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 measurablethan 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 section addresses 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
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
In requiring firms to use undiscounted cash flows to test for impairment of longlived tangible assets, U.S. standard setters reasoned that a loss had not occurred if thefirm could recover in future cash flows an amount equal to or larger than the current book value. Accounting theorists and practitioners question the logic of using undiscounted, instead of discounted, cash flows in testing for impairment. In some cases, the economic value of the long-lived asset may decline below its carrying value but the firm would recognize no impairment because the undiscounted future cash flows from the asset exceed its carrying value
IFRS uses rules that are more theoretically defensible. Firms are required to determine whether an impairment has occurred and to measure impairment by comparing the book value of the long-lived asset to the greater of (1) the fair value of the assets minus estimated costs to sell the asset or (2) the value of the asset in use (which is the present value of estimated future cash flows from using the asset).
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
In requiring firms to use undiscounted cash flows to test for impairment of longlived tangible assets, U.S. standard setters reasoned that a loss had not occurred if thefirm could recover in future cash flows an amount equal to or larger than the current book value. Accounting theorists and practitioners question the logic of using undiscounted, instead of discounted, cash flows in testing for impairment. In some cases, the economic value of the long-lived asset may decline below its carrying value but the firm would recognize no impairment because the undiscounted future cash flows from the asset exceed its carrying value
IFRS uses rules that are more theoretically defensible. Firms are required to determine whether an impairment has occurred and to measure impairment by comparing the book value of the long-lived asset to the greater of (1) the fair value of the assets minus estimated costs to sell the asset or (2) the value of the asset in use (which is the present value of estimated future cash flows from using the asset).
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