Asset impairment disclosures: will accounting for asset impairment lead to performance impairment?

Current reporting practices for unrealized asset impairments are inconsistent. To address this problem, in December 1990 the Financial Accounting Standards Board issued a discussion memorandum, followed in November 1993 by an exposure draft, Accounting for the Impairment of Long-Lived Assets. Given the considerable costs of implementing such a standard, some have asked if the disclosures the FASB might require are worthwhile. If the net cost of these disclosures is significant, companies would be penalized and performance might suffer. This article explores the costs and benefits of providing asset impairment information to see if such disclosures might impair a company's performance.

THE CONCEPT Of IMPAIRMENT

If an asset's value declines, the asset has suffered economic impairment. If its value in place (the net present value of remaining cash flows) falls below its abandonment value (the amount that could be obtained through sale or other disposal), the asset should be abandoned and an impairment realized. If an asset is disposed of for less than book value, a realized loss will be recognized.

If the asset's value in place declines but remains greater than its abandonment value, the asset should be retained. This type of impairment is unrealized because there is no disposal. As long as an asset's value in place remains above book value, no loss is recognized. However, if the asset's value under such circumstances declines so it is worth less than book value, a loss may be recognized, even though there is no disposal.

DEFINING AN ASSET'S VALUE

Several valuation bases were described in the FASB DM, including the present value of future cash flows, the sum of undiscounted future cash flows, current market value and net realizable value. Future cash flow measures are theoretically superior but subject to substantial uncertainty and potential manipulation. However, current market value and net realizable value are sometimes difficult to obtain and may be inappropriate benchmarks for some company-specific assets.

Another difficulty inherent in evaluating impairment is specifying the appropriate level for the analysis. In many cases, it is impossible to estimate cash flows for specific assets; evaluation must then be based on the narrowest group of assets for which sound cash flow estimates are available. Unfortunately, such aggregation allows companies to group poorly performing assets with high performers to avoid the impairment charge.

The potential requirements of the standard raise the possibility that significant--and costly--changes in a company's accounting system will be necessary. Many companies' information systems cannot break out actual cash flows, even for groups of assets. In addition, basing valuation on future cash flow measures means a company must generate and validate formal, consistent forecasting models. Further, if companies are required to consider writedowns annually for a large number of assets (or asset groups), the yearend burden on both internal staff and external auditors could increase substantially. Increasing impairment disclosures at first glance may seem far too costly and, hence, a poor allocation of company resources.

POSTAUDITING

Reporting on writedowns, however, is not an independent process; impairment cannot be considered in isolation. More specifically, a substantial amount of the related analysis already is performed routinely by many companies' financial management systems. This process often is called postauditing (also tracking and monitoring) of capital expenditures. Postauditing is the evaluation of independent assets or groups of assets on a regular basis to decide whether to keep or abandon them.

In practice, there are varying levels of sophistication in companies with such systems. Studies show that while many companies lack sophisticated postauditing systems, more than 75% of large industrial companies have institutionalized some kind of a postaudit process. Sophisticated postauditing systems are more likely to

* Evaluate projects based on cash flows (as opposed to accounting numbers).

* Have a formal abandonment process that bases decisions on discounted cash flow analysis.

* Perform postaudits on a regular basis.

SOPHISTICATED SYSTEMS

Exhibit 1, page 59, shows a sophisticated postauditing system that monitors writedowns (the blue shaded portions). After the investment decision, a company must decide which assets to evaluate or postaudit. Some companies choose a few projects that are large in terms of dollar investment; others choose a variety of projects, large and small; still other companies choose projects randomly. One immediate impact of accounting for asset impairment is most companies probably will have to increase substantially the number of assets subject to postaudit evaluation.

The next step is to examine the asset's current performance, which involves comparing actual cash flows with expected cash flows. This part of the process also can be used to evaluate the management that proposed the investment and the management that implemented it (if they are different). The analysis may be particularly beneficial by revealing relevant information to help plan and implement future capital asset investments and build reputations for managers proposing investments.

At this point, a company should explicitly consider abandoning the asset in question by estimating the value of the asset in place and comparing the result with the abandonment value. However, because of the cost, many companies conduct this part of the analysis only if the asset is performing poorly. If the value of the asset in place is less than the abandonment value, the asset should be abandoned and the capital reallocated.

If an asset is retained, reporting on asset impairment requires additional steps. The value of the asset in place should be compared with its book value. If the asset's value is lower, a writedown may be necessary. The appropriate measure of impairment has been a controversial issue; many view the use of discounted cash flows as providing substantial opportunity for generating future accounting profits. It has been argued undiscounted cash flows correlate highly with discounted cash flows and, as such, are a better measure in terms of consistency across companies. While economic theory supports discounting cash flows, little practical advice is available on selecting a discount rate. The ED combines these two approaches by defining the impairment loss as the difference between discounted cash flows and book value but only recognizing the impairment if undiscounted cash flows are less than book values.

POSTAUDITING: AN EXAMPLE

Exhibit 2, page 60, shows a simple numerical example. Consider three capital asset investments, all with the same expected net present value at the time of investment. All three are expected to return $50,000 cash flows at the end of each of five years after investment. Assume the cost of each asset is $150,000 and cash flows are discounted at 16%. As shown in step 1, the net present value of each asset is $13,715. The company chooses to invest. At the end of the first year, the actual cash flows are as shown in step 2. Asset A does not perform as well as expected, asset B performs as expected and asset C performs slightly better than expected.

The company should investigate the reasons for these results and use them to

* Evaluate the manager(s) currently in charge of the investment project.

* Evaluate those proposing the investment project.

* Revise the estimation process and its parameters to improve future decision making.

To consider abandoning these assets, the net present value of remaining cash flows must be estimated. This is shown in step 3. Assume, due to a downward trend in market conditions, the cash flows for years two to five are $38,000 for asset A, 40,000 for asset B and $45,000 for asset C. The net present value is calculated, assuming the cost of capital is unchanged. If the abandonment value is $110,000 in each case, the decisions are obvious: asset A should be abandoned; assets B and C should be retained. In terms of economic decision making, the process is complete.

However, as noted above, an additional step must be added to incorporate disclosures of unrealized asset impairment into the process, as shown in step 4. Book values are obtained for the remaining assets (assume asset A was disposed of before the balance sheet date). If each asset has an expected life of five years, with no residual value, and straight-line depreciation is used, the book value at the end of year one would be $120,000 ($150,000 - $30,000).

Under these assumptions, asset C is not impaired relative to book value. Asset B, however, is impaired relative to book value; the company has suffered an unrealised loss of $8,073. To decide whether this loss should be recognized on the current year's income statement, the sum of undiscounted cash flows ($160,000) should be compared to the book value ($120,000). Since book value does not overstate the asset, the impairment is not recognized. The income statement for the year would include only the $10,000 realized loss from the disposal of asset A (the $120,000 book value less the $110,000 abandonment value). The $8,073 loss associated with the impairment of asset B remains unrecognized. All information discovered during this process should be provided to those involved in the investment process to enhance future decision making.

IS IT REALLY BENEFICIAL?

As the above example illustrates, the process of determining writedowns is (or can be) a subset of the financial management system many companies already have in place. Hence, the relative costs and benefits cannot be considered independently. Exhibit 3, page 62, summarizes the costs and benefits of requiring disclosures, taking into consideration whether a company already is postauditing and whether it has materially impaired assets.

If a company already is postauditing, the costs of increased impairment disclosures may be relatively small. Since the systems already are in place, these companies will need only to add the steps illustrated in exhibit 1. Many companies also will have to increase the scale, and possibly the sophistication, of their postauditing systems. Doing so benefits a company in the long run by increasing the efficiency of capital allocation. In the short run, increased postauditing provides high-quality performance evaluation information. The company also may benefit if materially impaired assets are discovered. While providing new information to the market about poorly performing assets may result in stock price reductions, a positive reaction often occurs when abandonments of poorly performing assets are announced; the market is relieved the capital will be reallocated to assets with superior returns. Assuming a relatively high level of market sophistication in terms of asset valuation, upward revaluations are most likely.

If a company currently does not have a postauditing system in place, the costs of increased impairment disclosure may be substantial. However, implementing such a system has significant short- and long-run benefits because it facilitates efficient capital allocation within a company. During implementation, companies may discover significantly impaired assets that may or may not need to be abandoned. If the market was not already aware of these impairments, there. could be a negative effect on stock prices. However, as noted above, share prices ultimately will increase as nonperforming assets are purged.

POSSIBLE PERFORMANCE INCREASE

The benefits and costs of asset impairment standards cannot be considered independently of the benefits and costs of the postauditing process itself. If asset impairment disclosures lead companies not currently postauditing to do so, these companies may benefit substantially. Companies already postauditing also may receive increased benefits from being forced to postaudit a greater percentage of their assets or to conduct postauditing in a more sophisticated manner. Such benefits to a great extent may offset any costs of the increased disclosures. Hence, accounting for asset impairment should not lead to performance impairment. In fact, the result is expected to be quite the opposite: Requiring such disclosures may bring substantial benefits in capital allocation within a company and result in substantial increases in overall performance.

EXECUTIVE SUMMARY

* INCONSISTENT REPORTING practices for unrealized asset impairments have led the Financial Accounting Standards Board to issue an exposure draft, Accounting for the Impairment of Long-Lived Assets. There is concern, however, that the cost of implementing such a standard may exceed the benefits.

* MEASUREMENT IS A MAJOR difficulty in making impairment disclosures. The ED describes several valuation bases but emphasizes cash flow measurs. As a result, a new standard may require significant changes in a company's accounting system with resulting cost increases.

* SOME COMPANIES ALREADY HAVE implemented a process known as postauditing--independent assets or groups of assets are evaluated regularly to decide if the assets should be kept or abandoned. More than 75% of large industrial companies have some type of postaudit process.

* IF A COMPANY ALREADY IS postauditing, the costs of increased impairment disclosures may be relatively small. If a company does not already have a system in place, the costs of increased disclosures may be substantial. But the system could yield short- and long-run benefits by facilitating efficient capital allocation within the company.

* ACCOUNTING FOR ASSET impairment should not lead to performance impairment. In fact, requiring such disclosures may bring substantial benefits and result in increases in overall performance.

KIMBERLY J. SMITH, CPA, PhD, is associate professor of business administration, College of William and Mary, Williamsburg, Virginia. She is a member of the American Accounting Association, the Financial Management Association and the Institute of Management Accountants.