An asset is written down due to impairment. In subsequent accounting periods, the effects on the firm’s financial statements will include: a. Lower pretax cash flow b. Higher profitability. c. Higher depreciation expense. d. Higher shareholders’ equity. Which choice and why?
I had to refer to p. 405 of Volume 3 to think this one throught. Here goes. When a company takes an impairment charge, it immediately increases expense, reduces profitability (in the current year), and reduces shareholders’ equity (i.e., we rule out Choice “D”). Because the impairment charge has been taken, net net book value of the asset is smaller so that depreciation in, say, the next year is smaller. This rules out Choice “C”. Because depreciation expense is smaller in the next year, we would expect the company to report higher earnings, i.e., Choice “B” is looking good. Finally, I don’t know what to do with Choice “A”, since impairment is a non-cash activity. My answer is Choice “B”. Please note that for tax purposes, an impairment charge is not recognized until the company disposes of the asset being impaired (e.g., the asset is sold or retired).
I would think it is choice A. Since you took a higher expense in the year immediately following, there goes your higher NI down the drain, and so with it your Higher Profitability (Choice B is out). By this – and with cadlag’s reasoning for C and D – A remains the only choice left. EBITDA would be lower - so your pre-tax cash flow would be lower too. CP
Good thinking cadlag, but why would you not take choice D "Higher shareholders’ equity. ", if you think profitability will be higher?
Hi, Dreary. An increase in shareholders’ equity would be a reasonable expectation given that you expect net income to be higher. However, I am thinking of shareholders’ equity relative to what shareholder’s equity was prior to the writedown. It would take some time to catch up, i.e., it would be lower (not higher) relative to the pre-writedown level of shareholders’ equity. Profitability on the other hand would be greater, since net income is expected to increase and we have a smaller equity, i.e., ROE is higher.
cpk123, true for first year, but the question asks about subsequent years. cadlag, you should not compare to year of the hit, but to previous state of the financials. The reason profitability will be higher is not because the next year profitbility will be better than the year you got hit (that’s obvious), but rather because your depreciation will be lower going forward, so NI will be a higher level than pre write-down state. So with respect to equity, you would think that going forward, equity will be higher due to higher NI, but will it? That is, we should ignore the first year, and ask what the numbers will be as compared to pre write-down numbers.
Hi, Dreary. I will need to bail me out on this one. Starting to fade in and out of consciousness.
ok, here is what Stalla says: Shareholders’ equity will be reduced by the difference between the amount by which the asset’s book value is reduced on the balance sheet and the related change in the net deferred tax asset/liability. Whatever that means, I rest my case!
I was under the impression that writing down an asset would cause NI & assets to be lower in the ealier years. In later years, assets would increase causing higher equity? My Answer would of been D
my answer would be B. Less depreciation in subsequent years so higher income…
B
By charging an impairment, you decrease your assets and equity, and hence the profitability in subsequent years (in terms of both ROA and ROE) will be lower.
I would answer B.
The larger picture on this is the “Big Bath” accounting. New guy takes over for old guy, and impairs the bejeezus out of everything. “Holy cow, this place was a mess when I took over. They were carrying all this stuff on the books and depreciating it when it was seriously f-ed”. But the next period, when the profitability is on the new guy’s watch, the depreciation expense is lower so NI is higher so it looks like the new guy has really turned the place around.
Before reading the thread: B. After reading the thread: B. Higher net income in subsequent periods due to lower depreciation expense. If you measure profitability by ROA, assets are also lower in subsequent periods. However, the most important thing is that the NI number is the numerator in profitability formulas. Measuring ROE will yield a higher result in subsequent periods too because equity took a one-time hit with the write-down and is catching up. Also, the percentage move in NI is greater than you would have in equity, which would yield a higher result: ROA = 10/500 = 2% ROA2 = 15/495 = 3.03% Even if, for some reason, equity were higher in subsequent periods, the increased NI will offset this: ROE = 10/200 = 5% ROE2 = 15/240 = 6.25%
Hello all, I would advice you to read this general article: http://www.investopedia.com/study-guide/cfa-exam/level-1/assets/cfa20.asp I would go for A.
B. Not A because impairment does not affect cash flow for the same reason that depreciation does not affect cash flow.
Impairment would go out of your earnings. It is not a NON-Cash expense like Depreciation. So your Net income which is the starting point of your cash flow statement would definitely go down, and hence your cash flow will be lower. CP
cpk123, I am not sure it is any different than depreciation. In either case, you would add the charge back to NI to arrive at casf flow from operation (CFO). Say you wrote down an asset which had a BV of $100k. In calculating CFO, you would add back teh $100k loss on retirement of asset, just as you do with depreciation. Could you clarify your point?
From Investopedia Quote: A company’s asset that is worth less on the market than the value listed on the company’s balance sheet. This will result in a write-down of that same asset account to the stated market price. Accounts that are likely to be written down are the company’s goodwill, accounts receivable and long-term assets. Investopedia Says… If the sum of all estimated future cash flows is less than the carrying value of the asset, then the asset would be considered impaired and would have to be written down to its fair value. Once an asset is written down, it may only be written back up under very few circumstances. Firm’s carrying goodwill on their books are required to make tests of impairment annually. Any impairments found will then be expensed on the company’s income statement. End Quote The Asset Impairment IS NOT A Sale of an asset. It is a Write down in the value of an asset. From my understanding – it is only a Write down in the value of the asset, which then shows up as an EXPENSE item, therefore a REDUCTION IN CASH. This is not like a Sale of an asset at a GAIN or a LOSS - which then gets Subtracted (for Gain) and added (for Loss) on the Sale of the asset. I think there is a primary distinction to be made here. CP