Impairment of Assets

A company might write down or write off the value of an asset. Suppose the company buys $100,000 worth of equipment, but then a natural disaster such as a flood occurs (like this) and part of the equipment is damaged. After repair, the equipment is still usable but less efficient. To accurately reflect the financial condition of the business, the value of the equipment should no longer be reported in the Balance Sheet as $100,000. Instead, we should write down the value of the equipment.

However, if the equipment is completely damaged, we must write it off the from the Balance Sheet because it no longer serves a purpose and has no future value. Old equipment can be written off even if it still has some functionality. For example, a company may upgrade its machinery or buy brand new computers.
When the value of an asset is written down or written off, that asset becomes impaired.

Impairment is very similar to depreciation: it is an expense in the Income Statement that reduces the company’s Profit Before Tax and Net Income, and it is added back as a non-cash expense in the Cash Flow Statement, reducing the company’s asset in the Balance Sheet.

Impairment of asset increases the company’s cash balance because of the tax savings: it reduces the company’s taxes because it is reported in the Income Statement, but the company does not pay the expense in cash. Impairment is a one-time or non-recurring event. Unlike Depreciation, the company does not expect to keep writing down its assets every year.

Here, we will take three examples to illustrate impairment of assets: Inventory, Accounts Receivable and “Property, plant and equipment”.

Impairment of Inventory

There was a power outage on a weekend, and our refrigerator was not functioning. We found out that some of our packaged food was rotten, and its total value was $500. In this case, we must write off the damaged inventory from our Balance Sheet.

1. Income Statement – Record $500.00 expense as inventories written off. This expense saves us some taxes.
2. Cash Flow Statement – Inventories written off is non-cash expense, so we must reverse it in the Cash flows from operating activities section.
3. Balance Sheet – Value of inventory reduced from $22,000 to $21,500.

Impairment of Accounts Receivable

One of our corporate customers bankrupt suddenly, and they still owe us $800. Since we will not be able to recover $800 from the customer, we must write off $800 from accounts receivable in the Balance Sheet. To achieve this, we make three changes in the Financial Statements:

1. Income Statement – Record $800 expense as receivables written off. This expense saves us some taxes.
2. Cash Flow Statement – Receivables written off is non-cash expense, so we must reverse it in the Cash flows from operating activities section.
3. Balance Sheet – Value of accounts receivable reduced from $45,000 to $44,200.

Impairment of Property, Plant and Equipment

One of our refrigerators is totally out of order and not justified for high costs of repair. The value of that refrigerator is $3,000. We must write off the damaged refrigerator from our Balance Sheet. To achieve this, we make three changes in the Financial Statements:

1. Income Statement – Record $3,000 expense as PP&E written off. This expense saves us some taxes.
2. Cash Flow Statement – Inventories written off is non-cash expense, so we must reverse it in the Cash flows from operating activities section.
3. Balance Sheet – Value of inventory reduced from $12,000 to $9,000.

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