CFA Level 1
Assets - Asset Impairment
What is Impairment?
Assets are said to be impaired when their net carrying value, (acquisition cost - accumulated depreciation), is greater than the future undiscounted cash flow that these assets can provide and be disposed for.
Under U.S. GAAP impaired assets must be recognized once there is evidence of a lack of recoverability of the net carrying amount. Once impairment has been recognized it cannot be restored. Analysts must know that some foreign countries and the IASB allow companies to recognize increases in previously impaired assets.
Asset impairment occurs when there are:
- Changes in regulation and business climate
- Declines in usage rate
- Technology changes
- Forecasts of a significant decline in the long-term profitability of the asset
Write-downs affect past reported income. The loss should be reported on the income statement before tax as a component of continuing operations. Generally impairment recognized for financial reporting is not deductible for tax purposes until the affected assets are disposed of. That said, in most cases recognition of an impairment leads to a deferred tax asset.
Impaired assets held for sale are assets that are no longer in use and are expected to be disposed of or abandoned. The disposition decision differs from a write-down because once a company classifies impaired assets as assets for sale or abandonment, it is actually severing these assets from assets of continuing operations as they are no longer expected to contribute to ongoing operations. This is the accounting impact: assets held for sales must be written down to fair value less the cost of selling them. These assets can no longer be depreciated.
Assets Impairment - Effects on Financial Statements and Ratios
- Past income statements are not restated. The current income statement will include an impairment loss in income before tax from continuing operations. Net income will also be lower.
- On the balance sheet, long-term assets are reduced by the impairment. A deferred-tax asset is created (if there was a deferred tax liability it is reduced). Stockholders' equity is reduced as a result of the impairment loss included in the income statement.
- Current and future fixed-asset turnover will increase (lower fixed assets).
- Since stockholders' equity will be lower, debt-to-equity will be lower.
- Debt-to-assets will be higher.
- Cash flow based ratios will remain unaffected (no cash implications).
- Future net income will be higher as there will be lower asset value, and thus a smaller depreciation expense.
- Future ROA and ROE will increase.
- Past ratios that evaluated fixed assets and depreciation policy are distorted by impairment write-downs.