IAS 36 Impairment of assets published in 1998 and subsequently amended in 2004 and in 2008, seeks to ensure that an asset is not carried on the statement of financial position at a value that is greater that it’s recoverable amount. This paper aims to critically appraise the circumstances where an impairment loss is deemed to have occurred and explain when companies should perform an impairment review of assets, while discussing the effects of impairment decisions on the firm’s financial position and performance.
Previously there was little authoritative guidance on the accounting for asset impairments. The absence of explicit guidance for many assets permitted substantial discretion in terms of amounts and timing of write offs (Francis et al, 1996). Over time accounting standards have moved towards presenting more items at fair value on the Balance Sheet. In doing so IAS 36 tries to remove as much discretion as possible. The primary objective of IAS 36 Impairment of Assets is to ensure that an entity’s assets are carried at no more than their recoverable amount and the standard sets out the criteria for defining how the recoverable amount is determined. Entities are required to conduct impairment tests where there is an indication of impairment of an asset, with the exception of goodwill and certain intangible assets for which an annual impairment test is required. Intangible assets with an indefinite useful life, an intangible asset not yet available for use and acquired goodwill should all be measured annually whether or not there is any indication of impairment.
Impairment is deemed to occur when the carrying amount is higher than the recoverable amount (i.e. the value in use. the asset’s net selling price or the fair value as determined in accordance with IFRS 13). At the end of each reporting period an entity is required to assess whether there is any indication of impairment. If an indication of impairment is evident then the assets recoverable amount must be calculated [IAS 36.9]. An impairment loss is recognised where the recoverable amount is below the carrying amount [IAS 36.59]. The impairment loss should be immediately recognised, generally as an expense unless it relates to a revalued asset where the impairment loss is treated as a revaluation decrease [IAS 36.60]. In the case of goodwill, a cash-generating unit to which goodwill has been allocated shall be tested for impairment at least annually by comparing the carrying amount of the unit, including the goodwill, with the recoverable amount of the unit: [IAS 36.90] In each situation, if the carrying amount of the unit exceeds the recoverable amount of the unit, the entity must recognise an impairment loss. This is a radical change in accounting for goodwill. Previously, International Accounting Standards required recognition of Goodwill subject to amortisation over its useful lifetime.
Indicators of impairment are set out in IAS 36 with a view to making the decision less subjective than previously was the case. Negative changes in technology, markets, economy and law could all have adverse impact on the value of an entity’s assets. Indicators of impairment could be as a result of internal or external sources. The market value of an asset may decline as a result of usage or the passage of time. Other external indicators of a decline in value could be the result of significant technological, market, economic, or legal changes which occur and have an adverse effect on the asset or entity. Market interest rates may impact the discount rate used in calculating the value in use of an asset and therefore decreasing its recoverable amount. Internal indicators of an impairment review could be the result of obsolete or physically damage assets, or if an asset is part of a restructure or held for sale, or where the economic performance of an asset is worse than expected.
Despite the standard being objectively set, it can be difficult in determining the measurement of value attributable in assessing impairment options. The timings and measurement of asset write-downs rely heavily on estimates. A number of features of impairment testing and measurement process make implementation a challenge. Triggering events to indicate impairment are many and vary greatly in significance and severity. Different valuation models are used and there is little conformity in the selection of discount rates. (Comiskey and Mulford, 2010). A difference in nature continues to exist between fair values disclosed by management. While the standard seeks to increase transparency and eliminate the subjectivity of accounting for impairments, the exercise for determining if an asset is impaired and by how much remains at management’s discretion. It was felt that previously management took advantage of the discretion afforded by accounting rules to manipulate earnings either by not recognising impairment when it has occurred or by recognising it only when it is advantages (to them) to do so (Francis et al, 1996). The standard now seeks to address this discretion by requiring annual impairment (Goodwill and intangibles) or impairment reviews to be carried out whenever there is an indication of impairment. Even still, there is an element of discretion afforded to the calculation of impairments and so management incentives to manage earnings can still play a part in any impairment decisions. These estimates might be managed to alter or avoid impairments, limiting the comparability across firms. A goodwill impairment loss, for example, is estimated in most cases from management’s projections of future cash flows (Z Li et al, 2011). This is problematic to the investors who are unable to see through these potential manipulations. Indeed, investors and analysts have the option to adjust, or indeed totally ignore, reported accounting numbers, therefore it is far less certain whether this reporting behaviour actually misleads users or reduces reliability and relevance (Lhaopadchan, 2010). Additionally, financial statements differ from the management accounts used by an entity and the effect of any impairment further widens a gap already existing between management information accounts used by the board and the financial statements audited and published.
Earnings manipulation is one such concern given the judgemental approach to the indication of and calculation of impairment. One of the most widely cited papers that investigate the effect of executive compensation plan on accounting choice is Healy (1985). Healy hypothesizes that managers have an economic incentive to manipulate earnings in order to increase their cash compensation, this being the case certain accounting standards allow for this more than others and IAS 36 still allows for an element of judgement in the calculation of impairments. Furthermore, papers have cited the nature behind recognition (or lack of recognition) of impairments and IAS 36 permits an impairment loss on a long lived asset to be reversed if the economic value of the asset recovers. This has been seen to have a direct impact on the practice of impairments whereby reversibility has a positive effect on a manager’s decision to record asset impairments. ‘Permitting reversals significantly increases the likelihood that a manager will record the impairment’ (Trottier 2013) thus highlighting the discretion that management can withhold towards the treatment of impairments.
Volatile financial markets and shifting economic conditions can impact the value of a company’s assets across the Balance Sheet. The recent global meltdown of financial markets was accompanied by highly publicised asset write-downs (Spear and Taylor 2011) and so the standard seeks to address the transparency of the financial statements by ensuring that impairments are directly reflected through the profit and loss account and statement of comprehensive income, disclosed by class of asset. It is not surprising that the most frequent write down activities took place during periods of economic recession confirming the strong relationship between asset write-downs and economic conditions. In 2013 the consolidated results of PSA Peugeot Citroen saw a €1,101 million impairment charge, mainly recognised with respect to the assets of the Automotive Division, primarily to reflect the deteriorating automobile markets and adverse exchange rate movements in Russia and Latin America. Additionally, in 2014 Vodafone’s end of year profits dropped after a £6.6bn impairment relating to the value of European operations whereby lower than expected cash flows were the result of a tougher macroeconomic environment and heavy price competition contributing to a total decline in revenues. Both investors and financial analysts revise their expectations downward on the announcement of an impairment loss. The negative impact of the loss serves as a leading indicator of a decline in the future profitability of an entity. (Z Li et al, 2011).
In conclusion, despite the presumed benefits associated with Fair Value accounting, it is shown that in practice managerial self-interests and earnings management concerns appear to motivate many impairment decisions (Lhaopadchan, 2010). IAS 36 goes further than any previous standard and subsequent amendments to eliminate any subjectivity involved in highlighting and calculating an impairment loss. While goodwill should be assessed annually for impairment other potentially impaired assets are only reviewed in detail for impairment if there is an indication of impairment, some of which are highlighted by the standard itself, however the indicator of impairment could go unidentified resulting in misleading financial statements. Additionally many calculations of impairment use management projections which could include error or contain an element of managerial self-interest and manipulation. Generally speaking the reaction of market participants to any impairment disclosed in the financial statements is of a negative nature with the exception of restructuring costs for which highlight future spend. While the standard seeks to provide a truer and fairer representation of asset value it should be noted with caution the subjective nature of any calculations. Even with an unqualified audit report on the financial statements the audit opinion on impairment is only as good as the information provided and made available to the external auditors.
Hence, it can be concluded that IAS 36 Impairment of assets has come far to contribute to improve the transparency of the financial statements by successfully determining when and how impairment reviews should be conducted, however there will remain an element of managerial judgement for which caution should be taken by all users of the financial statements.
‘Causes and effects of discretionary asset write-off’, Francis, J.. J. D. Hanna, and L. Vincent. Journal of Accounting Research Volume 34, 1996.
‘Goodwill, Triggering Events and Impairment Accounting’, Eugene E Comiskey; Charles W. Mulford. Managerial Finance, Volume 36 (9): 22 – August 10 2010
‘Causes and Consequences of Goodwill Impairment Losses’ Z Li et al. Review of Accounting Studies, Volume 16 (4) – Dec 1, 2011 – May 11 – 2010.
‘Fair Value Accounting and Intangible Assets.’ Lhaopadchan. Journal of Financial Regulation and Compliance, Volume 18 (2)
‘The Effect of Reversibility on a Manager’s Decision to Record Asset Impairments’, Trottier, Kim. Journal Accounting Perspectives , Volume 12 (1) – Mar 1, 2013
‘The Effect/Decisions of Bonus Schemes on Accounting Choices’, Healy, P M. Journal of Accounting and Economics Volume 7 (1), 1985
‘Asset Write Downs: Evidence from 2001-2008’, Spear, Nasser A; Taylor, Alexandra M. Australian Accounting Review, Volume 21 (1) – Mar 1, 2011
Relationship between IFRS Adoption and Financial Report Readability for Australian Companies
1 Executive summary The impact and relationship between the international financial reporting standards (IFRS) adoption of the Australian companies’ financial reports’ readability will be mainly discussed in this report. Firstly, according to the research result of Cheung and Lau (2016), the text length of financial reports has increased and the complexity has decreased in the post-IFRS adoption period, so the readability of financial reports has improved. Secondly, the length of the notes disclosed has increased significantly in the specific accounting policies. So it will require more disclosure of these selected accounting principles after IFRS adoption. Moreover, IFRS adoption has both advantages and disadvantages. Although Australia adopts IFRS, the accounting procedures and practices that these companies used are not necessarily can be internationally consistent and comparable.
2 Introduction Most countries now adopt IFRS, and the purpose of IFRS is to set a better accounting standard to provide clearer disclosure. (Aasb.gov.au, 2004). Australia began adopting International Financial Reporting Standards in 2005. The report mainly analyses the relationship between adopting IFRS and the Australian companies’ financial report’s readability based on the results of Cheung and Lau’s research report. Firstly, analyse the importance and measurement of readability, where measurement readability consists of two dimensions: length and complexity. Secondly, discuss the impact of adopting IFRS on readability and selected accounting policies. Moreover, discuss the advantages and disadvantages of adopting IFRS.
3 Analyse readability 3.1 Why readability is important?
In relation to the importance of readability, Firstly, communicate effectively with the target users is important. Because the main purpose of communication is to transfer the information that the sender wants to others, so the information must be delivered in a reliable and understandable way. If the information cannot be properly understood by the target user, then this will be less useful for the user’s decision making and monitoring purposes (Cheung and Lau, 2016). The effectiveness of communication not only depends on the user’s ability to understand but also depends on whether the sender’s information has better readability. All public companies publish annual financial reports because this is the way information is communicated between business managers and shareholders. Management can effectively disseminate information and make decisions through financial reports, and investors can make predictions about future returns based on the annual reports (Baker and Kare, 1992). But not all users have the accounting background, so the most important feature of financial report is to be easy-to-understand because it can effectively help users make the right decisions. Secondly, the effectiveness of financial report can be affected by readability and comprehensibility. The readability of financial reports is determined by the writer, and comprehensibility is determined by the user. The important feature of financial report is the need to present financial information so that users can easily understand it. So the financial report should be more readable to ensure that all users understand the content of the financial report. And the information in the financial reports must be reliable and effectively contain the company’s financial performance. Therefore, high-quality financial reports should disclose the company’s financial information in detail and better to make it more readable for users. Moreover, Li (2008) states that many research results show that the financial reports’ readability will influence the current income and future sustainable income. The trading behavior of investor, analyst’s following and analysts’ reports are all affected by the readability of financial reports (Cheung and Lau, 2016). Li (2008) states that the companies with easy-to-read financial reports can obtain longer-lasting profitable income, while financial reports with lower-income companies are hard to understand and read. According to Miller (2010), because the readability of financial reports allows investors to better understand the company’s scale, financial position and financial performance, so it will effect the trading activities of investors. According to De Franco et al. (2013), the higher readability reports will provide more understandable analyst report and the quantity of trading will increase.
3.2 Readability measurement
Cheung and Lau (2016) state that measuring the financial report’s readability through two dimensions which are length and complexity. The length is measured by the number of words reported, and normally longer reports are less readable. However, the research results show that more text reports can disclose more detailed information and after the adoption of IFRS improved readability. The fog index is used to measure the complexity and it is a function that represents the length of a sentence and the percentage of complex words that includes three or more syllables. Normally higher fog index has less readability and vice versa.
4 The relationship between adopting IFRS and the Australian companies’ financial report’s readability 4.1 Influence on readability
According to Cheung and Lau (2016), they measure the readability of financial report by words length and complexity, and in order to analyse the relationship between adopting IFRS and the Australian companies’ financial report’s readability, they selected samples from all Australian companies listed on the ASX. Firstly, according to Ding et al (2007), compare with most domestic accounting standards, IFRS need greater disclosures. This may be because the number of words will increase after the IFRS adoption. According to Figure 1, Cheung and Lau analysed the selected data and found that after IFRS adoption the length of words has increased. For example, average number of words increased from 14961 to 23949, and the median increased from 13328 to 25058. The mean of length increased from 9.47 to 9.97, and the median increased from 9.5 to 10.13, but the fog index has declined.
Secondly, Cheung and Lau (2016) state that partners in KPMG and Ernst