  • International Federation of Accountants (IFAC): www.ifac.org

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