Hi, i’m just getting confused on the effect in ROE/ROA after an asset is impairment and written downwards.
Lets assume an asset is impaired as its carrying value exceeded its recoverable cost, so on the balance sheet 1) the asset was written down by $10,000 and 2) on the income statement a $10000 loss was incurred.
Ignoring any tax effects, how can ROA decline in the first year when both income and assets are down? This is what confuses me.
In subsequent years, as assets are now less and income is higher due to less depreciation, ROE/ROA are higher and in this i agree with the CFA material, but during the first year? I cant grasp the concept!
In the first year, both assets and income fall by the same amount (eg. if you write down a $10,000 asset, then you remove this from assets, and also pass the impairment through the income statement as an expense).
So assume your net income was $20,000, your assets were $110,000, and your equity is $60,000. Pre-write down it would be as follows:
ROA = $20,000 / $110,000 = 18.2%
ROE = $20,000 / $60,000 = 33.3%
Post-write down, net income would be $10,000 (as you pass the $10,000 additional expense), assets would be $100,000 (as you wrote down the asset of $10,000), and equity would be $50,000 (as retained earnings would fall as a result of the drop in net income from $20,000 to $10,000). So now:
ROA = $10,000 / $100,000 = 10.0%
ROE = $10,000 / $50,000 = 20.0%
So in the first year ROA and ROE are both lower.
Strictly speaking, it is not always true. If your ratio>1 (which is rare, but theoretically possible), then it will go up. e.g. E=300, A=200, ROA=1.5.
If you write down 100 worth of assets, new ROA is 200/100=2.0. Same for equity, although ROE>1 is even more improbable.
For the purposes of the exam, “most likely” these ratios will go down.
@nsker I’m not quite sure what you mean.
ROA is (net profit)/(assets)
ROE is (net profit)/(equity)
Without the net profit figure you cannot calculate the ratios. However, even in your scenario of E=300 and A=200, if 100 was written off then E=200 and A=100.
Yes, if net profit was higher than equity or assets then it would lead to a higher number, but you would be starting from a negative equity position so you could argue that ROE is infinite as equity cannot be less than 0 for a limited company.
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