Impairment of long-lived assets: recognition, measurement and disclosure. (Accounting)by Gottlied, Max
Investors, creditors, and financial statement analysts often express surprise and anger when huge write-offs of long-lived assets are reported. They believe management and auditors should have warned users of the statements about the possibility of these write-offs. These beliefs, whether correct or not erode the public's confidence in the credibility of financial statements.
Compounding this problem is the lack of accounting literature on asset impairments. There is little guidance on when to recognize impairments, how impairments should be measured and how they should be disclosed.
Reaction By the Accounting Profession
In July 1980, the AICPA sent the FASB an issues paper entitled, Accounting for the Inability to Fully Recover the Carrying Amount of Long-Lived Assets. The conclusion of the paper was that asset impairments should be recognized in the financial statements. Then, however, the FASB voted not to add the topic of impairment to its agenda.
During 1984 to 1986, the Emerging Issues Task Force discussed this problem. It noted the divergent measurement practices for impairments, and the significant increase in the frequency of write-downs.
In October 1987, FASAC ranked impairment as the most important issue for possible inclusion on the agenda of the FASB. Finally, in November 1988, the FASB added this project to its agenda, and in December 1990 it issued a Discussion Memorandum analyzing the various issues and sub- issues involved.
References in the Literature
An early reference to accounting for asset impairments is found in APBO 4, which describes basic concepts underlying financial statements. It states that declines in the market values of noncurrent assets are generally not recorded until the assets are disposed of or determined to be worthless. It goes on to state, "In unusual circumstances persuasive evidence may exist of an inability to recover cost although the facilities have not become worthless. The amount at which those facilities are carried is sometimes reduced to recoverable cost...." SFAS 5, Accounting for Contingencies, states that when it is both probable that an asset has been impaired and the loss can be reasonably estimated, the loss should be accrued, and the asset written down. However, it goes on to declare, "In some cases the carrying amount of an operating asset not intended for disposal may exceed the amount expected to be recoverable ...." The question of whether in those cases it is appropriate to write down the carrying amount of the asset ... is not covered by this statement."
SFAS 19 makes the same declaration: "The question of whether to write down the carrying amount of productive assets ... is unsettled under present generally accepted accounting principles." While both SFASs 5 and 19 acknowledge the problem of impairment, they do not address it.
In a 1980 issue paper on asset impairment presented to the FASB, the AICPA task force made the following specific recommendations:
1. The inability to fully recover the carrying amounts of long-lived assets should be reported in the statements;
2. The concept of permanent decline is unsatisfactory and the probability test of SFAS 5 is a preferable alternative; and
If an asset has been written down, future upward adjustments that do not exceed the carrying amount before the write-down should be permitted if the evidence indicates a recovery.
An Overview of the Broad Issues
To determine whether an asset has been impaired, we must compare its historical carrying cost to some other measure of value. The amount of the impairment is the excess of the asset's carrying cost over this value. Accordingly, a major and central question that presents itself is: What measure of value should be used for this comparison?
There are a number of possibilities from which to choose: current cost (replacement cost), current market value (selling price), net realizable value (selling price minus disposal costs), or the sum of the future net cash flows from the asset. The cash flows may or may not be discounted to present value using an appropriate interest rate. This rate can be the company's incremental borrowing rate, its cost of capital, or a risk-free rate.
In a survey by the Financial Executive Institute, 46% of the companies surveyed used net realizable value as the measurement base, 18% used undiscounted future net cash flows, 14% used the present value of future net cash flows, while 18% used some combination of all these methods.
Another issue that now comes to the foreground is that of asset groupings. The issue is: What asset or group of assets is to be measured? Although assets may be bought individually, they are often used jointly in production. If cash flows result from the common use of these assets, then cash flows usually cannot be attributed to individual assets within the group. A grouping may be the entire entity, or a specific plant, division, branch, or business segment.
Once it has been determined what group to measure and against what value it should be measured, the issue of when to measure emerges. Should measurement for evidence of impairment be performed on an ongoing basis (such as every year or every quarter), or only when events indicate that an impairment may have occurred?
Another central issue to be raised is: should impairment recognition be limited to situations where the impairment is judged to be permanent? Or may impairment also be recognized if it is only temporary? In the FEI survey, 36% of the companies used the permanency criterion, while 60% based their decision upon the probability test used in FASB SFAS 5 to measure loss contingencies. However, the FEI survey includes only those companies that made a write-down.
Finally, another issue is the restoration of a write-down. If economic conditions change favorably and the asset has recovered its value, are companies required (or permitted) to write the asset back up to historical carrying cost?
Specifics of the Issues
The first and most central issue is determining which value to use as the base against which the asset's carrying value is to be measured. A detailed discussion of the alternatives may be helpful.
Current cost is the amount of cash that would have to be paid to acquire this used asset. Advocates of this measure point to the objective nature of this measurement since it can be determined from trade journals, catalogs, and appraisals. Opponents argue that acquisition values are irrelevant if the company is able to generate positive cash flows from the asset.
Current market value is the amount of cash to be expected from selling the asset. Advocates of this approach declare that it gives users a dependable indication of an asset's liquidation value and provides information regarding the company's ability to adapt to changing conditions. Opponents argue that market prices may not be available for used, highly specialized equipment, and regardless, the value of an asset lies not in what it can be sold for, but in what it can produce.
Discounted cash flow is the discounted amount of cash inflows the asset is expected to produce, less the discounted cash outflows associated with generating the inflows. As mentioned, advocates of this approach argue, that the value of an asset lies in its ability to produce cash flows, and because of the time value of money, these flows should be discounted to their present value. Opponents point to the difficulty and subjectivity involved in estimating future flows and of selecting a discount rate, since one rate may not be appropriate for all companies.
The next issue is that of grouping--whether to measure assets individually or as part of a group. This can have practical consequences. For example, assume asset X has a carrying value of $50,000 and a measurement value of $45,000, while asset Y has values of $60,000 and $65,000, respectively. If assets are measured separately, then an impairment of $5,000 would be recognized on asset X. However, if assets are measured as a group, no impairment is recognized because the total carrying value ($110,000) equals the total measurement value ($110,000) and the individual gains and losses have canceled each other out.
In the FEI survey, 28% used individual assets, 38% used the production facility group, 16% used a product line group, and 18% used a division, subsidiary, or other group.
Those in favor of grouping maintain that since assets are placed jointly into service and jointly produce cash flows, their individual values are indeterminable. Opponents argue that one company's grouping may be different from another company's grouping, leading to incomparability.
When to Measure
Should measurements take place annually, or only when circumstances indicate an impairment has taken place? Possible circumstances include a reduction in the extent the asset is used, a loss of market share, or a change in law or government policy. Those in favor of annual measurements feel this is consistent with the treatment of other items such as leases which require annual measurements under SFAS 13. In addition, there may be occasions in that circumstances indicating impairment are not apparent, and without an annual "check up," the impairment would be overlooked. Opponents argue that such measurements are costly and should be avoided unless there is indication of impairment.
Impairment Is Permanent
Must a permanence criterion be used to recognize impairment, or would a probability criterion suffice? Past practice has generally been understood to limit recognition to situations where the impairment is considered permanent. However, the FEI survey found that currently 60% of companies that made a write-down used a probability test and recognized impairment if it was probable and estimable. Advocates of the permanence criterion contend that historically, its use has caused no problems for preparers and users of financial statements and that any changes to a different criterion may lead companies to make arbitrary changes. Opponents argue that permanence requires companies to foresee the future, which would result in varying interpretations of the meaning of "permanence."
Where to Display the Impairment
If impairments are to be recognized, should they be displayed as a separate line item within continuing operations, as a separate line item outside of continuing operations (similar to the treatment of extraordinary items), or "buried" within the body of the statements and merely disclosed in the footnotes? In the FEI survey, 38% of the companies displayed impairments as a separate line item within continuing operations, 24% displayed them on a separate line outside continuing operations, while the remaining companies did not present a separate display.
Those in favor of a separate line item within continuing operations argue that since these assets are used in continuing operations, their write-down should also appear in the same section. Opponents argue that since impairments are nonrecurring, they would distort income from continuing operations. In addition, this type of display does not allow for the presentation of earnings per share. Those in favor of presentation within the footnotes state that such a display provides users with the necessary information without drawing undue attention to the write-down.
If an impairment exists but is not recognized in the statements (because the permanence or probability criteria have not been fulfilled), should it be disclosed in the footnotes? Many argue strongly in favor of disclosure because, historically, investors and creditors have roundly criticized the frequent lack of warnings for impending write-downs, and have questioned how long companies knew of the impairment before the write-down occurred. Thus, credibility of financial reporting has been eroded in the eyes of the public. Opponents contend that since impairment criteria have not been met, the chances of an actual impairment occurring are small, and disclosure may focus users' attention to a particular group of assets that may be no more vulnerable than other assets.
This brings us to the last issue. If an impairment has been recognized and subsequently the asset recovers its value, may this recovery be recognized? For example, a company determines that its product is harmful to the environment, and thus writes down the machines involved in the production of the product. Subsequently, an independent scientific study concludes that the product is safe and the earlier determination was an error. May this company now write-up these machines? In the FEI study, 63% of the companies felt it would be inappropriate to recognize recovery, 25% deemed it appropriate, while 12% said it would depend on the circumstances. Those in favor argue this would be consistent with the use of lower of cost or market for marketable securities where recoveries to original carrying values are permitted because of use of the portfolio method. Those opposed feel that subsequent adjustments might cause users to question the credibility of the initial measurements. This point is especially cogent if the impairment was classified as permanent in nature.
In the Meantime...
The recognition of impairment of assets is a thorny issue that has existed for many years. This issue is currently on the agenda of the FASB. Until an authoritative pronouncement is issued, what should companies do?
Some have recommended that the fair market value of the asset should be disclosed if on the balance sheet date it has fallen below cost. They argue that fair market value is a question of fact, not judgment, and such facts are often easy to come by. Preparers of statements would have no need to speculate about the future as would be the case under the permanence and probability criteria. Since many business failures are preceded by a decline in the fair market value of plant assets, such disclosures would serve as an early warning signal to investors and creditors.
We agree with this approach for the short-run, but feel that in the long-run, a clearly defined permanence or probability criterion would be more useful.
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