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Impairment analysis is an accounting term most often applied to goodwill. In short, goodwill is the amount an individual pays for a company over and above the company’s book value. Accountants must review this figure to determine its accuracy and assess whether it is impaired, which often results in a write-off against the company’s earnings. Other items in a company’s accounting processes can be part of impairment analysis, for example, physical assets or financial instruments held as investments.
Historically, companies were able to amortize goodwill over a lengthy period of time, generally around 40 years total. Accounting standards have changed, however, requiring accountants to conduct an impairment analysis to assess whether the historical goodwill is currently accurate or not. When accountants determine that goodwill impairment does indeed exist, an entry is necessary to adjust it in order to present a more accurate balance sheet to stakeholders. The entry reduces the goodwill account on the balance sheet and places an extraordinary loss on the company’s income statement. This generally occurs at least once a year for most businesses.
Goodwill impairment is a bit more technical under the newer accounting standards. Accountants need to determine the fair value for all business units in the company using net present value for future cash flows. They then compare this figure to the company’s carrying value based on the information from a company’s balance sheet. Carrying value is total asset book value plus goodwill less liabilities. Fair value — as derived from the net present value — that is less than the carrying value results in impairment and requires an adjusted entry.
Physical asset impairment analysis often involves the review of a company’s cash, more commonly called capital in accounting terms. Two types of capital impairment can exist in a company. The first is when a significant reduction in the company capital occurs for one-time use, which may not be related to the use of cash in normal operations. Second, total capital less than the par value of capital stock is also an impairment. Accounting standards also provide direction for handling entries for these impairment scenarios.
Financial instruments may also be part of a company’s impairment analysis. Investments that are worth less today than in a previous period are subject to this review. Accountants need to make similar write-offs for these assets. The impaired amount — as computed using standard accounting techniques — reduces the asset balance and net profit for a specific period. Disclosures are necessary to explain these impairments to stakeholders.