What is impairment?
Impairment is a sudden decrease in the value of assets. It is booked when the net book value of the asset exceeds the recoverable amount. The formula to calculate impairment is as follows:
Net book value – Recoverable Amount = Impairment
The recoverable amount of asset is higher of value in use – VIU (present value of future cash flows generated from the asset) and fair value less cost to sell (FV – CTS).
At the end of each accounting period, assets are checked for impairment. The procedure includes calculation of VIU by discounting the future cash flows and summing them up and comparing them to the amount of fair value less cost to sell.
The higher of these two amounts is the recoverable amount. The recoverable amount is then compared to the net book value (cost – accumulated depreciation) of the asset.
If the netbook value is higher than the recoverable amount, then an impairment expense is booked. Impairment is the difference between NBV and recoverable amount.
If the NBV is lower than the recoverable amount, then no impairment expense is booked.
Financial statements are documents or reports that quantify the performance of the business in four separate statements. It is essential for every entity to prepare these statements at the end of every accounting period.
These statements are then checked for their reliability and correctness by an audit firm. The four financial statements are commonly known as:
- Income statement
- Balance sheet
- Statement of changes in equity
- Statement of cash flow
Impairment affecting income statement:
Impairment is classified as a revenue expenditure and is reported under the head operating expenses.
Operating expenses are deducted from the gross profit in order to calculate the amount of net profit earned by the company. Gross profit is revenue less cost of goods sold.
Net profit = Sales – Cost of Goods Sold – Operating Expenses
A decrease in impairment means that the value of assets has also decreased. Since the carrying amount of assets has decreased, the depreciation expense for the coming years would reduce too which would positively affect the profitability of the business.
Impairment affecting balance sheet:
The balance sheet lists down all the assets that it holds on the balance sheet at their net book value/carrying amount. Impairment of is a reduction in the asset’s value due to obsolescence or damage to the asset.
Hence, the value of assets on the balance sheet is also reduced. However, another impact would be that the value of assets would decrease at a slower rate from now on since the amount of depreciation would reduce each year due to the lower value of assets.
Impairment affecting cash flow statement:
Impairment is a non-cash expense that is reported under the operating expenses section of the income statement. Cash flow statement is made with the purpose of reporting all the cash transactions throughout the year exhibiting every cash inflow and outflow on the face of the financial statement.
Any non-cash income or expense included in the operating profit is eliminated by adjustments made under the operating activities section of cash flow statement.
Just like the depreciation expense is added back to the operating profit, an impairment expense is also added back to the operating profit in the cash flow statement to arrive at the net cash flow from operating activities amount.
Impairment affecting statement of changes in equity: Impairment has no effect on statement of changes in equity.