Asset impairments are normal changes on a company’s balance sheet. They’re how accountants prudently reevaluate asset worth in alignment with the market.
Specifically, when a company records an asset, they record it at the purchase price and depreciate its value over time. However, if price simulations indicate that the free market value (FMV) of the asset is lower than its carrying amount, then the asset must be impaired to match the FMV. This impairment entry debits an expense account and credits the asset account.
But what impact does impairment expense have on taxes? In most countries, nothing1.
In general, tax authorities attempt to tax company income as close to its cash base as possible, rather that its accrual base. This means tax authorities do not allow impairment as a deductible expense to taxable income because impairment expense is not connected to a sale or purchase in the accounting period.
If you’re less familiar with tax deductions, check out this article on the tax base of assets.
Unrealized & Realized Losses in Tax Deductions
Two key words for this topic are unrealized losses and realized losses. Unrealized losses are those that exist “on paper” only — there is not a real transaction behind them. Realized losses, however, are those for which there is a transaction behind
The most common scenario illustrating this dynamic is investments that have lost market value but not been sold. For example, if you buy stock at $10 and its price decreases to $5, you have an unrealized loss of $5. However, when you sell it, you have a realized loss of $5.
The same applies to impairments. Asset impairments are unrealized losses because there is no real transaction behind them — they’re notional adjustments done by accountants to keep book values reflective of the market.
Since tax authorities attempt to tax companies closer to a cash basis than an accrual basis, they’re less concerned with unrealized gains/losses. This is why they do not allow asset impairments against taxable income.
Are Goodwill Impairments Tax Deductible?
Goodwill is a special case. A common question is whether goodwill is tax deductible at all, i.e does its amortization decrease taxable income? The short answer is that it’s deductible if arising from an asset deal, but not if arising from a stock deal.
However, regardless of if goodwill arises from an asset deal or stock deal, impairments to goodwill are not tax deductible because they are unrealized losses, i.e they don’t manifest from a real transaction.
A Note on Bad Debt and Accounts Receivable
Technically, bad debt on accounts receivable is an impairment. In many cases, it’s just a provision used in the GAAP accounts based on historical values as a means of transparency and prudence. In these cases, it — as an impairment — is not tax deductible.
However, in some cases bad debt can be near-certain. For example, if a large client claims bankruptcy and you know you won’t be paid for the order you delivered, then the bad debt is a sure thing. In these cases, bad debt — as an impairment — is tax deductible.
What kinds of assets are impaired?
In this article, we’ve talked about impairments on fixed assets, long term intangible assets, and accounts receivable. But are there other assets to be impaired?
To understand this, we need to know the real reason for impairments. The actual purpose of asset impairment is to align an asset with its recoverable amount. If the asset is intended for sale, such as inventory, then it needs to be aligned with free market value, i.e competitors.
However, if the asset is simply intended to serve the business and not be sold, such as a tractor on a farm, it may not need to be impaired. Why? Because it’s recoverable amount is the cash it generates for the company. It follows the normal depreciation schedule in most cases, and this is sufficient.
All things said, whether an asset is impaired depends entirely on how it is used in a specific company. If its recoverable amount is deemed lower than the carrying amount, it needs to be impaired by aligning with the free market value (FMV).
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- This article is intended for educational purposes only and should not be considered tax advice.