What's an Impairment?

An impairment is an event that can skew a company's profit readings, and lead investors to use adjusted earnings per share as opposed to reported earnings per share. Understanding what an impairment is, is fairly simple. To start you need to recall that a company's balance sheet is formed of three core sections: assets, liabilities and equity. Impairments (or impairment charges) involve the assets section of the balance sheet. An impairment can be defined as the following:

A reduction in the value of an asset compared to the value shown on the assets section of a balance sheet

For example, say a machine is shown on a balance sheet to be worth £5,000. Now assume that an independent valuation has been undertaken and the results are that the machine is only worth £2,000, not £5,000. This change in the value of the asset needs to be reflected in the balance sheet - the value of the asset needs to be reduced, through incurring an impairment charge. In the next set of results, the company will incur that charge, and that would impact the full-year results. 

Clearly an impairment is an exceptional (one-off) charge, hence why investors tend to factor these out of results, and seek to use adjusted profit figures. However, since the reported profit figures are still affected, it can open up opportunities to get in companies where underlying profitability is very good, but skewed downwards. Although it skews profitability downwards, an impairment is an example of a non-cash expense - it requires no actual cash outlay. However, be careful. If the impairment is large, asset backing is diminished, so the company may not look as good value post-impairment.

An Example

Above is an example of an impairment charge that Rose Petroleum (LSE:ROSE) incurred on its uranium assets in FY 2013. As per the highlighted line, the impairment was incurred on intangible exploration and evaluation assets to the tune of £2.93m. That impairment essentially tells investors that those intangible assets are not worth as much as previously expected. The result is a £2.93m charge to profits on the accounts. Without that impairment charge, the company would have made a small operating profit.

To confirm the impairment, we need to check the balance sheet again. Assuming that there has not been a lot of value added over the year (i.e. assuming that assets have not grown significantly), then we would expect to see a sharp drop in the intangible assets. If intangible assets have grown, the drop would be less severe than £2.93m.
 
As per the non-current assets on the balance sheet, there has been a sharp fall in the company's 'Intangible Assets', which confirms the impairment. The size of the drop is ~£2.87m, which suggests that intangible assets grew by £0.06m over the year. This is less severe than the £2.93m charge, and that is usually the case. The value of the assets shown in 2012 is often stated as the carrying value - the value that the balance sheet carries before revision. There has therefore been a reduction in the carrying value of the intangible assets during 2013. Notice how total assets have dropped from £3.94m to £3.00m - there is now less non-current asset backing for the company's current valuation versus 2012.

Since the methodology of valuing an asset can differ and is largely subjective, many companies tend to incur impairment charges every few years, although the scale of the impairment is ultimately what matters. Small impairments are usually fine, but a series of large impairments could well call into question the credibility of management - have they been spending cash on assets that are not as good as first thought?