Firms report long-lived operational assets at acquisition costs minus the accumulated depreciation to date (adjusted acquisition cost). The use of acquisition-cost-based reporting rests on the presumption that such amounts are more objectively measurable than the fair values of fixed assets. Difficulties encountered in determining fair values include:
- the absence of active markets for many used fixed assets, particularly those specific to a particular firm’s needs.
- the need to identify comparable assets currently available in the market to value assets in place.
- the need to make assumptions about the effect of technological and other improvements when using the prices of new assets currently available on the market in the valuation process.
Nevertheless, accounting standards require firms to determine whether the net book values of long-lived assets are not overstated relative to the economic reality of market values. In particular, accounting standards are concerned with how long-lived asset values must be tested for impairments and written down if impairment losses have occurred (an application of conservatism). To understand how accounting measurement rules affect your analysis of the profitability of a firm and your expectations of future profitability, you should develop answers to the following questions:
- Are asset impairment charges consistent with the firm’s economic environment?
- Are the charges transitory or do they occur frequently?
- Are asset impairment charges or IFRS upward revaluations based on reliable fair value estimates?
To sharpen your ability to make these judgments, the following sections examine the U.S. GAAP and IFRS standards related to reporting long-lived assets when book values and market values differ. The next three sections deal with three basic types of longlived operating assets: (1) long-lived assets subject to depreciation and amortization (land is in this category even though it is not depreciated), (2) intangible assets not subject to amortization because of indefinite lives, and (3) goodwill. Then, a fourth sectionaddresses upward revaluations of long-lived assets under IFRS
Impairment of Long-Lived Assets Subject to Depreciation and Amortization
The development of new technologies by competitors, changes in government regulations, changes in demographic trends, and other external factors may reduce the future benefits originally anticipated from long-lived assets. Firms are required to assess whether conditions exist implying that the carrying amounts of fixed assets are not recoverable, and if they are not, firms are to write down the assets to their fair values and recognize impairment losses in income from continuing operations
Impairment of Long-Lived Assets Subject to Depreciation and Amortization
The development of new technologies by competitors, changes in government regulations, changes in demographic trends, and other external factors may reduce the future benefits originally anticipated from long-lived assets. Firms are required to assess whether conditions exist implying that the carrying amounts of fixed assets are not recoverable, and if they are not, firms are to write down the assets to their fair values and recognize impairment losses in income from continuing operations
U.S. GAAP defines a carrying amount (that is, the book value at the moment of the impairment test) as not being recoverable if it is greater than the sum of the undiscounted cash flows expected from the asset’s use and disposal. If an impairment charge is to be recorded because the asset’s carrying amount is not recoverable, the charge equals the amount by which the carrying value exceeds the asset’s fair value. Under U.S. GAAP although the firm uses undiscounted future cash flows to decide whether an impairment charge is necessary, fair value is used to determine the actual impairment charge.
Differences in U.S. GAAP and IFRS Impairment of Long-Lived Assets
To illustrate the differences between U.S. GAAP and IFRS, assume that a real estate company owns an apartment building that originally cost $20 million, with a current carrying amount of $15 million. The company originally expected to collect rents of $1.67 million each year for 30 years before selling the apartment complex for $8 million. Deteriorating neighborhood conditions, however, have caused the company to reassess the future rentals, especially given a recent appraisal that set a fair value for the apartment building at $10 million. The company now estimates that it will receive rentals of $1.35 million per year for 15 years and then will sell the building for $5 million. The company uses an 8% discount rate to compute the present value for this investment. Costs to sell are estimated at $300,000.
U.S. GAAP Treatment: Because total undiscounted future cash flows of $25.25 million [($1.35 3 15) รพ $5] exceed the carrying value of $15 million, the real estatecompany reports no impairment loss. In essence, the firm has suffered an economic loss but will not report any loss for financial reporting. If the total undiscounted future cashflows in this illustration were estimated to fall below the carrying value of $15 million, the real estate company would compute an impairment loss as the difference between the carrying value and the fair market value of the apartment building (in this case, $10 million). The company would report the impairment loss of $5 million in income from continuing operations, and the apartment building would be recorded at the new carrying value of $10 million
IFRS Treatment: Under IFRS, the greater of the asset’s value in use and fair value from sale is identified first. Value in use is $13.1 million, obtained by using the 8% discount rate to compute the present value of a 15-year annuity of $1.35 million cashinflow plus the present value of $5 million received at the end of Year 15. The value from a sale is $9.7 million, the $10 million fair value minus $0.3 million in disposal costs. The larger of the two, $13.1 million, is then compared to the carrying value of $15 million, triggering a $1.9 million impairment. The company would report an impairment loss of $1.9 million in income from continuing operations, and the apartment building would be recorded at the new carrying value of $13.1 million
Differences in U.S. GAAP and IFRS Impairment of Long-Lived Assets
To illustrate the differences between U.S. GAAP and IFRS, assume that a real estate company owns an apartment building that originally cost $20 million, with a current carrying amount of $15 million. The company originally expected to collect rents of $1.67 million each year for 30 years before selling the apartment complex for $8 million. Deteriorating neighborhood conditions, however, have caused the company to reassess the future rentals, especially given a recent appraisal that set a fair value for the apartment building at $10 million. The company now estimates that it will receive rentals of $1.35 million per year for 15 years and then will sell the building for $5 million. The company uses an 8% discount rate to compute the present value for this investment. Costs to sell are estimated at $300,000.
U.S. GAAP Treatment: Because total undiscounted future cash flows of $25.25 million [($1.35 3 15) รพ $5] exceed the carrying value of $15 million, the real estatecompany reports no impairment loss. In essence, the firm has suffered an economic loss but will not report any loss for financial reporting. If the total undiscounted future cashflows in this illustration were estimated to fall below the carrying value of $15 million, the real estate company would compute an impairment loss as the difference between the carrying value and the fair market value of the apartment building (in this case, $10 million). The company would report the impairment loss of $5 million in income from continuing operations, and the apartment building would be recorded at the new carrying value of $10 million
IFRS Treatment: Under IFRS, the greater of the asset’s value in use and fair value from sale is identified first. Value in use is $13.1 million, obtained by using the 8% discount rate to compute the present value of a 15-year annuity of $1.35 million cashinflow plus the present value of $5 million received at the end of Year 15. The value from a sale is $9.7 million, the $10 million fair value minus $0.3 million in disposal costs. The larger of the two, $13.1 million, is then compared to the carrying value of $15 million, triggering a $1.9 million impairment. The company would report an impairment loss of $1.9 million in income from continuing operations, and the apartment building would be recorded at the new carrying value of $13.1 million
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