Writedowns and Impairments

Introduction

Writedowns and impairments are crucial concepts in financial accounting and corporate finance. They pertain to the reduction in the book value of an asset when it becomes worth less than its carrying amount on the company’s balance sheet. This markdown can result from several factors, such as changes in market conditions, technology, obsolescence, or economic downturns. Understanding these concepts is essential for investors, analysts, accountants, and financial managers, as they have a significant impact on a company’s financial statements and ratios.

Defining Writedowns and Impairments

Writedowns

A writedown occurs when the carrying value of an asset is reduced due to a decline in its market value, technological obsolescence, or other factors. This reduction is typically reflected in the income statement as an expense, thereby reducing net income for the period. Writedowns are often a result of:

Impairments

Impairment occurs when an asset’s carrying amount exceeds the recoverable amount, which is the higher of its fair value less costs to sell and its value in use (the present value of future cash flows expected from the asset). Impairments usually occur due to factors such as:

Accounting for Writedowns and Impairments

Recognition in Financial Statements

When a writedown or impairment occurs, companies must recognize this loss in their financial statements. The specific accounting treatment can vary based on the type of asset and the accounting standards followed (such as IFRS, GAAP, etc.).

  1. Income Statement: The loss from a writedown or impairment is usually recorded as an expense, which directly reduces net income.
  2. Balance Sheet: The carrying amount of the asset is reduced to its recoverable value.
  3. Cash Flow Statement: Non-cash writedowns and impairments are added back to net income in the operating activities section because they do not impact cash flow directly.

Reversal of Impairment

Under certain accounting standards like IFRS, if the circumstances that led to an impairment change and the recoverable amount of the asset increases, the previously recognized impairment loss can be reversed, except for goodwill. However, the amount of the reversal is limited to the original carrying value had the impairment not been recognized.

Factors Leading to Writedowns and Impairments

Market Conditions

Economic factors such as recessions, market volatility, or industry-specific downturns can lead to significant declines in asset values. Companies operating in cyclical industries like real estate, commodities, and manufacturing are particularly susceptible to market condition-induced impairments and writedowns.

Technological Advancements

Rapid technological changes can render existing assets obsolete. For example, advances in semiconductor technology can make older manufacturing equipment less valuable, necessitating a writedown. Similarly, companies involved in software development may need to write down software that has become outdated.

Regulatory Changes

Changes in laws and regulations can impact asset values. For instance, stricter environmental regulations may devalue older machinery that fails to meet current standards, leading to impairments.

Internal Factors

Impairment Testing

Frequency of Testing

Different accounting standards prescribe varying frequencies for impairment testing. For instance, under IFRS, assets are tested for impairment whenever there is an indication that the asset may be impaired. Goodwill and intangible assets with indefinite useful lives are tested at least annually.

Testing Procedures

  1. Identifying Indicators of Impairment: Factors such as market value declines, adverse changes in the economy, or internal reports indicating poor performance may signal the need for an impairment test.
  2. Measuring Recoverable Amount: The recoverable amount is the higher of fair value less costs to sell and value in use.
  3. Comparing Carrying and Recoverable Amounts: If the carrying amount exceeds the recoverable amount, an impairment loss is recognized.

Impact on Financial Metrics

Writedowns and impairments can significantly impact a company’s financial metrics and ratios, affecting investor perceptions and valuation.

Profitability Ratios

Asset Turnover Ratios

Valuation Metrics

Debt Covenants

Writedowns and impairments can also affect a company’s compliance with debt covenants. These covenants often include requirements to maintain certain financial ratios, and unexpected impairments may lead to breaches, triggering adverse consequences such as loan renegotiations or increased borrowing costs.

Real-world Examples

Case Study 1: General Electric

General Electric (GE) has had multiple instances where writedowns and impairments significantly impacted their financials. For example, in 2018, GE faced a substantial impairment charge related to its power division, due to a decline in the market for fossil fuel-based power generation equipment.

Case Study 2: Oil & Gas Industry

The oil and gas industry is particularly prone to impairments due to volatile commodity prices. For instance, during the oil price crash in 2014, many companies including ExxonMobil and Chevron, wrote down the value of their reserves, impacting their balance sheets and leading to significant impairment charges.

Case Study 3: Technology Sector

In the technology sector, companies like Intel and IBM have periodically written down the value of older technologies as they pivot to new innovations. This is common as rapid technological advancements can quickly reduce the economic viability of existing assets.

Regulatory and Reporting Standards

International Financial Reporting Standards (IFRS)

Under IFRS, IAS 36 Impairment of Assets provides the guidelines for performing impairment tests and recording impairment losses. Key standards include:

Generally Accepted Accounting Principles (GAAP)

Under U.S. GAAP, the following standards are primarily relevant:

Best Practices for Managing Impairments and Writedowns

Regular Monitoring

Risk Management

Transparency and Disclosure

Conclusion

Writedowns and impairments are inherent aspects of asset management in financial accounting. They warrant careful consideration and proactive management to mitigate their impacts on financial health and investor perceptions. Understanding and adhering to the appropriate accounting standards, conducting regular asset reviews, and maintaining transparent reporting are essential practices for effectively managing writedowns and impairments.