“An impairment loss is and indication that the firm has not recognized sufficient depreciation or amortization expense, and has overstated earnings as a result” … This is wrong, right? The firm thought the asset´s value was more that it it really was and therefore it has recognized MORE THAN SUFFICIENT depreciation, or I am wrong?
This is correct.
Your machine is worth $100,000 but your net book value is $200,000; you haven’t depreciated it fast enough.
ok it is really worth 100,000 but you were depreciating it at 200,000. Suppose the machine has a 10 year useful live, no salvage value, we make the impairment at year 4. So the firm was depreciating (200,000/10)= 20,000 * 7 = 80,000 and if in the beginning they knew the real value it was like this, (100,000/10= 10 *4 = 40,000 … YES, you would have depreciated fast enoough, and as a result your net income was higher if you have done it with 100,000 rather than the 200,000… still dont get it, please explain more detailed S2000
I’ll give you real-life example. Company had asset with book value of $1M where management knew the market value of asset is $700k. In order not to make their shareholders unhappy, they did not depreciate the asset with higher value. Hence their profit for those years was higher then it should have been. The new auditors came in and told the management that they have to impair the asset to reflect its true value. So they asked the management to impair the asset with $300k by expensing it out. For that particular year, company went into loss due to this impairment. So they overstated their previous years’ income statement. I hope it clarifies.
Four years ago you bought a machine for $300,000, and decided to depreciate it straight-line for 12 years with zero salvage: $25,000 per year. Today’s book value is therefore $200,000 (= $300,000 − ($25,000 × 4)).
If the fair market value is $100,000, then you’ve been depreciating it too slowly: your annual depreciation should have been $50,000 instead of $25,000 ($300,000 − ($50,000 × 4) = $100,000).
So the statement’s correct: you show an impairment loss when the fair value is less than the book value, and that situation arises when your historical depreciation has been too low (so that your historical earnings have been too high).
Thank you both!
My pleasure.