In company reporting, the measurement of the amount of impairment of many types of assets is so subjective as to be meaningless

The International Accounting Standard Board (IASB) and the Federal Accounting Standard Board (FASB) are working together in order to create an international set of accounting standards. The aim is to prevent frauds, to regularize more the accountancy profession and to make it easier for users to compare different companies from their annual reports. While in process of creating the perfect sets of accounting standards the boards are in perpetual reform of their accounting standards. One of the recent discussions was talking about “the measurement of the amount of impairment of many types of assets” and the problems arising due to the subjectivity of managers’ accountants. This essay will first, define an asset and the accounting standard IAS 36. Then the discussion will explain why companies need to impair assets and how to calculate the recoverable amount. Finally, this composition will give examples to support its argumentation and define some residual problems arising with the valuation of assets.

According to the International Accounting Standard Board (IASB), “an asset is a resource controlled by the enterprise as a result of past events and from which future economic benefits are expected to flow to the enterprise” (IASB cited in Raccountant, 2008). These items can be used to produce goods or be sold in exchange for cash. Some assets are tangible (land, buildings, machinery, etc…) others are intangible (goodwill, investments, etc…). Most assets have a limited life and need to be depreciated and amortised such that they can be replace later.

There exist factors that can affect the value of an asset. The variation of the asset can be related to fluctuation of the economic market or due to obsolescence of the asset. The value of an asset is therefore directly linked to the market; in other words, what the demand is willing to pay for the item. The Entrepreneur explains that “rapid changes in market demand can create obsolescence of plant, machines and patents and can cause assets to lose some or all of their capacity to recover their costs” (Entrepreneur, 2000).

According to IAS 36, “an asset is impaired when its carrying amount exceeds its recoverable amount” (Deloitte, 2010). The latter explains that, on the balance sheet, an asset can be over-evaluated. The recoverable amount is the “higher of an asset’s fair value less costs to sell […] and its value in use” (Deloitte, 2010; 36.6). In order to, adjust the value of this asset; the accountant must conduct an impairment test. However, once a tangible asset has been impaired it does not need to be impaired again the next year. The following table (table 1) is a summary of Richard research describing the impairment by sectors and the impairment losses by sectors. The results from the table 1 demonstrate a strong need for impairment in the sector of media, support services, transport and construction. This could be because these sectors could be using more intangible assets and goodwill than others.

Table 1: Impairment activity by sector

Table from the Richard research page 26 and 30

The standard states that an annual impairment should be exercised on goodwill, on any intangible asset which life expectancy is undefined or on an intangible asset that is not yet usable. Assuming that an asset’s “fair value less costs to sell cannot be determined, then recoverable amount is the value in use” (Deloitte, 2010: IAS 36.20). In the situation where the asset is going to be disposed of then the “recoverable amount is fair value less costs to sell” (Deloitte, 2010: IAS 36.21). An asset does not need any impairment if “fair value less costs to sell or value in use is more than carrying amount” (Deloitte, 2010: IAS 36.19).

In order to impair an asset the accountant needs to know the carrying amount of that asset. The carrying amount is the value of the asset found in the balance sheet which can vary from one accounting year to another. The amount of this asset has been reported after “deducting accumulated depreciation and accumulated impairment losses” (Deloitte, 2010: IAS 36.6).

The recoverable amount is then recorded as a loss or profit in the financial statement, the income statement and the profit and loss account.

However, Richard explains that the estimation of the “recoverable amount of the asset are open to subjectivity in their calculations the value-in-use method particularly so, as this method has a wider potential for errors” (Richard, 2006: 19). The latter argument describe that the calculation of the revaluation of the asset is not really easy and is entirely up to the accountant. The evaluation of the price the demand is willing to pay for the items is very variable and not constant, and mainly depends on the economic situation of the market at the time of the evaluation.

The impairment of assets is an important tool that can help to revaluate the risk of future investment. The impairment of asset should help describing the value of the asset with the given economic situation. In other words, accountant must calculate the recoverable amount taking in account the uncertainty and the risk of the value in use describe by the market. Indeed, “to reduce the uncertainty [and] avoid potential disclosure responsibility and risk, […] accounting personnel should test and confirm the asset impairment, and provide more reliable asset value information report to the users of information” (Sun & Xu, 2010: 199). A survey has reported that over 170 “users of financial statements” (Ernest & Young, 2009: 2), 66% are finding the impairment value in the financial statements useful for their investment decision-making process.

Therefore, the impairment is essential for shareholders and potential investors because it gives them information regarding the value of the company. The impairment made by a company can help users to evaluate if the company is well managed and have an incentive of how it responds to risk. Also, it can help shareholders understand the amount of dividend they are expected to receive.

Indeed, assuming that the accountant did not properly impair the asset of a company, the company’s entire value can be under-estimated or over-estimated. This could affect the decision-making of the investors. A good example of bad managerial accountant impairment is the case of HBOS in 2008, when Lloyds TSB wanted to buy HBOS. HBOS has “admitted […] that it had taken a surprise £3.3 billion in impairment charges against its corporate lending activities over the 11 months to the end of November” (Miles Costello and Helen Power, 2008). HBOS has had to carry heavy impairment charges which could have been avoided. The company should have perceived the abnormal economic activity and should have created a provision to cover its corporate lending activities. The company’s “impairment charges rose by £1.6 billion in just two months, October and November” (Miles Costello and Helen Power, 2008). Instead of recognizing a managerial mistake, HBOS “blamed this on sliding investment markets and the worsening economic conditions, [Furthermore] analysts were stunned by the size of the charges, which sent HBOs shares tumbling more than 18 per cent down” (Miles Costello and Helen Power, 2008).

However, a company could use the impairment tool to benefit from it by revaluating an increase in the value of assets. According to the Entrepreneur, “management uses the accounting rules and manipulates earnings either by not recognizing impairment when it has occurred or by recognizing it only when it is advantageous to do so” (Entrepreneur, 2000). Theoretically a company could manipulate impairment such that it could increase their turnover or their earning per share. Moreover, Lhaopadchan argues that “the recognition of acquired goodwill […] have resulted in providing self-interested managers with greater opportunities to engage in earnings and balance sheet manipulations that are of doubtful value to users” (S. Lhaopadchan, 2010: 1-2). Therefore, it is essential for an entity to remain ethical and to properly and objectively calculate the impairment of assets.

To conclude, the measurement of the amount of impairment of many types of assets is very important because it allows users to evaluate properly the value of the company. The public demands more transparency regarding the activity of companies. This is a legitimate request, especially if it regards shareholders who have already invested their money in the company. Impairment is essential to the well-being of a company and its calculation must be dealt with professionalism and integrity. The managerial accountant must be objective when choosing which assets is to impair but at the end the importance is not which assets is impaired but more how to present it.

Bibliography:

Books:

Andrews, Richard (2006). Impairment of assets: measurement without disclosure? London: Association of Chartered Certified Accountants.

Journals:

Shipan Sun and Xia Xu. (2010). Study on the Asset Impairment Accounting. International Journal of Business and Management. 5 (6)

Suntharee Lhaopadchan . (2010). Fair value accounting and intangible assets: goodwill impairment and managerial choice . Journal of Financial Regulation and Compliance . 13 (2), 25/02/2011.

Websites:

Entrepreneur. (2000). Impairment Write-Offs: Truth or Manipulation?(corporate assets)(Statistical Data Included). Available: http://www.entrepreneur.com/tradejournals/article/64781966.html. Last accessed 25/02/2011.

Ernest & Young. (2010). Meeting today’s financial challenges – Impairment reporting: improving stakeholder confidence. Available: http://www.ey.com/Publication/vwLUAssets/Meeting_todays_financial_challenges_- _Impairment_reporting_- _Improving_stakeholder_confidence/$FILE/EY_Meeting_todays_financial_challenges_- _Impairment_reporti. . Last accessed 25/02/2011.

Miles Costello and Helen Power. (2008). Lloyds team starts work as HBOS investors vote ‘yes’. Available: http://business.timesonline.co.uk/tol/business/industry_sectors/banking_and_finance/article53 33683.ece. Last accessed 25/02/2011.