Amortization vs Impairment
A firm owns a number of assets including fixed assets that are used in the production of goods and services, current assets that can be used to cover day to day expenses, and intangible assets such as a company’s goodwill. Assets are recorded in the firm’s balance sheet at their cost values. The values of the firm’s assets reduce over time and, therefore, need to be adjusted to their fair market value. Asset impairment and amortization are concepts related to the adjustment of an asset’s cost to its fair market value. Despite the similarities between these two concepts, there are a number of important differences. The following article takes a closer look at both these terms and outlines the similarities and differences between the two.
What is Impairment?
There may be instances in which a fixed asset loses its value and needs to be written down in the accounting books of the firm. In such an instance, the value of the asset is written down to its true market price or it is sold. An asset that loses its value and needs to be written down is referred to as an impaired asset. An asset can become impaired for a number of reasons, which include becoming obsolete, failing to meet regulatory standards, damages to the asset, changing market conditions. Once an asset has been impaired, there is very little possibility for the asset to be written up; therefore, the asset must be carefully evaluated before it is categorized as an impaired asset. Other company accounts such as goodwill and accounts receivable can also become impaired. Firms are required to conduct regular tests on asset impairment (especially on goodwill), and then write off any impairment.
What is Amortization?
The accrual principle in accounting states that an asset’s cost should be expensed over its useful life. Amortization is one such method that is used in accrual accounting to deduce the fair market value of an intangible asset. Amortization is similar to depreciation; however, while depreciation is over tangible assets amortization is over intangible assets such as a company’s goodwill. When an asset is amortized, its cost is prorated over the time period that the asset is in use, in order to show a more realistic and fair value of the intangible asset. For example, a pharmaceutical company has acquired a patent over a new drug, for a period of 10 years. The company amortizes this by dividing the cost involved in creating the drug over the life of the patent, and each portion of the cost is recorded as an expense in the income statement and reduced from the cost.
Amortization vs Impairment
Impairment and amortization both come together in the accrual principle of accounting that requires a company to record assets at their fair market value. There is, however, a number of major differences between the two. Impairment occurs when the value of the assets reduces drastically as a result of damage to the asset, an asset becoming obsolete, or other scenarios in which the asset’s value falls, which creates the need for the value of the asset to be written down to its true market value. Amortization is the continuous process under which the asset’s cost is expensed over its useful life. The value of the asset is reduced by a proportionate amount, which is recorded as an expense in the income statement. This is done to show the fair value of the asset, as the value of assets reduces with time.
What is the difference between Amortisation and Impairment?
• The value of the firm’s assets reduces over time and, therefore, need to be adjusted to their fair market value. Asset impairment and amortization are concepts related to the adjustment of an asset’s cost to its fair market value.
• When an asset is amortized, its cost is prorated over a time period that the asset is in use, in order to show a more realistic and fair value of the intangible asset.
• Impairment occurs when the values of the assets reduces drastically, as a result of damage to the asset, the asset becoming obsolete, or other scenarios in which the value of the asset fall and create the need for the value of the asset to be written down to its true market value.