What is Book Value Reduction?
A book value reduction lowers the value at which an asset is carried on the books. This reduction occurs because changes in the asset or market conditions have reduced its current market value.
- A book value reduction is the result of the decreased market value of an asset.
- Book value reductions to an asset account are accompanied by a charge to an expense account, which lowers net income on the income statement.
- Many companies will publicly present both GAAP earnings, with the book value reduction charge, as well as non-GAAP earnings, excluding the charge.
- When a company writes down asset levels unexpectedly and with little economic justification, it can signal trouble.
Understanding Book Value Reduction
Book value reduction is a non-cash charge recorded in the general ledger. It includes a reduction to the value of an asset on the balance sheet, as well as an offsetting expense. As such, it also reduces net income on the income statement in the same accounting period in which the book value reduction is identified and booked. Under some circumstances, the book value reduction and related expense can be a hefty figure that may result in significant losses for the reporting entity.
Since it is regarded as an unusual item, companies usually report generally accepted accounting principles (GAAP) net income (or loss), taking into account the book value reduction charge, as well as a "pro forma" or non-GAAP earnings that excludes the charge. A book value reduction is more commonly called an asset write-down or impairment in the popular press.
Requirements for Book Value Reduction
While GAAP requires a reduction in book value of an asset if there has been significant impairment, it would be impossible to test all assets for such impairment on a monthly or quarterly basis. Therefore, GAAP specifies guidelines about when such impairment tests should be made. Specifically, property, plant, and equipment and finite-life intangible assets — which are depreciated or amortized over time — should be tested for impairment when market or asset changes suggest the book value of the asset may be overstated and not fully recoverable.
A test for possible book value reduction may be indicated in a number of situations. These include a substantial decrease in market price, an adverse change in the physical condition of the asset, economic conditions, a negative political change in the country where the asset is located, and so on.
Under GAAP, intangible long-lived assets that are not subject to amortization, like goodwill, should be evaluated for impairment at least annually.
GAAP vs. IFRS Differences
The accounting rules regarding the reversal of book value reductions differ between GAAP and International Financial Reporting Standards (IFRS). For example, U.S. GAAP prohibits the reversal of previous inventory write-downs, but IFRS permits them under certain circumstances. On the other hand, both GAAP and IFRS prohibit reversals of goodwill write-downs.
Example of Book Value Reduction
A book value reduction is recorded in a journal entry as a decrease in value to an asset account, a credit, and an increase to an expense account, a debit. For example, assume ABC Company, a video streaming service, acquired XYZ Corp, a brick-and-mortar movie store chain, 10 years ago. ABC recorded $10 million of goodwill at the time of acquisition. Every year, under GAAP, it is required to reassess the value of its reported goodwill to determine if it is still accurate or if a goodwill impairment has been incurred.
ABC Company is performing their annual goodwill test and determines that the demand for physical video rentals and purchases is down significantly from the time they acquired XYZ Corp. They also determine the likelihood of a rebound in this market is unlikely in the future. Since goodwill is impaired, a book value reduction is in order. ABC's accountants will record a journal entry to credit the goodwill asset account and debit a goodwill impairment expense account. The expense will lower ABC's reported net income on its next reported income statement.
Financial analysts keep a close eye out for changes in book value estimates. When a company writes down asset levels unexpectedly and with little economic justification, it can signal trouble. Public companies will go to great lengths to explain adjustments through their corporate communications and investor relations teams.