Impairment
Introduction:
A reduction
in the value of an asset or earnings by the amount of
an expense or loss. It is an accounting procedure used when an asset has
been determined to be uncollectible and is therefore charged off as a loss. On
the books, the amount is removed from the asset portion of a balance sheet and
recorded as an expense item on the income statement.
Asset Impairment Charges
Depreciation and amortization expense allocates an assets purchase price
over its useful life. In essence, the expense is intended to reflect the
declining value of the asset due to normal wear and tear.
However, sometimes the value of an asset can decline suddenly. Examples
include a vehicle destroyed in an accident (a tangible asset) or losing a
patent lawsuit (intangible asset). In such cases the asset is said to be
impaired and the accounting treatment depends on the type of asset and the
accounting standards in use.
- Tangible Assets Held
for Use U.S.
standards require impairment when the undiscounted value of expected
future cash flows is less than the carrying value of the asset. Once this
is determined, the cash flows are discounted to arrive at the appropriate
asset value and the impairment charge represents the difference between
the revaluation and the carrying value. The impairment test should be
performed whenever events suggest impairment is possible. International
Accounting Standards are similar except with regard to the mechanics of
revaluation.
- Goodwill and Other
Intangible Assets with Indefinite Lives must be tested at least
annually for impairment, and the charge reflects any difference between
the carrying value and the fair or recoverable value.
- Amortizable
Intangible Assets are treated similarly to tangible assets held
for use.
- Tangible Assets Held
for Sale are tested for impairment when the decision is made to
sell the asset. The impairment charge is the difference between the fair
value, less any selling costs, and the carrying value.
Once impaired, under
U.S.
standards the asset cannot be revalued upward even if the conditions of
impairment are reversed (say, a court decision overturned on appeal.) Under
IAS, upward revaluations are permitted, and in the case of previously impaired
assets the reversal would increase profits in the period the reversal occurs.
Goodwill Impairment:
Goodwill is an accounting term used to reflect the
portion of the market value of a business entity not directly attributable to
its assets and liabilities; it normally arises only in case of an acquisition.
It reflects the ability of the entity to make a higher profit than would be
derived from selling the tangible assets. Goodwill is also known as an
intangible asset.
Goodwill impairment is defined as the difference between the book value of
goodwill and the implied fair value of goodwill. Unlike other assets, goodwill
cannot be defined as a stand-alone asset and must be valued as a residual of
all other assets. Therefore, the estimation of goodwill impairment is not as
simple as measuring the difference between market capitalization and net book
value. There is a greater emphasis on asset valuation. Therefore, it is
critical for any goodwill impairment analysis that the valuation firm has a
thorough knowledge of tangible and intangible asset valuation methodology, and
purchase price allocation.
Under pooling, companies merged through stock-for-stock trades and were not
required to revalue their assets or account for goodwill. Goodwill is the
amount that the purchase price exceeds the fair value of the acquired company’s
net assets. It’s the premium one company pays to buy another.
GAAP requires companies to allocate the purchase price of an acquired
company (or group of assets) among identifiable financial, tangible and
intangible assets. The valuation of identifiable intangible assets is a very
complicated process; it typically requires several valuation analyses.
Treatment of Goodwill and Intangibles:
Goodwill and intangible assets often represent a considerable portion of an
enterprise's net worth, and recent changes to Financial Accounting Standards
Board (FASB) rules for treating goodwill and intangibles may have an important
effect on the valuation of some companies. The implications for past, pending
and future mergers, acquisitions and other deals are significant, so it is important
that business owners be familiar with these new rules, FASB Statements 141,
Business Combinations, and 142, Goodwill and Intangible Assets.
FASB 141 requires all business combinations to be evaluated using the purchase
method of accounting, and it specifically prohibits use of the
pooling-of-interests method. It also provides recognition criteria for
intangible assets other than goodwill, along with general guidelines for
assigning values to assets acquired and liabilities assumed.
FASB 141 defines an intangible asset apart from goodwill as:
> An asset arising from a contractual or legal right,
such as a patent, trademark or copyright.
> An asset other than contractual that can be sold,
transferred, licensed, rented or exchanged individually or in combination with
a related contract, asset or liability.
Under FASB 141, parties to a business combination are required to estimate the
fair value of acquired intangible assets in the following manner. First,
intangible assets must be categorized by type, such as customer lists,
trademarks, patents, software, intellectual property, etc. Second, intangible
assets with an identifiable remaining useful life must be separated from those
with an indefinite useful life. The latter are then classified as goodwill and
must be subject to a two-step test for impairment under FASB 142, which
companies were required to adopt by January 1, 2002.
Amortization Eliminated
The major change of FASB 142 is that amortization of goodwill will no longer be
permitted, although it will still be recognized as an asset. Instead, goodwill
and other intangibles will be subject to an annual test for impairment of
value. Not only will the change affect goodwill related to acquisitions
completed after the effective date, it will also affect any balance of goodwill
from previous deals that has not already been amortized. In the past, goodwill
has been amortized over its useful life, up to a period not to exceed 40 years.
Instead of amortizing goodwill, companies will now have to test goodwill at
least once a year for impairment. Businesses must perform this testing in new
reporting units, develop valuation methodologies for those units and
subjectively value identifiable intangible assets. FASB 142 requires businesses
to perform a Transitional Impairment Test on all goodwill within six months.
The calculated amounts should be measured as of the first of the year. If this
first step indicates that goodwill is impaired, any impairment loss should be
calculated and recorded as soon as possible prior to year-end.
Two-Step Process
After the initial Transitional Impairment Test is conducted,
businesses must perform the Goodwill Impairment Test on an annual basis (with
certain exceptions) under FASB 142. This process must be conducted at the
reporting unit level, defined as the lowest level of an entity, i.e., business
units, subsidiaries, operating units, divisions, etc. There are two steps to
the process:
1. Identify potential impairments by comparing the fair value of a reporting
unit to its carrying amount, including goodwill. Goodwill is not considered
impaired as long as the fair value of the unit is greater than its carrying
value. The second step is only required if an impairment to goodwill is
identified in step one.
2. Compare the implied fair market value of goodwill to its carrying amount. If
the carrying amount of goodwill exceeds its implied fair market value, an
impairment loss is recognized. That loss is equal to the carrying amount of
goodwill that is in excess of its implied fair market value, and it must be
presented as a separate line item on financial statements.
Step I - Test for Potential Impairment
·
Compares fair value of reporting unit with its
carrying amount (accounting value).
·
If fair value of reporting unit is greater than
its carrying amount (including recorded goodwill), then no impairment… no need
to perform Step II.
·
If the reporting unit carrying amount (including
recorded goodwill) is greater than its fair value, then must complete Step II
to measure the amount of impairment, if any.
Step II - Measuring the amount of impairment loss
·
This step compares the implied fair value at
goodwill of the reporting unit with the carrying amount of that goodwill.
Note 13 of SFAS 142 states "The fair value of goodwill can be measured
only as a residual and cannot be measured directly. Therefore, this Statement
includes a methodology to determine an amount that achieves a reasonable
estimate of the value of goodwill for purposes of measuring an impairment loss.
That estimate is referred to herein as the implied value of
goodwill".
·
The implied fair market value of goodwill shall
be determined in the same manner as the amount of goodwill recognized in a
business combination is determined.
·
In order to determine the implied fair value of
the goodwill, all assets must be valued.
·
Assets subject to testing under SFAS 121 must be
tested before goodwill can be tested under SFAS 142.
·
If the carrying amount of a reporting unit
goodwill exceed the implied fair value of that goodwill, then an impairment
loss must be recognized for an amount equal to that excess.
·
The impairment loss cannot exceed the carrying
amount of the goodwill. Only the value of goodwill is adjusted through this
process.
·
The adjusted carrying amount of goodwill will be
its new accounting basis.
·
Goodwill can not be increased to its original
carrying amount in the future. Once written down, it stays down.
See Paragraph(s) 19 - 22 of SFAS 142.
Historically, accounting for business combinations has been one of the most
controversial issues in financial reporting. With the rapid pace of change in
today's marketplace-driven by technological advances, new business models and
other factors-the role of financial reporting in maintaining stability of capital
markets will only increase. FASB 141 and 142 are intended to address critical
issues of currency and accuracy in financial reporting.
Experts expect the Securities & Exchange Commission to put a magnifying
glass to the new subjective valuations that will arise from FASB 141 and 142,
and the agency is likely to pay particularly close attention to how those
valuations are allocated in the purchase price in merger and acquisition deals.
That being the case, it is critical that companies hire a reputable firm to
provide expert valuations and impairment opinions under the new
statements.
> Write-off
Write-off may refer to either an accounting
write-off or an income tax write-off.
Income tax
In income tax calculation, a
write-off is the itemized deduction of an item's value from one's taxable
income. Thus, if a person has a taxable income of $50,000 per year, a $100
telephone for business use would lower the taxable income to $49,900. If that
person is in a 25% tax bracket, the tax due would be lowered from $7,481 to
$7,456. Thus the net cost of the telephone is $75 instead of $100.
Accounting
In business accounting, the term
write-off is used to refer to an investment (such as a purchase of salable
goods) for which a return on the investment is now impossible or unlikely. The
item's potential return is thus canceled and removed from ("written
off") the business's balance sheet. Common write-offs in retail include
spoiled and damaged goods.
Banking
Similarly, banks write off bad
debt that is declared noncollectable (such as a loan on a defunct business or a
credit card due that is now in default), removing it from their balance sheets.
Negative Write-offs
A negative write off is the
opposite of a write-off. That is, it is term used to refer to an overpayment
amount that will not be refunded to the individual or organization that has
overpaid on a claim. Negative write offs can sometimes be seen as fraudulant
activity because those who overpay a claim or bill are not informed that they
have overpaid and are not given any chance to reconcile their overpayment or be
refunded.
Write-down
Many of the consequences of the
subprime crisis at financial institutions are referred to as a
"write-down", which is synonymous with a write-off.
While a write-off
in banking refers to a bad loan that is declared uncollectable, removing it
from its balance sheet, a write-down, according to Investopedia, means:
Reducing the book value of an asset because it is overvalued compared to
the market value.
So while a "write-off" removes
the loan from the balance sheet, a "write-down" reduces the value of
the loan in the balance sheet. Despite this difference, both terms indicate
that the loaned money in question has no chance of being recovered.
For example, on October 6, 2007, The
Washington Post wrote:
"Washington Mutual will write down by $150 million the value of $17
billion in loans"
Write off – An Accounting Strategy:
Write-offs are an accounting strategy that allows for the reduction in value
of an asset or as a means of removing bad debt from the financial records of
the business. The use of a
write-off is a task
that can help a company maintain a more accurate inventory of the worth of
current assets. This includes the amount of funds currently residing in the Accounts
Receivable section of the financial records.
From time to time, a company may encounter a situation where a client
encounters financial hardship, and is unable to pay for goods or services
rendered. This creates a situation where the invoice for the services continues
to remain on the books of the company as an asset. When it becomes clear that
there is no chance of collecting on the outstanding invoice, it is advantageous
for the company to choose to write off the amount of the invoice as a bad debt.
An account
write-off is not something that a
company usually does without making reasonable attempts to collect the
outstanding debt. Once all reasonable efforts have taken place and the debt
remains unpaid, the company may determine that continuing to carry the debt on
the books will ultimately cost more in taxes, labor, and other resources than
the total amount of the debt. When this is the case, the company will opt for
enacting a
write-off. This declaration can also
result in using the amount of the bad debt as a tax
write-off,
which may in turn lower the amount of taxes due for the period in which the
declaration took place.
In other instances, write-offs may be allowed to reduce the value of an
asset to more accurately reflect the decrease in market value as the asset
grows older. A
write-off on production machinery
or office equipment are examples of how the
write-off
can be utilized, since both these assets do decline in value and functionality
over time. The
write-off process in many
manufacturing companies will require internal processes that may involve
declaring equipment and related parts to be obsolete, allowing for the items to
be written off as a deduction on taxes.
