Asset impairments and writedowns: do we need any FASB rules?
Accounting rules provide some guidance for recording the inability to fully recover the carrying amounts of current assets. For example, FAS 12 (1975), "Accounting for Marketable Securities", requires a writedown due to nontemporary declines in market value of noncurrent securities. Similarly, the general rule for inventories is the lower of the cost or market. However, with regard to impairments of long-lived fixed assets. existing accounting rules fail to provide any guidance. There is no guidance as to when a writedown should occur or how to measure the impairment loss. This has resulted in a wide variety of industry practices (to be discussed later) and has added to the confusion among the investing public. At last the Financial Accounting Standards Board (FASB) has taken up this issue in its 1990 Discussion Memorandum, "Accounting for the impairment of Long-lived Assets and identifiable Intangibles" and is currently in the "hearing" process. The purpose of this paper is to analyze the accounting issues related to the asset impairment problem.
There has been a dramatic increase in the frequency and magnitude of asset writedowns during the 1980s. From 1986 to mid- 1988, the Dow Jones Industrials alone have taken at least $10 billion in impairment related writedowns Forbes, July 25, 1988). Pearson and Okubara (Accounting Horizons, March 1987) report that over $26 billion in writedown charges were announced by public corporations during 1985-86. The impact of these writedowns on the earnings for NYSE firms is demonstrated by the ratio of writedowns to operating income: the ratio has increased from a mean of 8% in 1975 to 24% in 1985, 27% in 1986, and 26% in 1987. Writedowns analyzed ill this study are operationally defined to include: impairment of fixed assets, write-offs of excess manufacturing capacity, abandonment, restructurings, personnel reductions, and plant closings. This broad definition is consistent with the reporting practices of the Wall Street Journal and the Accounting Research Bulletin 169, issued by the Securities Exchange Commission (SEC). Some of the larger writedown charges reported by major corporations in the 1980s include the following:
Writedowns Company (in millions) Year Description Union Pacific $1,700 1986 Restructuring of operations, including disposal of oil and gas properties, and writedown of an oil refinery General Motors 2,100 1990 Writedowns related to plant closings and employment restructurings Citicorp 2,863 1990 Includes writeoffs on consumer loans, global finance and cross-border refinancing portfolios Burlington Resources 230 1988 Reserves for impairment contingencies Homestake Mining 33 1990 Inability to recover the carrying amount of investments in NAM Control Data 650 1990 Restructuring charges, plant closings and other writeoffs,
It is possible that changes in accounting procedures can be responses to real variables (like reduced product demand, low capacity utilization), and they can induce real effects such as reductions in expenses and changes in taxable income). An asset writedown may be a signal of forthcoming corporate restructurings that may enhance the economic value of the firm or may signal bad news about future cash flow expectations. Many writedown's can be thought of as one-time tax shields. Code Section 167, Reg.1167(a)-8, provides for retirement of depreciable property; Re, 1- I 67(a)-9 provides for obsolescence deduction for operating facilities and other depreciable property; Code Sec. 162 allows deductions for employee termination benefits and relocation expenses. Deductions for abandonment of machinery and equipment, of goodwill, of worthless property, leases etc., and deductions for loss of useful value of property are allowed under Code Sec. 165. The present value of this one-time tax shield must be compared with the present value of tax shields emanating from a continuation of the existing depreciation policy (see Strong and Meyer, Journal Finance, July, 1987).
Behavioral research suggests that management may delay project terminations beyond the optimum time because of a failure to ignore "sunk costs" in investment decisions. Hence, when management admits its mistake and closes the plant, the market may view it favorably and decrease its estimate of expected losses. On the negative side, writeoffs indicate that the fixed assets have become impaired and cannot be operated at the current capacity or efficiency level any longer. This disclosure may provide new information to the market about future net operating cash flows, the firm's growth opportunities, and may result in stock price revision.
Pearson and Okubara (Accounting Horizons, March, 1987) point out that recent writeoffs related to restructurings have some special features: 1) the magnitude of the dollars involved; 2) a sudden spurt in the number of firms undergoing the process; and 3) partial writedowns of assets remaining in use. There is very little guidance in authoritative pronouncements by the FASB, the SEC or the AICPA that govern the writedown of operating assets.
Specific accounting rules requiring a loss recognition for non-temporary value declines can be summarized as follows. APB Statement No. 4 1970) contains one of the earliest references to asset impairments. When technological obsolescence reduces the utility of productive facilities, the effect should be recognized over the remaining useful life. Section M-5C of this statement requires an adjustment to depreciation rates or the recognition of unamortized cost as a current period loss. However, the method of quantification of the loss is not discussed. Also this reference does not identify the circumstances under which a partial writedown should occur except stating "unusual" circumstances.
APB Opinion 18 (paragraph 19-h), "The Equity Method of Investments in Common Stock", requires that a loss in value of all investment which is other than a temporary decline should be recognized. ARB 43 chapter 4) affirms that a departure from cost basis of pricing the inventory is required when the utility of the goods is no longer as great as its cost... A loss of utility is to be reflected as a charge against the revenues of the period in which it occurs". APB statement 4 (paragraph 75) states that "impairment is recoginzed ... when a commitment, in terms of a formal plan, has been made to abandon a segment of a business or to sell a segment of a business at less than its carrying amount, when enterprise assets are damaged and so forth". FASB statement No. 13 (paragraph 17-d) Accounting for Leases" states that if the decline in estimated residual value is judged to be other than temporary... the resulting reduction in the net investment shall be recognized as a loss in the period in which the estimate is changed."
FASB statement 34 (paragraph 19). Capitalization of Interest Cost". states "Interest capitalization shall not cease when present accounting principles require recognition of a lower value for the asset other than acquisition cost". The essence of these pronouncements indicates that a loss in the value of these investments must be recognized if it is other than temporary. The FASB acknowledges the lack of guidance with regard to impairment of long-lived operating assets in SFAS 5, Accounting, for Contingencies", paragraph 31.
Measurement of an impairment loss is a difficult issue. The unresolved issue is whether the writedown should be restricted to the unrecoverable cost of the asset or to the unrecoverable cost plus a normal profit. Other alternatives include measuring the recoverable amount of the asset by using the net realizable value method or expected net future cashflows. The Accounting Standards Division of the AICPA in its 1980 Issues paper, "Accounting for the Inability to Fully Recover the Carrying Amounts of Long Lived Assets" discusses the following measurement techniques for the impairment loss. If the inability to fully recover the carrying amounts of long lived assets is to be reported in financial statements, the various asset measurement techniques permitted undercurrent practice are as follows:
CURRENT REPRODUCTION COST: The amount of cash (or its equivalent) that would have to be paid to acquire an identical asset currently, after adjusting for relevant depreciation.
CURRENT REPLACEMENT COST: The cost to acquire an asset that would perform the function of the asset owned (less depreciation).
NET REALIZABLE VALUE: The expected amount of cash (or equivalent) to be received from sale of an asset, net of selling costs.
NET PRESENT VALUE OF EXPECTED FUTURE CASH FLOWS: Net present value of the expected future cashflows generated by the asset; this is described as value in use. Finance theory indicates that this is a theoretically superior measure.
CURRENT COST: The cost of replacing the remaining service potential of the asset. Current cost differs from current replacement cost with regard to the service potential of the owned asset. For example, when the service potential of the asset owned is less than the service potential of the asset that would replace it, the current cost will be less than the current replacement cost.
RECOVERABLE AMOUNT: The net realizable value of an asset to be sold or the net present value of an asset that is retained.
VALUE TO THE BUSINESS: Lower of current cost and recoverable amount, which is the higher of net realizable value and net present value of future cashflows. The rationale for measurement at value to the business is that the asset value should depend on the circumstances of the business. Sometimes it is also called "deprival value", because it can be assessed by asking how much the firm needs to be compensated for loss of the asset. Current cost sets the upper limit for the value of the asset.
Obviously using seven different methods to quantify impairment loss results in widely divergent writedown amounts, and managers can pick and choose the loss they want to report. Also many times objective market prices are not available for plant and machinery that have been designed for a specific purpose. Estimating future cashflows generated by the asset is a difficult task and involves a great deal of uncertainty. Selecting a discount rate to discount this future stream of cashflows is an even trickier task.
Another measurement issue is related to the unit of accounting individual assets or groups of assets. While projecting the cashflows for individual assets used in conjunction with other assets, should one consider the earnings power of those other assets (portfolio approach)? Braun, Rohan, and Yospe (Journal of Accountancy, April, 1991) argue that revenues are sometimes generated jointly by groups of assets and hence the portfolio approach is justified. In such cases assigning future cashflows to individual assets may be difficult and the logical step would be to write those assets down as a group. This grouping issue is further analyzed a little later in this article.
If firms are allowed to record the inability to recover the carrying amounts of operating assets, then the next question is whether the carrying amounts should be adjusted upward for subsequent recoveries. Upward adjustments are consistent with accounting for allowances for doubtful accounts receivable and inconsistent with accounting for inventories. Proponents of upward revision could argue that such a rule will reflect the true financial condition of the firms. However, allowing firms to write down assets and then back up again, gives managers considerable amount of discretion to manipulate earnings.
All SEC filings that contain a description of a firm's property (e.g. Form 10-K), should discuss the utilization of facilities. The SEC provides that "where current year changes in idle facilities have a material impact on the results of the operations, it would be necessary to address such matters in Management's Discussion an Analysis of Financial Condition and Results of Operations" (SEC, ASR 298). Beresford and Neary (Ffinancial Executive, July, 1985) argue that disclosures can allay fears of investors in some situations. For example, when a competitor has recently written down productive assets, a firm disclosing a high utilization of its own productive assets would reassure the investors. An interesting empirical test would examine whether the SEC mandated plant/facility utilization disclosure supplies useful information that is relevant to estimating the market values. Do such supplementary disclosures possess incremental explanatory power beyond that provided by writedown amounts?
Another question relating to disclosure is the method of disclosure. Should the disclosure be made in the annual report in the MDA section or in footnotes to financial statements? Should writedowns be disclosed on pre-tax or after-tax basis? How detailed should the disclosures be? The current practice is to lump all events associated with the writedown together and provide one amount (e.g., employee severance pay and relocation expenses are often included with writeoffs). Firms usually combine all types of writeoffs such as facilities, goodwill, fixed assets, plant closings, restructurings and personnel reductions and make separation of the components difficult (see "Impairments and Writeoffs of Long-lived Assets", by Fried, Schiff and Sondhi, National Association of Accountants, Montvale, N.J., 1989).
Schuetze (Journal of Accountancy, December, 1987) argues that disclosure must be required of the fair value of non-monetary assets when fair value is less than cost. Whether or not fair value of an asset is less than cost is an empirical issue (a question of fact), not a judgment. Sometimes facts may be hard to determine or costly to gather. But the rule would be unambiguous and the disclosure would be mandatory. Schuetze goes on to argue that if there were no disclosure or if the auditor's reports were unqualified, the user of the financial statements would be entitled to assume that the independent auditor was satisfied that the fair value of the asset is at least equal to the cost.
When the management has disclosed a possible inability to recover fully the carrying amount of an asset without writing down the carrying amount, the auditors have issued a "subject to" qualified opinion. The 1987 AICPA survey used the NAARS data base to list a few examples of these audit opinions. Do such qualified opinions contain new information? One can compare a group of firm that took a writedown with another group of firms that did not writedown when there was an impairment and check to see if there are any systematic differences between the two groups. The results would have implications for rule making bodies like the FASB, the SEC and the AICPA, as well as investors. An examination of the relationship between the magnitude and timing of large write-offs and audit qualifications or auditor changes would be interesting. An investigation of the relationship between write-offs and subsequent increase in audit fees would also shed some light on industry practices.
The Financial Executive Institute (FEI) surveyed a number of companies reporting unusual charges in 1985. The criteria for recognizing the impairment of long-lived assets is ambiguous in current accounting standards. Prior to the issuance of AICPA Issues Paper in 1980, writedowns were recorded only when it was determined that an asset has become permanently impaired. However, this issues paper concluded that the concept of permanent decline is unsatisfactory and recommended a probability test similar to the one contained in SFAS 5.
The FEI survey indicated that 60% of the decisions to write down an asset were based on a probability test similar to that in FASB statement 5, "Accounting for Contingencies". Also another 36% were based on the permanent decline test. SFAS 5 uses a
OTHER BUSINESS UNTIS: For internal reporting purposes, ABC MART treats each of its departmental stores including the auto repair shops and garden shops and each of its grocery stores (including the bakery and cafeteria) as distinct, aggregated units. Hence each departmental store and each grocery store is treated as separate business unit. Table 3 illustrates assets aggregated in this way and the impairment losses total 25.62 million. Again this loss is significantly different from the losses determined using the other two grouping schemes.
Table 3: ABC MART INC. Assets Grouped as Business Units (In thousands of dollars) Net Book Appropriate Measure of Recorded Value Measure of value less writedown Value book value amount Departmental Store W: 38,520 26,500 (12,020) (12,020) Departmental Store X: 14,820 30,010 15,190 0 Departmental Store Y: 25,300 18,200 (7,100) 7,100) Grocery Store M: 9,800 9,900 100 0 Grocery Store N: 30,400 23,900 (6,500) (6,500)
The following table summarizes the impairment losses under three different grouping methods:
Method of Grouping: Writedown Charge (thousands of dollars) Business Segment 10,330 Business Unit 25,620 Individual Asset 28,920
These numbers demonstrate that different methods of aggregation can result in dramatically different amounts of writedown charges. When ABC MART'S assets are grouped according to business segment, the impairment loss is the smallest because the value declines in some assets are offset by baslue gains in other assets within the same segment. On the other hand, when assets are grouped individually, value gains on other assets are ignored and only impairment losses on assets are recognized and thus leading to the largest amount of writedowns.
Timing of these writedowns is currently at the discretion of the management. But stockholders and analysts could question why the assets were not written down the previous quarter or the previous year. Or why not next year? One possibility is that corporations are recognizing these asset impairments when the stock market conditions are favorable, not necessarily when the losses occur. Another view is that these writedowns are a feature of "Big Bath" accounting.
Critics question not only the year in which writedowns are recognized but also question why writedowns tend to get reported more frequently in the fourth quarter than in the first three quarters. Generally accepted accounting principles and the current reporting requirements give considerable flexibility to managers with regard to expense recognition in the first three quarters. Because the fourth quarter results are closely tied to the annual report and subject to audit, managerial discretion is considerably reduced. This author obtained some data from the National Association of Accountants (NAA) and selected a sample of 357 writeoffs from this NAA data base for the period 1980 through 1986. Of these 357, as many as 257 (a whopping 72%) of the writedowns were disclosed in the fourth quarter and another 54 in the third quarter. The first quarter writedowns totalled 16 and there were 30 disclosures in the second quarter. The first two quarters combined accounted for only 12.8% of the total writedowns in this sample. If economic impairments occur due to macroeconomic factors such as reduced demand for the product, foreign competition, cutbacks in federal spending, inflation, strength of the dollar, and technological obsolescence, one would expect that writedowns would occur evenly over the four quarters when one considers a six-year span. Time and again, fourth quarter writedowns swamp writedowns in other quarters. This late disclosure of negative information is contrary to many accounting pronouncements and other SEC rulings that require the dissemination of negative information such as anticipated writeoffs, asset impairments and losses from discontinuations as early in the fiscal year as possible.
|Printer friendly Cite/link Email Feedback|
|Title Annotation:||Financial Accounting Standards Board|
|Publication:||South Dakota Business Review|
|Date:||Dec 1, 1991|
|Previous Article:||Trend of business.|
|Next Article:||Venture capital and South Dakota economic development.|