This week, I have an educational post, instead of a valuation one. It is all about impairment – a fancy term that I'm sure plenty of you have come across.
The post is divided into 4 segments:
– Impairment of tangible assets
– Events that lead to impairment
– Impairment of intangible assets
– Impairment of goodwill
Impairment of tangible assets
Impairment, in the realm of accounting, refers to the reduction of the value of an asset.
Therefore, the first thing that we need to establish is, how is the value of an asset being measured, and why is this so important?
Let's start with a simple example. Imagine that there’s a company named XYZ, that owns a car, but there’s no employee with a driver’s license. Well, what can they do with the car? Nothing, but to sell it. So its value is equal to whatever the company can sell the car for, minus the costs that will be incurred in the process of selling. Let’s assume that this number was $20k. In accounting, this is the so-called “fair value less selling costs“.
If the book value is $25k, that obviously doesn’t represent the fair value, and the car accounting-wise is overstated. Therefore, a $5k impairment would be recorded.
Now, let's imagine that there is someone who can drive it. In this case, the company can also derive value by using this asset. Therefore, the asset has so-called “value in use”. How can this asset be used? Plenty of ways. Let’s keep it simple, and assume that XYZ is a delivery business, and thanks to this asset, the company makes $2k net profit per month. The value of a business is the present value of future cash flows. Let’s assume that the value in use of the asset is $40k.
So, now, we have two numbers:
- Fair value less selling costs ($20k)
- Value in use ($40k)
On the balance sheet, the car is reported at $25k. So, is there an impairment? Which value should be used from the two above? The answer is – the higher one. That is the value of the asset to the business and that is referred to as “recoverable value“. The company can “recover” $40k of value from the asset.
As the recoverable value of $40k is above the book value of $25k –> There will be no impairment.
This so-called impairment test is mandatory and is done at least once a year.
Events that lead to impairment
There are plenty of events that could lead to impairment and they can be grouped into 3 categories:
- Change in demand – Remember the first example above, where the only option the company had was to sell the car? Well, if there is an adverse change in demand, that would lead to a lower price. So if the company is to sell the same asset, the cash received would be lower, leading to further impairment.
- Damage to the asset – Imagine if a tree falls over the car and it is now completely destroyed. It can no longer be sold for as much, and it can no longer be used. (Assuming there's no insurance on the car)
- Change in legal/economic condition – In the second example above, the business was generating $2k net profit per month. If the economic environment changes, and now the business is no longer as profitable, the value in use of $40k cannot be justified.
Although these are simple examples, if you understand this, you can follow the impairment of all physical assets.
Why would a company impair a building? Well, maybe the building is no longer in use, and the market prices declined significantly. Maybe there was a fire that damaged the building.
Why would a company impair inventory? The market prices could decline, it might be due to a flood that damaged the inventory, or it could be that the inventory became obsolete.
Intangible assets
Let’s introduce another company, named ABC, which owns a patent for cutting-edge technology. The company bought the patent from a start-up for $1 million. Based on the internal calculation, this patent will yield significant returns in the future and the price paid can be justified. So, on the balance sheet, there’s a patent reported with a book value of $1 million.
Recently, a few competitors developed similar technology, and the value of $1 million can no longer be justified. The estimated value in use has decreased and it is clear that an impairment would be recorded.
Impairment of goodwill
Now, let's bring the two companies together. The management of ABC decided that this whole patent cutting-edge technology is just not for them. Instead, they'll buy XYZ, the delivery business that owns a car. After running some calculations internally, they submitted an offer of $50k that was accepted.
So, they’re paying $50k for buying a car? Can they not buy a car and start their own business? Definitely, but it will take time until they get to the point of earning $2k/month. So paying more than the net assets value of a business is normal. They are also acquiring the customer relationships that XYZ built with its existing customers, the brand that was built over the years. These are intangible assets and some of them can be estimated.
So, on the balance sheet of ABC, there's $50k less cash, and instead, they got:
– Car – $20k (the price if they are to buy the car on the open market)
– Customer relationships – $10k
– Goodwill – $20k
Goodwill is an accounting plug, that explains the entire cash outflow for an acquisition and it only occurs in this event. This is also subject to impairment.
When does it get impaired? When the value of the acquired business has declined and what is on the balance sheet can no longer be justified.
As mentioned earlier, the value of the business is the present value of the future cash flows. If the delivery business starts losing money and is expected to do so in the future, it is difficult to justify the $50k on the balance sheet. So, goodwill will get impaired. Impairment of goodwill is basically a result of a poor acquisition.
The management had certain assumptions, under which the value of the acquired company was estimated, and turns out they were wrong.
I hope that you enjoy this post, and I'll try to share more educational content.
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