Definition:

Impairments refer to the reduction in the recoverable amount of a fixed asset or goodwill below its carrying amount on the balance sheet. This occurs when the market value of an asset declines significantly, or when the asset is no longer expected to generate future economic benefits.

Examples

1. A manufacturing plant that becomes obsolete due to technological advancements.
2. A retail store that suffers from a significant decline in customer traffic.
3. A piece of machinery that is damaged and cannot be repaired.

Formula:

Impairment Loss = Carrying Amount - Recoverable Amount

How to use the metric:

Impairment is used to adjust the book value of an asset to reflect its current market value, ensuring that the financial statements provide a true and fair view of the company's financial position. It is typically recorded as an expense on the income statement, reducing net income.

Limitations:

1. Subjectivity: Determining the recoverable amount often involves significant judgment and estimation, which can introduce bias.
2. Timing: Impairments may not be recognized promptly, leading to delayed reflection of asset value changes.
3. Complexity: The process of testing for impairment can be complex and resource-intensive.

Applies to:

Industries with significant fixed assets or goodwill, such as manufacturing, retail, and technology, where asset values can fluctuate due to market conditions or technological changes.

Doesn't apply to:

Industries with minimal fixed assets or where asset values are less volatile, such as service-based industries, because they rely more on human capital than physical assets.

Summary:

Impairments are adjustments made to the value of an asset when its market value falls below its book value, ensuring accurate financial reporting. While useful for reflecting true asset values, impairments involve subjective judgment and can be complex to calculate. They are most relevant in asset-heavy industries.