Loan impairment occurs when the lender expects to be able to collect less than the full value of the loan. Either the value of the collateral has been reduced, such as when a car is worth less than its loan, or the borrower can no longer afford to pay the full value, such as when student loans are consolidated and the principal reduced.
Impairment
The concept of impairment is a way for a lender to estimate its future earnings based on a current, realistic view of the revenue it expects to make in the future, rather than simply estimating by the amount that it's technically owed. Critically, this is an estimate of what's going to happen in the future, not a reflection of what's already happened. A loan that's been paid off is not impaired.
Calculation
Generally speaking, the impairment is the full amount of the loan minus the expected repayment. For example, if an auto loan has $10,000 left on it but the borrower is in bankruptcy and expects to settle for $4,000, the impairment is $6,000. However, there are several ways to calculate impairment. You can calculate the future value of all payments, which takes inflation into account. If a loan is not backed with collateral you can use the fair market value of what the loan could be sold to another lender or collection agency. If it is backed with collateral you can use the market value of that asset. For instance if the car above is worth $3,000, the impairment can be calculated as $7,000.
Early Repayment
Lenders may be willing to offer an early repayment discount, or to settle for receiving only a portion of the loan amount back, if they think that's less risky than allowing the original payment schedule to go on. In those cases the loan obligation is discharged, and the difference between the lender's expected profit and its actual profit is written off as a loss.
Accounting Treatment
When a lender believes it will not receive the full repayment of the loan, it can re-measure the loan and re-estimate future cash flows, with a discount rate of the loan's effective interest rate. This allows the lender to value its assets correctly on balance sheet. If the lender restructures a loan with troubled borrowers, the difference between the original payments and the new payments can be recognized as impairment on an income statement as well.
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