If the value of an asset, as shown in the balance sheet, exceeds its actual value to a company, then the amount shown in the balance sheet needs to be reduced. This reduction is shown as a cost in the P & L. This is impairment.
For most assets the test is that the balance sheet value exceeds both the amount for which the asset could be sold and the present value of the future cashflows it will generate.
In general, the possibility that an asset has been impaired will be examined if the asset has in some way become less useful since it was acquired. There are exceptions to this:
- The value of goodwill is subject to an annual review.
- The value of other intangible assets that have an indefinite life or are not yet in use is also subject to annual review.
- The value of stocks (inventories) must always be stated at the lower of cost and net realisable value (the price at which they could be sold minus the cost of selling).
- Investment properties and certain agricultural assets may be valued at fair value, in which case the value must always be stated at a current fair value and changes taken through the P & L.
- Financial assets, pension funds and assets held for sale are subject to separate, sometimes quite complex, rules.
From an investor's point of view, impairments are usually one off events and should be treated as exceptionals. Goodwill reflects the history of a company and has very little relationship to future cash flows so it should be ignored anyway.