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FAS 144: Tailor-Made to Confound Financial Analysts

It should come as no great surprise to savvy analysts that far too many accounting standards were written to benefit someone else other than investors and analysts. FAS 144 on impairment of long-lived asset is yet another example, but perhaps more than any other, it suffers by comparison to its counterpart in IFRS, IAS 36.

The principle underlying IAS 36 is quite simple, and fairly intelligent:

  1. If recent events indicate that the economic benefits to be derived from an asset (or group) may be less than the booked amount (‘carrying value’), go to Step 2.
  2. If fair value is less than carrying amount, write the asset down to its fair value, and report a loss.  Future depreciation should be adjusted accordingly.

The principle underlying FAS 144 is also simple, but completely divorced from reality:

  1. If recent events indicate that the economic benefits to be derived from an asset (or group) may be less than the booked amount (‘carrying value’), go to Step 2.
  2. If the undiscounted cash flows to be realized from holding the asset are less than its carrying amount, go to Step 3.
  3. If fair value is less than carrying amount, write the asset down to its fair value, and report a loss.  Future depreciation should be adjusted accordingly.

Both standards start out the same, but FAS 144 inserts the extra step, in italics, above–to require comparison of the undiscounted cash flows of an asset to its carrying value.

Old School Bean Counting

A cardinal rule of finance is that one should never sum cash flows from different points in time–without first adjusting for the time value of money.  Not adjusting for time value is the equivalent of adding apples and oranges.  So, in order to excuse what economists consider idiotic, the FASB had to hark back to abacus days and the roots of historic cost accounting.

Pure historic cost accounting, now pretty much debunked and defunct, posited that profit for a period is the difference between revenue recognized and a fair share of historic costs.  Thus, recovery of historic costs (i.e., the ancient finance heuristic called “payback”) is the measure of profitability.

To the historic cost lover, the net book value of an asset is appropriately based on historic cost unless future revenues can’t be expected to recover the carrying amount.  It doesn’t matter whether cost-covering revenues are scheduled for recognition in 1 year or 50 years.  But, in all fairness to ancient bean counters, cash flow timing must have been an annoying detail when having to construct spreadsheets in pencil.  But, FAS 144 is a child of the information age, so why the seemingly slavish devotion to the traditions of our beloved ancestors?

Politics as Usual

According to FASB Chairman Herz, relevance in accounting is paramount.  Since sunk (i.e., historic costs) are irrelevant to economic decision makers, their demise as a basis of accounting must be inevitable. Yet, FAS 144 allows historic costs measures for assets to remain on the balance sheet long past their time.  To understand why the conflict between what the FASB says and what it does, one need only compare the patterns of reported net income under FAS 144 versus IAS 36.

  • First, we need to realize that over the life of any asset, the total effect on net income will be the same.  So, the difference between FAS 144 and IAS 36 will manifest itself by differences in timing and classification: when asset costs are reported, and how–as either depreciation or impairment losses.
  • Second, as events impair the value of an asset, the sum of undiscounted cash flows will dip below an asset’s carrying amount later than the sum of discounted cash flows.
  • Therefore, IAS 36 will report impairments sooner (in a more timely fashion), more frequently, and in smaller increments than FAS 144.  Relatedly, FAS 144 will likely report more costs as impairments than depreciation.

Coping with FAS 144

Reporting impairment costs less frequently and in larger globs, is intended to convey that they are non-recurring, and therefore, should be ignored when estimating the present value of future earnings.  Analysts need to realize that impairments recognized in FAS 144 are largely the result of events occurring in earlier periods.  However, that doesn’t mean there is no important information in the number. When attempting to estimate “permanent” income, or estimating earnings trends, I recommend that the impairment charge of the current period be spread out against reported income of prior periods–but for how many periods depends on the circumstances.  For industries with long product life cycles, three years might be appropriate.

In all cases, the question should be asked whether an impairment charge is not simply a substitute for under-depreciation in prior periods.  Also, read MD&A of prior periods thoroughly.  Impairment charges rarely occur overnight.  Did management provide adequate discussion of the events leading up to the impairment charge?

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