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.
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. …