ACF5150 Financial Reporting Issues

Group Critique Report

The essay is condensed from the following article:

Tangible Long-Lived Asset Impairments and Future

Operating Cash Flows under US GAAP and IFRS

Elizabeth A. Gordon and Hsiao-Tang Hsu (2018) Tangible Long-Lived Asset Impairments

and Future Operating Cash Flows under U.S. GAAP and IFRS. The Accounting Review:

January 2018, Vol. 93, No. 1, pp. 187-211.

Due date: 4PM, 10th September

Tutor: Dharmendra Naidu

Tong ZHANG 29293782

Xiaotong LU 28463072

Shanshan YANG 28486447

Zheyi ZHANG

Xiaoyu LIN
Table of Contents

Part One ...................................................................................... Error! Bookmark not defined.

Objectives and Motivation ............................................................................................................... 2
Contribution or Significance and Implications .............................................................................. 4
Research Questions........................................................................................................................... 4
Literature Review ............................................................................................................................. 4
Hypothesis Development .................................................................................................................. 5
Data and Sample ............................................................................................................................... 5
Research Design and Method .......................................................................................................... 5
Results and Analysis ......................................................................................................................... 7
Empirical Results and analysis ....................................................................................................... 7
Analysis of Economic Factors, Reporting Incentives, and the Institutional Setting ...................... 8
Additional analysis ......................................................................................................................... 9
Conclusion ......................................................................................................................................... 9
Limitations and Future Research Directions ............................................................................... 10

Part Two ................................................................................................................................. 12

Weakness of IFRS........................................................................................................................... 12

References ............................................................................................................................... 15

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Part One

Objectives and Motivation

The measurement standards of impairment under the United States Generally

Accepted Accounting Principles (US GAAP) and International Financial Reporting Standards

(IFRS) are some difference which may impact on operating cash flow(OCF). This research

focus on the association between the LLA and OCF under those two different standards and

aim to identity the change of predictive value with the association identified, also investigate

the factors which are associated to predicting value of LLA impairment.

The prior studies state the common of impairment test for LLA, however, the two

standards diverge when considering the recognition time and measurement of loss (Brice 2009;

PWC 2009). Academically, there are few detail investigations at the association between the

impairment of tangible LLA and future OCF. Dechow (1994) states, it is important to enrich

the literature by investigate the capacity of tangible LLA impairment in terms of predicting.

For practical, the tangible LLA is expected to generating future OCF, such capacity is

considered associated with the impairment. Therefore, motivated by academic-enrich appeal

and literature support-providing for practical apply of accounting standards, the authors arrange

the investigating the difference of US GAAP and IFRS, specifically about the capacity of

tangible LLA to predict future OCF.

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Contribution or Significance and Implications

This article provides the basis and direction for future researchers about study of the

difference between IFRS and US GAAP, and also helps investors to better understand and

analyze enterprises. Also, corporate managers and standard setters can benefit from it.

Research Questions

There are two research questions in this study. The first one is whether US GAAP and

IFRS impairments for tangible LLAs are predictive of changes in future OCF. Another one is

whether impairment losses reported under US GAAP and IFRS are similarly predictive of

changes in future OCF.

Literature Review

Previous research documents indicate that current earnings, cash flows, and accruals

are informative about future OCF (Dechow 1994; Barth et al. 2001). More importantly,

disaggregated accruals contribute to the predictability of changes in future OCF (Barth et al.

2001). Base on the previous research, they excted that under both US GAAP and IFRS.

There are a negative association between reported impairment losses and changes in future

OCF.

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Hypothesis Development

Further, in view of the nature of LLAs, the study concluded that the negative

association between reported impairment losses and changes in future OCF will appear after

several years. Based on the difference in loss identification, the study predicts LLA loss under

IFRS to have incremental predictive value beyond US GAAP loss. Under US GAAP, the

impairments are delayed relative to those under IFRS.

Data and Sample

Samples of this study includes 21440 firm-year observations which represent 5433

firms from 26 countries from 2005 to 2011. The sample is generated from the combination of

Compustat data and Datastream data on LLA impairments with 39,775 samples. After consider

the main test requirement, data only in 2010 to 2011 and observation after 2009 are excluded

and trim data upper and lower 0.5% of each variable sample firm year observation.

Finally, there are 10,720 observations are US GAAP and IFRS reporters respectively. The

highest proportions of firms and observations are in the business service industry. Table1 &

table 2 present sample selection and sample composition.

Research Design and Method

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 To ensures that the data obtained could help answer the research question effectively,

the following two models are used to examine the predictive value of LLA impairment on the

change of future OCF.

Model 1

Model 2

In those two models, the future OCF is dependent variable, the current OCF and

IMPAIRit are independent variable. Besides this, others are control variable which used to

reduce the effect on OCF except for impairment.

Above model is used to predict future impairment which is dependent variable and

current impairment is the independent variable. Also, to control for reporting incentives,

control variables are included.

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Results and Analysis

Empirical Results and analysis

Result shows in table 4, where one-year-ahead OCF or four-year-ahead is the

dependent variable, the coefficients of interaction term (IFRSit*IMPAIRit) under model 1 and

2 are present significant negative association, which means the impairment under IFRS have

incremental predictive value, and further prove that impairments under US GAAP does not

affect future OCF significantly.

Table 5 measured the correlation between current impairment and the change of OCF

in past, current and future. Result shows that under US GAAP, current impairment is

significantly negative associate with past and current OCF. Furthermore, by setting the prior

year as the dependent variable, result suggests that impairment is related to decline in the past

cash flow. However, under IFRS, the negative relationship with past cash flow will be lower.

Following the prior study (Francis et al. 1996; Riedl 2004; Szczesny and Valentincic

2013), to measure whether the reported impairments would affect future impairments. By

estimate the tobit and OLS regression models, results from table 6 are positive significant

which implying that the predictive value under IFRS and US GAAP impairments are same.

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Analysis of Economic Factors, Reporting Incentives, and the Institutional Setting

Additional test applied to investigates the economic factors, reporting incentives, and

institutional characteristics brought to the association between impairments and future OCF.

Economic factors

Table 7 shows that both macroeconomic factors, ΔGDPit, and ΔIROAit, are positive

and significant as we expect, since an increase in GDP implies a period of growth and higher

future cash flows. Similarly, an increase in industry return on-assets suggests greater future

cash flows in the industry. However, the triple interactions including IFRSit, are consistently

significant and negative in both models, indicating the incremental predictive value of

impairments under IFRS even when economic conditions are strong.

Reporting incentives

By consider income smoothing, examine whether impairments are negatively related

to changes in future OCF. SMit, and “big bath” behavior, BATHit. in table 7, the result shows

that income smoothing and its interactions are not significant. However, taking a “big bath” is

significant in Model 2, which indicates higher cash flows after taking a “big bath”. Furthermore,

the coefficients of BATHit*IMPAIRit under model 1 and 2 present a significantly negative

association, which means over-impairment when impairments are taken during a “big bath”.

However, when interacted with IFRS, results shows significantly positive coefficients in both

two models which support that the over-impairment could mitigated under IFRS.

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Institutional characteristics

According to prior study1, in common law countries and high enforcement countries,

a higher predictive value of impairments is expected. To test institutional setting, CLAWit and

ENF are considered. In table 8, panel A, the result shows that the common law countries and

countries with high enforcement recognize more impairment losses. Moreover, the interaction

of common law and impairments are not significant, which means the predictive value of

impairments does not depend on the legal system. Furthermore, the results for enforcement

implies the predictive value of impairments would higher with enforcement.

Additional analysis

The study also tests of future operating income, the separate US GAAP and IFRS

models, impairment reversals, asset revaluations, single impairment in the sample period and

controlling for differences in depreciable base and depreciation estimates. According to the

results of tests, they all support the result of main test.

Conclusion

This paper provides evidence of the predicted value of LLA impairments for changes

in operating cash flows under US GAAP and IFRS. Compared with the existing literature, this

study extends the study to compare specific accounting issues with tangible LLA lesions, which

1 Ball et al. 2000, 2003; Lang, Raedy, and Wilson 2006; Leuz, Nanda, and Wysocki 2003; Bradshaw and Miller 2008
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are significantly different between US GAAP and IFRS. The main analysis shows that the

tangible LLA damage is flat and negatively correlated with the future OCF under IFRS, but

the average does not meet US GAAP. In addition, the study found that the relationship between

IFRS impairments and US GAAP impairments and future cash flow changes persist after

controlling for economic factors and reporting incentives.

Limitations and Future Research Directions

Although the results are informative, there are three main limitations. First, we cannot

directly prove whether the standard is implemented as they are written. Second, we are unable

to provide direct evidence as to whether or how standards are written to affect their usefulness

to users. Third, we assume that financial reporting users will find accounting measures more

useful when predicting future performance indicators and can provide indirect evidence on US

GAAP and IFRS standards.

About future research directions, first, most of the previous studies involved a single

country or in the short term, and this paper used a number of countries to test data over a long

period of time, which is conducive to the detection of the national institutional environment. A

more solid foundation can be provided for future research on this issue.

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 Second, investigating the predictive value of specific accounting standards extends

the study of the comparability of US GAAP and IFRS. The results of this research can help to

conduct a comparative study of IFRS and US GAAP.

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Part Two

Weakness of IFRS

This research article shows that LLA impairments under IFRS have incremental

predictive value beyond US GAAP impairments. However, there is a possibility that IFRS may

cause management earning. According to IFRS, the impairment loss is the amount by which

the carrying amount of the asset exceeds its recoverable amount, which is the higher of: (1) fair

value less costs to sell and (2) value in use (the present value of future cash flows in use,

including disposal value). Ball (2006) argues that when capital markets are illiquid, managers

exercise greater discretion over fair value measurements. When fair values are estimated using

valuation models, managers can influence the estimations through their choices of models and

parameters, thus opening the door to greater opportunistic earnings management. This same

concern carries over to IFRS asset impairment tests as well (IAS 36, Impairment of Assets).

Furthermore, the measurement of VIU (value in use) requires the use of cash flow projections

based on reasonable and supportable management assumptions, which could also increase

opportunistic behavior. Capkun, Collins and Jeanjean (2012) criticize IFRS for lack of

implementation guidance and for permitting greater flexibility in application, have contributed

to greater earnings management.

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The importance of cash flow to investors

Stated by the paper, under the context of IFRS, the tangible LLA impairment will

generate more valuable information for the potential user, such as the shareholder, investor,

and the lender, in addition, the quality will be reinforcing especially when there is high

enforcement. According to Schatt, Doukakis, Bessieux-Ollier & Walliser (2016), when

investor generating information from impairment, it is possible that the information is less

reliable as the data involve estimation. It is stated that the accounting information generated

by the guidance of IFRS will be more reliable and decision-making useful. According Jiao,

Koning, Mertens, and Roosenboom (2012), the impairment under IFRS is able to provide

more reliable and correct prediction in terms of future OCF, and also provide more reliable

information for financial statement. Additionally, the quality of prediction will enhance the

confidence of potential investor and debtor on such accounting information. Florou and Pope

(2012) used data from 10,852 companies in 45 countries between 2003 and 2006 and found

that institutional investors would increase their investment in companies using IFRS as they

consider the prediction of impairment could provide them more valuable financial

information. From the investment direction and investment style of these institutional

investors, they are more likely to benefit from high-quality financial statements, such quality

is more likely to result from the guidance of IFRS. At the same time, institutional investors'

holdings are strong in law enforcement, local accounting standards, and IFRS content.

Countries with larger differences are more significant and concentrated.

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Therefore, this research has successfully in terms of suggesting the predicting value of

impairment under IFRS and US GAAP to potential.

In terms of the regulator, especially for those who stand for the IFRS. The converging of US

GAAP and IFRS is a hot topic, though it is facing lots of difficulties. Suggested by Jiao et al.

(2012), IFRS present the better the comparability of IFRS is superior to US GAAP,

especially, when there is high enforcement. As stated in the research article, the level of

enforcement will affect the LLA will present advanced quality in terms of predicting future

OCF. Therefore, for those who stand for the converging of US GAAP and IFRS, this research

will provide them with more detail information to elaborate the importance of such converge.

However, the research development of the paper lacks the elaboration of the root of the

difference between IFRS and US GAAP. Stated by Kasztelnik (2015), when comes to the

understanding and comparing of US GAAP and IFRS, there should be an understanding of

the philosophy difference between them. As the matter of fact, the background of the paper

develops based on the difference between the difference between IFRS and US GAAP.

Therefore, in order to make the better understanding for the reader, this research should

mention the philosophy difference between the tow, which, the US GAAP is rule-based and

IFRS is principle-based accounting standard.

(2270 words)

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References

Barth, M., Landsman, W., Lang, M., & Williams, C. (2012). Are IFRS-based and US GAAP-
based accounting amounts comparable. Journal Of Accounting And Economics, 54(1),
68-93.

Ball, R. (2006). International financial reporting standards (IFRS): Pros and cons for investors.
Accounting and Business Research, 5-27.

Barth, M. , W. Landsman and M. Lang. 2008. International Accounting Standards and

Accounting Quality．Journal of Accounting Research，46(3): 467-498.

Capkun, V., Collins, D. W., & Jeanjean, T. 2012. Does adoption of IAS/IFRS deter earnings
management. Google Scholar, SSRN, uiova. edu, accessed, 22(8), 2014.

Dechow, P. 1994. Accounting earnings and cash flows as measures of firm

performance. Journal Of Accounting And Economics, 18(1), 3-42.

Francis, J., J. Hanna, and L. Vincent. 1996. Causes and effects of discretionary asset write-offs.
Journal of Accounting Research 34 (Supplement): 117–135.

Florou, A., and P. Pope. 2012. Mandatory IFRS Adoption and Institutional Investment
Decisions. Accounting Review Forthcomming

Jiao, T., Koning, M., Mertens, G., & Roosenboom, P. 2012. Mandatory IFRS adoption and
its impact on analysts' forecasts. International Review of Financial Analysis, 21, 56-63.

Kasztelnik, K. 2015. The Impairment of Long-Lived Assets and Reversing Revaluation

Review under US GAAP VS. IFRS Models in the United States. Accounting and Finance
Research, 4(3).

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Schatt, A., Doukakis, L., Bessieux-Ollier, C., & Walliser, E. (2016). Do Goodwill
Impairments by European Firms Provide Useful Information to Investors. Accounting In
Europe, 13(3), 307-327.

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Appendix

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