Assets that are unable to earn their original economic return
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Stranded assets are assets that are unable to earn their original economic return due to changes in the landscape in which the assets operate. In simpler terms, stranded assets are assets that are worth less than expected.
Stranded assets are assets that are unable to earn their original economic return.
Stranded assets impact both the balance sheet (reducing asset value) and income statement (non-cash loss).
An impairment test can determine whether an asset is stranded.
Understanding Stranded Assets
Stranded assets are assets that faced:
Conversion into liabilities
At an extreme, stranded assets may face obsolescence and, as a result, be written off a company’s balance sheet entirely, with the resulting loss reflected on the income statement.
Stranded assets arise due to unexpected negative changes in the assets earning power, caused primarily by external factors. For example, a machine used solely to produce gas-powered cars is likely to be considered a stranded asset as society becomes more environmentally conscious and increases its adoption of electric vehicles. As a result, the machine’s economic return would become impaired as it produces fewer gas-powered cars than originally intended.
Stranded assets are commonplace in industries faced with:
A quick technology lifecycle
Changing social norms
Testing an Asset for Impairment
To determine whether an asset is “stranded,” accountants conduct impairment tests. An impairment test is a common accounting procedure used to determine potential asset devaluations. Under the Generally Accepted Accounting Principles (GAAP) and International Financial Reporting Standards (IFRS), tangible assets and intangible assets must be written down when impaired below their book value.
Testing for Impairment under US GAAP
Under GAAP, the asset’s carrying value (original cost – accumulated depreciation) is compared with the undiscounted future cash flows (UFCF) generated by the asset. If the carrying amount exceeds the UFCF, the asset is considered impaired.
Testing for Impairment under IFRS
Under IFRS, the asset’s carrying value is compared to (1) the fair value less costs to sell the asset and (2) the fair value in use (the present value of future cash flows generated by the asset). If the carrying amount exceeds either the greater of either fair value less costs to sell or fair value in use, the asset is considered impaired.
Impact of Stranded Assets on Financial Statements
Asset devaluations impact a company’s income statement and balance sheet. The amount of the devaluation reduces the company’s assets value on the balance sheet, and the charge is reflected in the income statement as a loss. Since an asset devaluation is a non-cash event, there is no associated outflow of cash. To solidify your understanding of the impact of a stranded asset, let us walk through an example:
Example: A company reports under GAAP and is an operator of oil platforms. Due to the growing popularity of clean energy, management expects its oil platforms, currently at a carrying value of $5,000,000, to only be able to generate total undiscounted future cash flows of $3,000,000.
Question: Are the oil platforms considered impaired? If so, what would be the appropriate journal entries?
Answer: Under GAAP, the oil platforms are considered impaired, as the carrying value is above the total undiscounted future cash flows generated. An impairment loss of $2,000,000 would be necessary. The journal entries would be as follows:
Stranded Assets in an Environmentally Friendly Society
With progression towards a greener society and investors pursuing clean energy investments, fossil fuel companies’ assets are set to become stranded. According to a study, one to four trillion US dollars could be wiped off global fossil fuel assets as future demand for fossil fuel decreases.
For example, in the wake of the 2020 coronavirus pandemic, a downbeat view on longer-term oil prices, and countries pursuing the Paris Agreement climate goals, oil giant British Petroleum Company Plc reported plans to write down the value of its assets by USD 13-13.7 billion.
Not only are oil and gas companies facing stranded assets in the pursuit of a greener society – traditional car manufacturers are facing the same fate. Regulators in various jurisdictions are currently pursuing the electrification of cars to decrease carbon dioxide emissions
For example, China intends to make all new vehicles sold in 2035 eco-friendly, and Japan plans to stop the sale of gas-powered cars by the mid-2030s. In the U.S., California Governor Gavin Newson signed an executive order in 2020 stating that all vehicles sold in the state of California must be emission-free by 2035.
Currently, carmakers are in a race to update or modify factories dedicated to producing internal combustion engines to avoid them from becoming stranded.
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