Asset Impairment: No Guarantees - Essay Example

? Asset Impairment: No Guarantees [ID # “In company reporting, the measurement of the amount of impairment of many types of assets is so subjective as to be meaningless”. This statement is true with the assumption that all that investors want or need are iron-clad guarantees that can never be undermined, disproven or changed. This is clearly false: Investors would rather have some rather than no information. Thus, the statement itself is false. It is true that many types of asset impairment reportings are highly subjective. Some involve subjective determinations of value for objects that have a large variation in their value; others are simply inherently subjective. Some assets can't be reported simply, so the subjectivity arises from the choice of impairment modeling and accounting presentation: Like trying to map a 3-dimensional sphere on a 2-dimensional plane, inevitable distortions crop up no matter what approach one takes to presenting the data. Yet other assets, while objectively declining in value, do so at a rate that is impossible to determine, so any presentation is subjective because it is a choice as to what data to include and what not to, what prediction to make. Yet even this incomplete, subjective picture is far from meaningless for investors, auditors and stakeholders. Asset impairment is defined as, “An unexpected or sudden decline in the service utility of a capital asset, such as a factory, property or vehicle. This could be the result of physical damage to the asset, obsolescence due to technological innovation, or changes to the legal code. Impairments can be written off” (InvestorWords, 2011). Assets can decline for a variety of reasons. Simple wear and tear can make an asset less than its expected new or even used value: For example, a vehicle that operated in difficult conditions such as snow or sand could be below the expected market value for a vehicle of that age. In this sense, asset depreciation is a subset of asset impairment. But this determination can be subjective: It requires guessing the cost of the additional damage which could vary from potential buyer to potential buyer. Technological innovation can make some objects obsolete: Certainly, computers have obsolescence and an incredibly high rate of turnover. But anticipating that requires expecting Moore's Law to continue operating, as well as treating the computer as a unified asset, yet different parts of the computer depreciate at different rates and accounting standards are always changing to reflect that for different electronics (Ward, 2011). A legal change could make a piece of machinery become illegal in a particular country, but then the asset could be sold elsewhere, which could require a degree of subjective currency anticipation and assessment of liquidation risk and benefit. This is why goodwill is recognized as the standard for impairment of many assets, and it is commonly accepted that there is a great degree of subjectivity in making this determination. “We are facing a new era of economic development with a growing significance of intangible assets. Goodwill constitutes a significant asset for numerous companies, especially those which are operating in high technology industries. According to the growing importance of intangibles there has also been a significant change in standards associated with accounting for goodwill” (Jerman and Manzin, 2006). In particular, using fair value accounting for goodwill and for determining the need for disclosures leads to inherent subjectivity: “The fair value may be determined by using different approaches such as using available market prices, present value techniques, prices for similar assets and other valuation techniques. Users of financial information should consider that market values are not always on disposal. Consequently fair value estimates are based on subjective judgment” (Jerman and Manzin, 2006, 222-223). One of the reasons why there is so much subjectivity is because investors rightly demand disclosures of numerous factors that are difficult to determine or subjective. For example: Disclosures for goodwill impairment can include unanticipated competition, loss or disinterest of customers, business contracts and possible business contracts, regulations, loss of employees, and failures in budget and managing foresight (Jerman and Manzin, 2006, 222). All of these factors require careful judgment, not simply interpreting numbers, such that there is always both subjectivity and an error margin. Another major source of the subjectivity is interpreting and anticipating future cash flows (Nikolai et al, 2009, 533). Discount rates, directions and sources of flows, etc. are likely to vary, and reporting all flows as if they will continue at their present magnitude would be violating the fiduciary duty to shareholders for comprehensive information. A further complication arises when considering the fact that the cash flow from an asset may be different than the generated market cash flow (Nikolai et al, 2009, 533-534). A company may have a proprietary or unique method of using the asset that others are not likely to replicate. Imagine a specialized electronic factory piece used by a company like Toyota to make electronics for their cars. A regular electronics manufacturer would view this as a broken piece of equipment that will have to be retooled, but Toyota sees immense cash flow from it by retaining it in house (Nikolai et al, 2009, 533-534). Should the accountant a) Unproblematically represent the value as the cash flow without explanation, despite the fact that it would not yield that value on the open market; b) Unproblematically represent the value as the expected market value, despite the fact that that transparently conflicts with the noted value elsewhere on the balance sheet and the fact that the asset might be worth its full cash flow if it is sold or transferred to a partner company or to a company in the same industry c) Present all the information with footnotes and make a determination? No matter what, some distortion and inaccuracy will result. Choice of test of depreciation, appreciation and/or impairment also changes the data (Nikolai et al, 2009, 533-534). Accelerated depreciation methods will have a different impaired value than ones acquired by a straight-line method. The accelerated depreciation will not meet the impairment test but it is a more honest interpretation of the data being presented consistent with the company's accounting principles. Collective Brands (2007) argues, “The estimate of fair value is highly subjective and requires significant judgment related to the estimate of the magnitude and timing of future reporting unit cash flows. If we determine that the estimated fair value of any reporting unit is less than the reporting unit's carrying value, then we will recognize an impairment charge. If goodwill on our consolidated balance sheet becomes impaired during a future period, the resulting impairment charge could have a material impact on our results of operations and financial condition”. Collective Brands found that accounting for their intangible assets like trademarks and derivatives as well as complying with new standards like FASB SFAS No. 157 changed their reporting of their impairment. NRG Energy describes their evaluation procedure: For assets to be held and used, if the Company determines that the undiscounted cash flows from the asset are less than the carrying amount of the asset, NRG must estimate fair value to determine the amount of any impairment loss. Assets held-for-sale are reported at the lower of the carrying amount or fair value less the cost to sell. The estimation of fair value under SFAS 144, whether in conjunction with an asset to be held and used or with an asset held-for-sale, and the evaluation of asset impairment are, by their nature subjective. NRG considers quoted market prices in active markets to the extent they are available. In the absence of such information, the Company may consider prices of similar assets, consult with brokers, or employ other valuation techniques. NRG will also discount the estimated future cash flows associated with the asset using a single interest rate representative of the risk involved with such an investment or employ an expected present value method that probability-weights a range of possible outcomes. The use of these methods involves the same inherent uncertainty of future cash flows as previously discussed with respect to undiscounted cash flows. Actual future market prices and project costs could vary from those used in the Company’s estimates, and the impact of such variations could be material. (2009) To get an adequate idea of cash flows requires consulting with brokers, sellers, price indexing and product comparison, etc. As an example of where the subjectivity is unavoidable, consider the case of selling a product that is no longer used or directly on the marketplace. It has some use: Some buyer will wish to purchase it. But since it is no longer being sold, there is no more blue book value. Looking at comparable products can help, but those comparable products may be justifiably more expensive due to being newer, or less expensive due to having cheaper construction and materials; more expensive due to being backed by existing manufacturers, or less because of the rarity of the old asset. Guessing all of this requires subjective determination in picking the best analog. Investors would like to have some idea of what the item is valued at on the market. The value of good reporting of impairment is transparent. “If done correctly, this will provide investors with more valuable information. Balance sheets are bloated with goodwill that resulted from acquisitions during the bubble years, when companies overpaid for assets by using overpriced stock. Over-inflated financial statements distort not only the analysis of a company but also what investors should pay for that stock. The new rules force companies to revalue these bad investments, much like what the stock market has done to individual stocks” (Wayman, 2011). Yet the very fact that one of the assets being valued is stocks itself causes subjectivity. Nothing is more difficult to determine or subjective as the ongoing value of a stock. Since the stock's value changes every day, how can an accountant present an honest impression to shareholders that isn't likely to be riddled with caveats? Investors get to monitor a company's successes and failures using this mechanism. “The impairment charge also provides investors with a way to evaluate corporate management and its decision-making track record. Companies that have to write off billions of dollars due to impairment have not made good investment decisions. Managements that bite the bullet and take an honest all-encompassing charge should be viewed more favorably than those who slowly bleed a company to death by deciding to take a series of recurring impairment charges, thereby manipulating reality” (Wayman, 2011). By being forced to honestly present the falling value of company assets repeatedly, the market gets a signal as to which companies have made good decisions and which ones have made bad, as well as which companies will own up to their mistakes and which will not. There are, of course, risks with subjectivity. “The accounting rules (FAS 141 and FAS 142) allow companies a great deal of discretion in allocating goodwill and determining its value. Determining fair value has always been as much an art as a science and different experts can arrive honestly at different valuations. In addition, it is possible for the allocation process to be manipulated for the purpose of avoiding flunking the impairment test. As managements attempt to avoid these charge-offs, more accounting shenanigans will undoubtedly result” (Wayman, 2011). Yet having some idea, even a distorted and borderline fraudulent idea, of how assets are valued is better than having no idea at all. When an asset is marked as subjective, it allows investors to ask for more information, to get more reports. If an asset is falsely viewed as objectively valued, investors can be led down the primrose path. Thus, it is clear that, despite subjectivity in impairment of assets, companies need to accommodate their investors and do the best job they can. There is no point in the fancy MBA and economics degrees that their accountants and executives get if they aren't going to face the music and make some difficult economic calculations. Works Cited Jerman, M. and Manzin, M. 2006, “Ac­c­ounti­ng Tr­e­a­tme­nt of Goodwi­ll i­n IFRS a­nd US GAAP”, Organizajaca, No. 6, November-December. Nikolai, LA, Bazley, JD, and Jones, JP. 2009, Intermediate Accounting, Cengage Learning. Ward, S. 2011, “What Capital Cost Allowance class are computers and computer equipment in?”, About.com. Wayman, R. 2011, “Impairment Charges: The Good, The Bad and The Ugly”, Investopedia. NRG Energy. 2009, “NRG 10-K”. Read More