How is Asset Disposal Linked to Financial Distress?

Asset disposal is a risk management strategy that aims to avoid defaulting on debt

Аsset disposal, as the name suggests, is the action of offloading assets to recuperate costs. However, this simple definition raises some very important questions. For example, is asset disposal just the same as the sale of an asset, or are there other technical considerations behind it? More importantly, how is it accounted for in a company’s financial records? Why do distressed companies, in particular, engage in asset disposal? Finally, is there a better way to manage risk and avoid having to offload assets at a potential loss?

Table of contents:

  1. What is Asset Disposal?
  2. How is Asset Disposal Accounted for?
  3. Risk Management by Financially Distressed Companies

What is Asset Disposal?

Asset disposal is a term that stands for the removal of long-term capital assets (fixed assets) from the company’s financial records. As per accounting standards (IFRS / US GAAP), this is referred to as the derecognition of assets. Hence, at the time of disposal, a journal entry is made in the company’s records.

How is Asset Disposal Accounted for?

The accounting journal entries for asset disposal vary depending on the circumstances in which it is performed. There exist the following scenarios:

Scenario 1: Disposal of a Fully Depreciated Asset

Company X acquired a building 10 years ago at a cost of $90m with an estimated useful life of 10 years and nil residual value. After ten years, the building is fully depreciated with accumulated depreciation equal to the cost and nil Net Book Value.

Cost (Building)$90m
Less: Accumulated Depreciation($90m)
Net Book Value

Since the building is fully depreciated, its cost and accumulated depreciation must be written off. Moreover, as the Cost Account is a debit account, and Accumulated Depreciation, being a contra-asset is a credit account, the following journal entry must be made to record this asset disposal:

Dr. Accumulated Depreciation$90m
Cr. Cost (Plant)$90m

Scenario 2: Disposal of Asset by Sale with a Gain (or Loss)

Let’s reconsider the same scenario but with a different outcome. This time around the company has decided to sell the building after 5 years. So, since the building isn’t fully depreciated, its Net Book Value would have only gone down in half:

Cost (Building)$90m
Less: Accumulated Depreciation for 5 years($45m)
Net Book Value$45m

Assuming a sale price for the building of $50m, the new journal entry would have to be:

Dr. Cash$50m
Dr. Accumulated Depreciation$45m
Cr. Cost (Building)$90m
                   Cr. Gain on Sale$5m

Alternatively, if the sale price is $40m, the company would record a loss of $5m.

Scenario 3: Disposal of Asset to Charity

Finally, instead of selling the building at the end of year 5 the company has decided to donate it to a charity. Hence, there would be no cash consideration and the disposal of the asset would count as a loss equal to its Net Book Value:

Dr. Loss on Disposal to Charity$45m
Dr. Accumulated Depreciation$45m
Cr. Cost (Building)$90m

The scenarios discussed above reflect how companies account for their disposal of assets. With respect to the Balance Sheet, the asset is completely derecognized, i.e. written off, in all cases. Correspondingly, a gain or loss (if any) is recognized on the Income Statement.

Risk Management by Financially Distressed Companies

What is Financial Distress?

Before we discuss how financially distressed companies use asset disposal as a risk management strategy, let’s define what financial distress is. According to the industry life cycle model, companies go through 4 stages of development – introduction, growth, maturity, decline.  A state of financial distress is most characteristic of the final stage. It reflects the inability of an entity to generate sufficient income to cover its needs. Hence, financially distressed companies are at risk of defaulting on their debts or going bankrupt.

Consider an example of a company that has obtained financing from a commercial bank. As per the terms of its loan, the company has to repay interest and make principal payments within a stipulated timeframe. Moreover, they have to maintain certain financial covenants including healthy interest cover, strong leverage, and other solvency ratios.

So, if the company is generating steady cash flows from operating activities and is able to repay its debt and comply with financial covenants, it is not at risk of financial distress. However, if it becomes unable to meet its obligations, it will have to default. The cost of financial distress can be very high as the lender may require immediate payment of total obligations. In that case, declaring bankruptcy may be the only solution.

How to Manage Financial Distress?

In order to avoid this, risk management strategies are actively deployed by companies to manage financial health. More specifically, companies implement mechanisms that regulate liquidity ratios as part of normal business operations. Such approaches aim to ensure there is at least enough cash on hand to pay off obligations as they are due without risking default.

However, in some cases risk management may fail leaving the company with the grim prospects of default and bankruptcy. Then the disposal of company assets might be the last resort  

If that were to occur, companies sell assets to release immediate cash and pay off outstanding obligations. When done well and on time, this measure can save a financially distressed company. Assets sold under circumstances of distress are usually acquired at prices lower than their fair market value. Because of the immediate need for liquidity, such disposals are considered a forced sale.  

What’s Next?

So far, we’ve only discussed risk management from the perspective of companies, whether distressed or stable. But there are a wide range of credit risk mitigation strategies landers employ to prevent default scenarios. Though, even then we can’t always keep abreast of adverse circumstances. Just as an example, company defaults usually surge in times of crisis, as evidenced by the 2020 pandemic.

Still, any prudent financial analyst will know how to leverage the full range of tools at their disposal to fend off catastrophic plunges in liquidity. As we saw, in many cases this comes down to proper ratio analysis. Working with ratios, however, isn’t as straightforward as determining when a company made a profit or a loss on the disposal of an asset. That’s why we recommend the Introduction to Financial Ratio Analysis to prospective financial analysts looking to grasp the underlying intuition behind many crucial corporate finance decisions.

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