Impairment of PP&E

Sometimes a long-term asset may lose some of its revenue-generating ability prior to the end of its useful life. (e.g., a significant decrease in the market value, physical change, or use of the assets). If the carrying amount of the asset is determined not to be recoverable, an asset impairment occurs and the carrying value should be written down. The amount of the write-down is recorded as a loss.

GAAP and IFRS differ as to the methodology used to determine impairment.

The GAAP methodology of determining impairment uses a two-step recoverability test. Occurrence of an impairment differs from recognition of an impairment. An impairment, whether recognized in financial reports or not, occurs as long as an asset's carrying value cannot be fully recovered in the future. However, only impairments that meet certain conditions are recognized in financial reports. SFAS 121 provides a two-step process:

• Recoverability test. Impairment must be recognized when the carrying value of the assets exceeds the undiscounted future cash flows from their use and disposal.

• Loss measurement. The excess of the carrying amount over the fair value of the assets. If the fair value is not available, the present value of future cash flows discounted at the firm's incremental borrowing rate should be used. That is:
  Impairment Loss = Book Value - Either Fair Value or Present Value of Future Cash Flows

Conversely, IFRS methodology uses a one-step approach. This approach requires that impairment loss be calculated if "impairment indicators" exist. This approach does not rely on net undiscounted future cash flows and subsequent comparison to asset carrying value as required in GAAP methodology. In addition, the impairment loss is calculated as the amount by which the carrying amount of the asset exceeds it recoverable amount. The recoverable amount is the higher of the following: 1) fair value less cost to sell, or 2) value in use (i.e., the present value of future cash flows including disposal value).

Impairment of Intangible Assets

• Similar accounting treatment if the intangible asset has a finite life.
• Tested annually for impairment for an intangible asset with an indefinite life.

Among the most interesting intangible assets is goodwill. Goodwill is the present value of future earnings in excess of a normal return on net identifiable assets. It stems from such factors as a good reputation, loyal customers, and superior management. Any business that earns significantly more than a normal rate of return actually has goodwill.

Goodwill is recorded in the accounts only if it is purchased by acquiring another business at a price higher than the fair market value of its net identifiable assets. It is not valued directly but inferred from the values of the acquired assets compared with the purchase price. It is the premium paid for the target company's reputation, brand names, customers or suppliers, technical knowledge, key personnel, and so forth.

Goodwill only has value insofar as it represents a sustainable competitive advantage that will result in abnormally high earnings. Analysts need to be aware of the possibility that the goodwill recognized by accountants may, in fact, represent overpayment for the acquired company. Since goodwill is inferred rather than computed directly, it will increase as the payment price increases. It is only after the passage of time that analysts will be able to evaluate the extent to which the purchase price was justified.

Under U.S. GAAP SFAS 142, goodwill is not amortized, but is tested annually for impairment. Goodwill impairment for each reporting unit should be tested in a two-step process at least once a year.

1. The fair value of a reporting unit is compared to its carrying amount (goodwill included) at the date of the periodic review. If the fair value at the review date is less than the carrying amount, then the second step is necessary.

2. The carrying value of goodwill is compared to its implied fair value (and a loss recognized when the carrying value is the higher of the two). To arrive at an implied fair value for goodwill, the FASB specifies that an entity should allocate the fair value of the reporting unit at the review date to all of its assets and liabilities as if the unit had been acquired in a combination with the fair value of the unit as its purchase price. The excess of that fair value (purchase price) over the fair value of the identifiable net asset is the implied fair value of goodwill.

Financial Impacts

The carrying value of long-lived assets should be written down to fair value (less cost of disposal, if intended for sale). The impairment loss is reported pretax as a component of income from continuing operations. Once recognized, the impairment loss cannot be restored.

Some impacts on current financial statements:

• Lower fixed assets and total assets.
• Both net income and tax expense are reduced due to the impairment loss.
• Tax payable: the impairment loss is not recognized for tax purposes until the property is disposed of. It leads to a deferred tax asset (a future tax benefit), not a current refund.
• Stockholders' equity is reduced, and thus the debt-to-equity ratio is increased.
• Impairment write-down has no effect on cash flows, since it is a non-cash charge.
• Asset turnover ratios tend to increase due to the lower asset base.
• Return on assets and return on equity are reduced because of the impairment loss.

The write-down affects future financial statements and ratios in the same way as it affects the current period, except in the following aspects:

• Future depreciation expenses are reduced due to the reduced book value of the asset.
• As a result, future net income and profit margin increases. Note that impairment loss is a one-time loss, and does not affect the income statements of future periods.
• Future return on assets and return on equity will both increase because of higher future profitability and a lower asset and equity base.

Assets Held for Sale

Long-lived assets held for sale are tested for impairment at the time they are categorized as held for sale. If the carrying value > fair value, an impairment is recognized. Assets held for sale should cease to be depreciated after reclassification as held for sale. Subsequent increases in fair value less cost of disposal are recognized as gains only to the extent of previously recognized write-downs.

Reversals of Impairments

U.S. GAAP:

• Not permitted for assets held for use.
• Permitted for assets held for sale.

IFRS:

• Loss may be reversed, but not to exceed the initial carrying amount adjusted for depreciation.

The Revaluation Model

Under U.S. accounting standards, it is compulsory to account for impairment in long-lived assets (downward revaluation). However, upward revaluation of long-lived assets to reflect fair market values is not allowed.

The balance sheet is more informative when assets and liabilities are stated at market value rather than historical cost. IASB and some other non-U.S. GAAP do permit upward revaluations. The purpose of a revaluation is to bring into the books the fair market value of long-lived assets.

• If an asset revaluation initially decreases the asset's carrying value, the decrease is recognized as a loss. Later, if there is an increase in the carrying value, the increase is recognized as a profit (up to the amount of the original decrease).
• If an asset revaluation initially increases its carrying value, the increase bypasses the income statement and goes to equity (revaluation surplus). Later, if there is a decrease, it first decreases the revaluation surplus, then goes to income.

Financial Statement Analysis Considerations:

• The leverage motivation. An upward revaluation may improve a firm's leverage.
• Income manipulation. Revaluations are subjective in nature. For example, a downward revaluation will reduce ROE in the current period but make the firm more profitable in future years, since total assets and shareholders' equity will be lower.
• Revaluation has no impact on cash flows.
• What is the true value of the firm's long-lived assets? Why is the revaluation necessary? Who does the appraisal? How often is it done?