The Hindu Business Line : The impairment pair

OVER the past few years, the focus of accounting research in the US has been on measuring the impact on certain pre-determined factors before and after the introduction of the accounting standards. The results of this will be very useful to standard-setters, either to revise the standards or introduce the now common interpretations to the standards. Edward J. Riedl of Harvard Business School has examined Statement of Financial Accounting Standards (SFAS) 121 (Accounting for the Impairment of Long-Lived Assets).

The essence of SFAS 121 is that the entity shall review long-lived assets for impairment whenever events or changes suggest that the carrying amount of the asset may not be recoverable. Impairment exists if an asset's recoverable cost — defined as undiscounted net cash inflows — is lower than its carrying value.

The parameters under which he tested SFAS 121 were, the association of economic factors with write-offs and the association between write-offs and "big-bath" reporting — the tendency to write off large amounts under impairment. The fact that the passage of SFAS 121 in 1995 was controversial with two of the seven FASB members objecting to the passing of the standard stimulated the research. It is not that controversy has left the Standard since implementation. The backlash forced the FASB to issue SFAS 144 (Accounting for the Disposal or Impairment of long-lived assets) in 2001.

The issues that could arise under SFAS 121 were that the guideline specified could result in write-offs that better reflect a firm's underlying economics. In the same breadth, it could be said that the use of undiscounted cash flows to trigger the write-offs may not accurately reflect the firm's underlying economics. The reporting discretion available to managers could decrease due to the structure of SFAS 121. The structure itself could be questioned due to the subjective estimates and assumption that form the core of the standard. Consequent to Enron, there were reports in the US that managers could leverage detail-oriented accounting standards to justify more aggressive reporting choices.

Research in this area reveal that write-offs resulted in negative stock price changes when announced, tend to be quite large in terms of absolute and percentage size, and tend to be reported in the fourth quarter. Surprisingly, entities that reported write-offs tended to have more changes in senior management. Firms that have written off assets have recorded significant negative abnormal returns for a two-year period after the write-off which would suggest that market participants may not fully comprehend the economic consequences of the write-off.

To accommodate all these vagaries, Tobit Regression Analysis was used where the dependent variable was the firm's net-of-tax assets write-off divided by the total assets, and the stacking regression variables were the percentage change in the US GDP, the median change in the firm's return on assets, the percentage change in sales, the change in the firm's pre-write-off earnings, change in the operating cash flows, a change in senior management, a proxy for big bath reporting, a proxy for earnings smoothing and a proxy for the firm's debt.

The results revealed that write-offs reported after the adoption of SFAS 121 had a lower association with economic factors and a higher association with big-bath reporting. This was true across macro, industry and firm level proxies. This confirmed the fact that write-offs reported under this standard are less reflective of the firm's underlying economics.

Managers are also applying greater flexibility in the reporting decisions relating to write-offs after the adoption of the standard. These inferences were robust to a set of alternate specifications too. Maybe the requirement of the standard to use undiscounted cash flows to trigger the impairment could be the cause of this.

Accounting Standard 28 introduced in India is probably in its infancy since it is applicable from April 1, 2004, for entities listed on the bourses and from April 2006 for others.

The standard has drawn heavily from on SFAS 144 and fine-tuned them for local conditions. With aggressive depreciation laws in India, one may find the number of users for the standard on impairment of assets few and far between.

Very few firms would disclose a high value under impairment of assets. It could be a useful idea to test the usability of the "non-core" accounting standards in India — the ones on impairment and discontinuing operations come to mind instantly.

(The author is a Hyderabad-based chartered accountant.)

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