What is Impairment of Financial Instruments?

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 Understanding first the meaning of Impairment.

In accounting, impairment is a permanent reduction in the value of a company asset. It may be a fixed asset or an intangible asset.

When testing an asset for impairment, the total profit, cash flow, or other benefits that can be generated by the asset is periodically compared with its current book value. If the book value of the asset exceeds the future cash flow or other benefits of the asset, the difference between the two is written off, and the value of the asset declines on the company's balance sheet.

Basics for why impairment happen?

  • Impairment can occur as the result of an unusual or one-time event, such as a change in legal or economic conditions, a change in consumer demand, or damage that impacts an asset.
  • Assets should be tested for impairment regularly to prevent overstatement on the balance sheet.
  • Impairment exists when an asset's fair value is less than its carrying value on the balance sheet.
  • If impairment is confirmed as a result of testing, an impairment loss should be recorded.
  • An impairment loss records an expense in the current period that appears on the income statement and simultaneously reduces the value of the impaired asset on the balance sheet.


How impairment is different from depreciation?

Impairment is unexpected damage. Depreciation is expected wear and tear.

The value of fixed assets such as machinery and equipment depreciates over time. The amount of depreciation taken in each accounting period is based on a predetermined schedule using either a straight line method or one of a number of accelerated depreciation methods.

Depreciation schedules allow for a set distribution of the reduction of an asset's value over its lifetime, unlike impairment, which accounts for an unusual and drastic drop in the fair value of an asset.

For instance:

  • A tractor depreciates in value from year to year throughout its useful lifetime.
  • A tractor that gets crushed by a falling tree has experienced an impairment that must be recorded on the books as such.      

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