Aug 9, 2019 in Economics

Executive Summary

The paper studies the concept of impairment of assets and fair value, and it attempts to build a connection between the performance of banks and their impairment activities. The findings were supported by academic research and discussion of the potential reasons behind the banking crisis and the role that fair value accounting could play in it.


Even though there is a big group of researchers who are against the idea of fair value accounting due to its ambiguous nature and lack of regulation, the UK banks and their problems were not connected with impairment activities. Therefore, further research is needed to evaluate the role of fair value pricing in the banking crisis. 

Impairment of Assets


Impairment of assets are purposed to guarantee that the assets are not listed on the balance sheet at the level that exceeds the recoverable amount. Any company has assets that cost less in the market than it is indicated in the balance sheet. That is why their cost is written-down according to deterioration, depreciation or other factors. The balance sheet usually contains both the market price and the impaired asset price. Some types of company’s assets are more likely to be written down than the others. They include accounts receivable, long-term assets, and goodwill.


If the expected future cash flow is less than the current value of the asset, it is considered impaired and should be written down according to the fair price. Generally, assets are not written up, and there are very few conditions under which it can happen. 


The origins of the assets impairment come from the Companies Act of 1985 when for the first time the non-current assets that carried the amount exceeding their economic worth were supposed to be written down. Afterwards, a national standard, FRS 11 was introduced along with its international equivalent IAS 36, and before that the completion of the assets impairment was not regulated, guided or monitored, and accountants had to deal with describing the depreciation of the asset all by themselves. Now it has fixed standards and regulation on completing the process of writing down assets. 


The impairment of assets is an important step in moving the financial reporting from the old-fashioned precautious attitude to realistic transparency. The impairment also insures that the historical cost shifts to the fair price basis. The prudence concept, widely spread before the beginning of impairment, was not descriptive enough, and a need for a conceptual framework grew over time. The impairment works to make sure that the assets are not overestimated, and it also has its specific rules. Goodwill must be reviewed for impairment on an annual basis. All other intangible assets must go through the impairment review procedure too, in case they are not amortised annually. Both tangible and intangible non-current assets must be reviewed for asset impairment if there are points indicating that the carrying amounts may be unrecoverable.


The review takes place under internal and external circumstances. The internal ones include physical damage or physical deterioration of the non-current assets, sufficient changes in the business operations organization, loss of key employees, and the internal reports that indicate that the performance of an asset has become worse or is expected to become so. The external circumstances under which impairment review is needed include a sufficient fall in the asset’s value in the market, a sufficient change in the market’s interest rates, closing down of a key employer in the local territory where the business operates, an important change in the competitive or regulatory landscape, and the exceed of the carrying antity amount over market capitalization (in case when the company or its part brings losses). 


Analysis: the impact impairment had on banks over the period from 2006 to 2010 

The companies chosen for research were banking institutions based in the UK, active now and publicly quoted. The data was retrieved from the FAME database. HSBC Holdings PLC is a publicly quoted UK bank that demonstrated almost double growth in turnover (from 55,361 in 2006 to 94,314 in 2010). However, the plummeting fall in net tangible assets from 203,178 to 113,361 is a questionable indicator. The company’s current ratio changes dramatically as the difference between assets and liabilities is 61,196 in 2006 and 222,289 which identifies sufficient growth of the company’s assets. The impairment tangibles are only stated in 2011, and the impairment counts up to 251 the same year. According to profitability trends, the company had a difficult period in 2008-2009 (negative turnover growth and profit before taxation) but the situation got better over time. No information is provided about the exceptional items. The company management did not concentrate enough on opening up their impairment assets information to the public. However, depreciated and amortised assets were reported on an annual basis. The generated dividends for the investors remained stable in spite of the turnover and the expansive growth of the business. 


Lloyds Banking Group PLC is a publicly quoted Edinburgh company that was heavily hit during the crisis period (4,248 of profit in 2006 and only 281 in 2010). However, the company experienced a four-times growth in net tangible assets over the period from 2009 to 2010 (from 39,196 to 122,789). Since the same period, the shareholders funds have always exceeded 40,000. It was a big investment of 750,146 that was made in 2009, and the result from this activity is not evident in the following years. The impairment analysis has shown that such activity came into place in 2009-2010 (202 and 65), and the reports concentrate more on depreciation and amortisation sections as well (both for tangible and intangible assets). Now the company has come into the stabilization period after the crisis but no relation of the company’s crisis problems and the impairment activities is seen. 


Barclays PLC’s profit has suddenly spiked in 2007-2008 (from 45,552 to 1,098,745) but it looks like the crisis made the profit smaller (534,136 in 2009 and only 83,890 in 2010). The impairment tangibles reporting shows only 53 in 2010, and the impairment reporting demonstrates 315 in 2010 and 601 in 2011. Although it is a brighter impairment case than with previous banks, the volume of impairment is too small to influence many other activities of the bak related to assets and liabilities. Once again, the reporting concentrates more on describing depreciation and amortisation rather than impairment of assets. 


The Royal Bank of Scotland Group Public Limited Company experienced significant losses in 2008 (-40,667) and until 2010 it couldn’t generate profit. The tangible assets fell from 19,3497 to 7,400 from 2009 to 2011. However, the company’s current ratio is more than 1. No information on impairment tangibles or impairment is available, but it is united with amortization. 


According to the data, there is no clear connection between the reporting of impairment of assets and the banking crisis of 2008. obviously, there were other reasons behind it, rather than the impairment of goodwill, for example. 

A Discussion of One Banking Case

Having a closer look at the case of Barclay’s PLC with the largest impairment charges, we can see that the company experienced sufficient decrease in fixed assets (from 753,465 in 2006 to 11,669 in 2007) and a sudden rise afterwards (2,014,575 in 2008). Current assets also changed dramatically – 243,222 in 2006, 1,215,692 in 2007 and 38,405 in 2008. The liabilities didn’t experience such changes, and the company managed to keep the current ratio above 1. Potentially, the loans that the bank had could be impacted by the impairment charges because of the risk of technical default in case if the bank does not fit the criteria of the lenders. However, the size of the impairment charges (even plus the amortization and depreciation charges) was too insufficient compared to the size of other costs and problems that the company faced during the crisis. 


Barclay’s PLC was sufficiently damaged by the crisis period from 2008 to 2009 when the profit fell after a big spike but potentially, it is more related to the connections with American banks that started out the crisis tendencies. 


Impairment represents more danger to the companies whose goodwill asset is higher (due to higher brand capitalization and global importance), while UK banks don’t depend heavily on these assets. Investments might be unrecoverable assets if a wrong investment decision was made but it is difficult to evaluate because of the long-lasting nature of the loan. 


If done correctly, the impairment and the fair value information empowers investors with more qualitative and realistic information. Impairment helps to remove the inflation distortion from the financial information – for instance, by removing the goodwill that came as a result of bubble-year acquisitions. It is not only an analysis of the current state but also the information on how much should be paid by investors for the share of the company. The new regulations push companies to reevaluate their former bad investments which makes them comparative to the situation in the individual stock market. 


Fair value and impairment are also ways for investors to evaluate the decision-making style and the corporate management quality as companies that have to write down sufficient sums of money did not make good investments. However, transparent companies that honestly demonstrate their mistakes in the form of fair value and asset impairment, deserve more attention than the ones that keep on manipulating reality until the company bursts like a bubble. 


paper details

Nevertheless, the positive impacts of fair price is limited as the current accounting rules (FAS 141 and 142) provide much freedom and confidentiality to companies in the process of their goodwill allocation and value determination. There's still no scientific ground under defining fair value, and the expert evaluation can vary depending on a variety of factors. Additionally, there is space for manipulation in the goodwill allocation in order the avoid the impairment review. Top management tries to evade form the charges, and there will always be machinations in the sphere. 


The process of goodwill allocation is discrete for the investors, and that is why there are opportunities for manipulative behaviour. Moreover, the companies are not required to attach the information on the goodwill fair price, even though the provision of such information generally leads to a well-informed decision on investment. 


The negative aspect of impairment of assets is that the process can impact the accessible loan by cutting down the equity too much. The lenders usually have special requirements for the operating ratios of the borrowing company. The unfulfilled requirements lead to unfavorable conditions that can even prevent the company of refinancing its debt, especially if it’s sufficient and there is even a larger need for investment. The loss of objectivity in the calculation of the fair value decreases its efficiency for financial reporting. If there are no quoted market prices, the experts make their estimations based on subjective assumptions only, and fair price becomes a tool for discretion and manipulation in management. 


Many opponents of the fair value accounting associate the banking crisis with this kind of financial reporting, and they insist that the banks have been seriously affected by it in a negative way. Even the President of the American Bankers Association explains the banking crisis as the consequence of fair value accounting. Some of the heavily hit companies’ executives also blame fair value accounting for their crises. Wallison argues that fair value accounting was actually the main cause behind a significant and sudden depreciation of assets which led to expanding unstability, and brought the harshest economic crisis in the United States since the Great Depression period. Wallison has continued his research and drove to a conclusion that fair value accounting should be either abandoned or sufficiently altered in order to be suitable to evaluate the real value of the assets instead of their earnings potential. This opinion is shared by Bloomfield and King. The mark to market approach in fair value accounting is claimed to be unobjective and harmful by these authors. The chairman of the Federal Reserve supported this opinion by calling the need to report the asset value basing on the current quotes a ‘vicious circle’. The framework of the fair value reporting potentially led banks to a contagious need provide unrealistic, historical information which led to the global banking system crisis. 


The academic research also proves that fair value pricing has been harmful for the banking system and may have caused crisis. Abdel-Khalik provides critique of the fair value accounting because of its mixed nature: the accounting system attempts to include both the satisfaction of the existing investors and the potential investors who are in the process of decision making. The first group is more interested in what happened to the equity, while the second is more potential-concerned. This conflict led to the ambiguous nature of accounting and lack of objectivity in evaluation. 


The supporters of the fair value approach state that fair value reporting is only a communication channels, and its manipulative use is not this channel’s fault. Moreover, it is unfair to blame the messenger of the problems instead of identifying deeper reasons for the crisis. The changes in fair value lead to unrealised gains and losses, and according to this the dividends from business activities can be paid out before the actual come of the cash flow. Besides, subjectivity in calculations also opens up opportunities for playing with earnings. There are several drawbacks in fair value accounting: they can be derived from models with simplistic assumptions and potential for measurement errors, and the unreliability from the input indicators containing forecast rather than the actual data. Some researchers concentrated on studying the classic accounting theory and explaining the general pros and cons of the fair price methodology while others attempted to connect the real economic crisis reasons to the fair price model. 

Generalised List of Fair Value Model Drawbacks 

  • Lack of measurement relevance because of the mixed bases elements in the balance sheet and contradictory aims of the reporting. 
  • Lack of measurement reliability because of the hypothetical nature of fair value with no good overview of the market quotes, shares and positions, and distorted estimates of the market conditions. The described assets are usually illiquid and inactive, so that is gets easier to represent success as failure, and vice versa. 
  • Off-optimum behaviour that results from mark to market which leads to anticipatory profits recognition (unlike in the traditional historical cost approach), and the selective nature of reporting in order to meet the forecasted figures. It is also believed that to certain extent, such behaviour leads to pro-cyclability and systematic risk in the market. As a result, the transparency and realism in financial statements deteriorates.  


Although many researchers associate the drawbacks of fair value accounting with the banking crisis, the UK banks reviewed in this assignment had to deal with other problems apart from impairment charges and the depreciation of assets. However, according to research findings and arguments, the discretion and ambiguity that the framework allows can make the information provided ineffective and manipulative. The measurement system also needs perfection because at the moment expert evaluations vary depending on the points of focus. 

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