The Effect of Reversibility on a Manager's Decision to Record Asset Impairments

Abstract

Over time, accounting standards have moved towards presenting more items at fair value on the balance sheet. Consistent with this trend, IAS 36 permits an impairment loss on a long-lived asset to be reversed if the economic value of the asset recovers. This paper explores the implication of allowing impairment reversals on a manager’s decision to record the loss. An expected utility model is developed to explore factors that affect his choice of action. The model is then calibrated with empirical data from an experiment conducted with 118 managers. The results suggest that permitting reversals significantly increases the likelihood that a manager will record the impairment, especially if the manager has a bonus plan. The bonus plan effect is not caused by the manager’s intention to smooth income through impairment reversals, but by his disutility from a bonus forgone if the value of the asset recovers but accounting rules prohibit him from reversing the loss. The participants’ demographics played a role in their judgment. Women and professional accountants were less likely to expect managers to truthfully report a loss, and accountants were least convinced that permitting reversals would improve reporting.