Adjusted long term impairment: Meaning, Criticisms & Real-World Uses

What Is Adjusted Long-Term Impairment?

Adjusted Long-Term Impairment refers to the reduction in the value of an entity's non-current assets recorded on its balance sheet, where the recorded value exceeds the amount that can be recovered through its use or sale. This concept is a crucial aspect of accounting principles and financial reporting, ensuring that a company's financial statements accurately reflect the true economic worth of its long-lived assets. When an asset's carrying amount is greater than its recoverable amount, an impairment loss is recognized, reducing the asset's book value. This adjustment is particularly important for stakeholders who rely on precise financial data to make informed decisions about a company's health and future prospects.

History and Origin

The concept of asset impairment has evolved significantly with the development of modern accounting standards. Prior to standardized rules, companies had more discretion in how they recognized declines in asset value. However, as global markets became more interconnected and the need for greater transparency in financial statements grew, accounting bodies introduced specific guidelines.

One of the most influential standards is IAS 36, "Impairment of Assets," adopted by the International Accounting Standards Board (IASB) in April 2001, which consolidated earlier requirements on assessing asset recoverability. This standard mandates procedures to ensure that assets are not carried in financial statements at more than their recoverable amount.⁶ The standard has been revised multiple times, including in March 2004 and May 2013, to refine requirements for business combinations and disclosures of recoverable amounts for non-financial assets.⁵ In the United States, similar principles are covered under Generally Accepted Accounting Principles (GAAP), primarily through ASC 360 for long-lived assets and ASC 350 for goodwill and other intangible assets. These standards aim to provide a consistent framework for recognizing when an asset's value has been permanently diminished.

Key Takeaways

Adjusted Long-Term Impairment occurs when an asset's book value exceeds its recoverable amount, necessitating a write-down.
This accounting adjustment ensures financial statements provide a true and fair view of a company's asset values.
Impairment losses directly impact a company's profitability, reducing net income on the income statement.
Mandated by accounting standards like IAS 36 and U.S. GAAP, impairment testing is a regular financial reporting requirement.
It highlights underlying issues with an asset's performance, market conditions, or management's initial valuation assumptions.

Formula and Calculation

An impairment loss is recognized when the carrying amount of an asset or cash-generating unit exceeds its recoverable amount. The formula for calculating an impairment loss is:

\text{Impairment Loss} = \text{Carrying Amount} - \text{Recoverable Amount}

Where:

Carrying Amount: The asset's value on the balance sheet, which is its original cost minus accumulated depreciation or amortization.
Recoverable Amount: The higher of an asset's fair value less costs of disposal and its value in use.⁴

Value in use is typically calculated as the present value of the future cash flow expected to be derived from the asset.

Interpreting the Adjusted Long-Term Impairment

Interpreting Adjusted Long-Term Impairment involves understanding why the write-down occurred and its implications for a company's financial health. A significant impairment charge signals that a previously held asset is no longer expected to generate the economic benefits initially anticipated. This could be due to various factors, such as technological obsolescence, unexpected changes in market demand, increased competition, or poor strategic decisions related to an acquisition.

A large impairment loss can severely impact a company's reported profitability, as it is recognized as an expense on the income statement. While it is a non-cash expense, it reduces reported earnings and can negatively affect investor perception. Analysts and investors scrutinize these adjustments to gauge management's forecasting accuracy and the underlying value of the company's assets.

Hypothetical Example

Imagine a technology company, "TechInnovate Inc.," acquired a specialized manufacturing plant for $500 million five years ago. This plant, a long-term asset, was expected to have a useful life of 20 years with no salvage value. TechInnovate used straight-line depreciation.

After five years, the accumulated depreciation is:

\frac{\text{\$500 million}}{20 \text{ years}} \times 5 \text{ years} = \text{\$125 million}

The carrying amount of the plant on the balance sheet is:

\text{\$500 million} - \text{\$125 million} = \text{\$375 million}

Due to rapid advancements in manufacturing technology and a decline in demand for the products produced by this specific plant, TechInnovate performs an impairment test. They determine that the plant's fair value less costs to sell is $200 million, and its value in use (present value of future cash flows) is $220 million.

The recoverable amount is the higher of these two values, which is $220 million.

Since the carrying amount ($375 million) exceeds the recoverable amount ($220 million), TechInnovate must recognize an Adjusted Long-Term Impairment loss:

\text{Impairment Loss} = \text{\$375 million} - \text{\$220 million} = \text{\$155 million}

This $155 million impairment loss would be recorded as an expense on TechInnovate's income statement, reducing its reported profit for the period. The plant's carrying amount on the balance sheet would be reduced to $220 million.

Practical Applications

Adjusted Long-Term Impairment is a critical component of financial reporting and financial analysis, appearing in various contexts:

Corporate Financial Statements: Companies regularly assess their long-term assets for impairment, particularly when there are indicators of a potential decline in value. These indicators can include significant changes in the business environment, a decline in an asset's physical condition, or a drop in market value. The resulting impairment losses are disclosed in their financial statements, affecting profitability and asset bases. For example, General Electric (GE) recorded a non-cash goodwill impairment charge of $22 billion in the third quarter of 2018, primarily related to its GE Power unit, which significantly impacted its reported results.³
Mergers and Acquisitions: Following an acquisition, the acquired assets, including goodwill and intangible assets, are often tested for impairment. If the acquired business fails to perform as expected, a goodwill impairment charge may be necessary.
Economic Downturns and Market Volatility: During periods of economic stress, such as recessions, companies may experience widespread declines in asset values. This often triggers impairment tests across industries, leading to significant write-downs. Studies indicate that total goodwill impairment recorded by U.S. public companies more than doubled in 2020, reaching $142.5 billion, due to the global economic crisis triggered by the COVID-19 pandemic.² Furthermore, economic stresses like inflation and interest rate fluctuations can make impairment analyses crucial for businesses to navigate their financial health.¹

Limitations and Criticisms

While Adjusted Long-Term Impairment aims to provide a more accurate depiction of asset values, it is not without limitations and criticisms. One primary challenge lies in the subjective nature of the valuation process, particularly in determining an asset's recoverable amount. Estimating future cash flow and appropriate discount rates can involve significant judgment, which can lead to variability in impairment calculations across different companies or even within the same company over time.

Critics also point out that impairment charges are often recognized after a significant decline has already occurred, potentially providing investors with lagging rather than leading indicators of financial distress. The non-cash nature of impairment losses can also be misunderstood; while they reduce reported earnings, they do not directly affect a company's cash flow in the period they are recognized.

Furthermore, some argue that the "triggering event" approach, where impairment tests are only required when indicators suggest a potential loss, can delay the recognition of declines in asset value. While standards like IAS 36 require annual impairment tests for goodwill and certain intangible assets, other long-lived assets are only tested when impairment indicators are present.

Adjusted Long-Term Impairment vs. Goodwill Impairment

Adjusted Long-Term Impairment is a broad term encompassing the reduction in value of any long-lived asset, including property, plant, equipment, and intangible assets. Goodwill Impairment, on the other hand, is a specific type of long-term impairment related solely to goodwill.

Goodwill arises when a company acquires another entity for a price higher than the fair value of its identifiable net assets. It represents intangible elements like brand reputation, customer relationships, or skilled workforce. Because goodwill does not independently generate cash flows and is not subject to depreciation or amortization under U.S. GAAP, it is tested for impairment annually, or more frequently if triggering events occur. The impairment test for goodwill compares its carrying value to its fair value. If the carrying value exceeds its fair value, an impairment loss is recognized.

Thus, while goodwill impairment is a specific instance of an asset write-down, Adjusted Long-Term Impairment is a broader category that covers the decline in value of any long-term asset, whether tangible or intangible.

FAQs

What causes an Adjusted Long-Term Impairment?

An Adjusted Long-Term Impairment is typically caused by events or changes in circumstances that indicate an asset's carrying amount may not be recoverable. Common causes include a significant decline in an asset's market value, adverse changes in the business or economic environment, technological obsolescence, or a decline in the expected performance or use of the asset.

Is an impairment loss a cash expense?

No, an impairment loss is a non-cash expense. It reduces the reported net income on a company's income statement but does not involve an outflow of cash flow from the company. It primarily serves as an accounting adjustment to reflect a decrease in the economic value of an asset on the balance sheet.

How often are long-term assets tested for impairment?

Under U.S. GAAP, long-lived assets (excluding goodwill and certain intangible assets with indefinite lives) are generally tested for impairment when there is an indication that their carrying amount may not be recoverable. Goodwill and intangible assets with indefinite lives are required to be tested for impairment at least annually. International Financial Reporting Standards (IFRS) also require an annual review for indicators of impairment for most assets, with an impairment test performed if indicators exist, and annual testing for goodwill and intangibles with indefinite useful lives.

Can an Adjusted Long-Term Impairment be reversed?

Under IFRS (e.g., IAS 36), an impairment loss for assets other than goodwill can be reversed if there is an indication that the impairment loss no longer exists or has decreased. However, the reversal cannot exceed the asset's carrying amount had no impairment loss been recognized. Under U.S. GAAP, impairment losses on long-lived assets held for use are generally not reversible once recognized. Impairment losses on assets held for sale may be reversed under specific conditions.