Chartered Financial Analyst (CFA) Practice Exam Level 2

What happens to the carrying amount of an investment if impairment is recognized?

1. It decreases to the fair value

2. It increases to reflect added earnings

3. It remains unchanged

4. It is written off entirely

The correct answer is: It decreases to the fair value

When impairment is recognized for an investment, the carrying amount of that investment decreases to its fair value. Impairment indicates that the investment's value has fallen below its carrying amount on the balance sheet, which means that the company must adjust the investment's book value to reflect this decrease. This adjustment ensures that the financial statements present a more accurate portrayal of the investment's worth. The fair value is essentially the amount that could be received for the investment in an orderly transaction between market participants. By decreasing the carrying amount to the fair value, the financial statements reflect the current economic reality and prevent the overstatement of the asset's value. Recognizing impairment is essential for compliance with accounting standards, which require assets to be valued at the lower of cost or market value when impairment indicators exist. Other options do not align with the treatment of impairment: increasing the carrying amount to reflect added earnings is inaccurate because impairment typically indicates a loss in value, whereas remaining unchanged contradicts the principle of recognizing impairment, and writing off the investment entirely does not happen unless there is no recoverable value left at all, which is a more extreme scenario.