An impaired asset is an asset whose market value is less than the amount carried on the balance sheet. Impairment of assets is commonly referred to as the “write-off” of an asset. Businesses are required to recognize a loss and write down the value of an asset if they determine that an asset has been impaired. Assets such as accounts receivable, notes receivable and goodwill are most likely to be impaired.
Depreciation of assets can happen to any business, but it can also be a sign of distress. Let’s see how it works and when it matters.
Understanding Impaired Assets
Here are the assets most susceptible to depreciation and what could be the triggering event:
- Accounts Receivable (AR): Accounts receivable are the money customers owe a business. Think of them as bar tabs. Companies use matching assets to proactively write off RAs based on historical amounts that have been written off. Still, there may be unique circumstances where more RAs than expected need to be written off. This can happen during a downturn in the economy when many customers default or are late in paying. It can also happen in a normal economy when a large customer defaults and the business is forced to write off the asset.
- Acceptable Notes: Think of them as loans owed to a bank. Due to the COVID-19 pandemic, many banks have been forced by the Federal Reserve to write off loans that could have gone wrong. Once the economy turned, the banks recorded a profit on the income statement and put the healthy loans back on the balance sheet.
- Good will: When one business buys another for more than the full book value of the acquiree, the acquiring business adds goodwill to its balance sheet to balance the transaction. Companies are required to test this amount of goodwill annually and determine whether the acquiree is still worth the premium paid for its assets. If this is not the case, the goodwill balance is impaired.
- Fixed assets: Capital assets include buildings, equipment and vehicles. It is rare for a fixed asset to need to be depreciated because most of it depreciates every year and some fixed assets (buildings) increase in value every year. A common reason that a tangible capital asset is depreciated is if it is sold for less than the current cost of ownership on the balance sheet.
Depreciation of fixed assets is an accounting function. There is no real money changing hands. It is governed by generally accepted accounting principles (GAAP) that all public companies are required to use by the Securities and Exchange Commission (SEC). If a company is public, it will hire an audit firm to make sure it is compliant with GAAP, and the audit firm will often be the one who tests and calculates the impairments.
Recognition of impaired assets
Let’s get to the heart of the matter of asset depreciation, starting with how to calculate it.
For ARs, it’s pretty straightforward. If a customer defaults, the business can write off the amount from their account. If a business has multiple accounts that are going bad at once due to an economic calamity, it can adjust the rate it uses for bad debt to proactively write off more. It is generally the same for fixed assets. There may be unique cases where an asset is depreciated before it is sold or transferred, but for the most part the business knows exactly the amount of depreciation because there is an actual transaction record.
Loans are more difficult and the process used by banks to cancel loans would take quite a manual to explain. Banks have multiple levels of loan risk, and they are moved to higher risk levels when payments are missed or paid late. If a loan is formally restructured with the customer or if the customer defaults, it is fully or partially amortized. Otherwise, the bank maintains an allowance for loan loss account based on historical losses, but does not cancel individual loans until forced to do so.
Goodwill is the most common write-down of assets for the types of public enterprises you will see as an investor. The company is required to assess each subsidiary each year and compare this value with the amount of assets (including goodwill) carried for it on the balance sheet. If the activity is failing and this deficit is expected to be permanent, the goodwill balance is adjusted and a loss is recorded in the income statement.
Goodwill impairment can occur for a number of reasons. The subsidiary could be poorly managed, manufacture a bad product, suffer a loss of market demand or simply have been overvalued during the acquisition.
GAAP requires that many assets be tested for impairment each year, but companies need to know well in advance what types of impairment are to come.
Example of impaired asset
In addition to writing off bad debts, many banks took on goodwill impairment charges in 2020. BBVA (NYSE: BBVA), PacWest Bancorp (NASDAQ: PACW), and Umpqua Holdings Corporation (NASDAQ: UMPQ) each wrote off over $ 1 billion in goodwill. United natural foods (NYSE: UNFI) wrote off nearly $ 500 million in goodwill at the end of 2019 when it determined that its acquisition of SuperValu had not been worth the price.
The greatest disability of all could come with Meta-platforms (NASDAQ: FB), the parent company of Facebook. In 2014, the company paid $ 22 billion for WhatsApp, which lost more than $ 200 million in the first half of the year. Facebook now has nearly $ 19 billion in business, but seven years later, WhatsApp still isn’t making enough money to justify that amount. Facebook’s net income in 2020 was $ 29 billion. This means that there is a possibility that Meta’s net income could be cut in half or by a third if it cancels out the goodwill related to WhatsApp.
Why is asset depreciation important?
Impairment of assets is often a routine accounting transaction. This does not mean that the company is in trouble or that the stock is overvalued on its own. However, beware if you come across shares of a company that is a serial acquirer and still ends up amortizing goodwill after a few years. Management is likely to continue to overpay and waste your money. Likewise, if a stock has a ton of AR write-offs every year, it can generate income by selling to unqualified clients.