As discussed earlier, most firms value property, plant, and equipment at depreciated historical cost. However, when a fixed asset’s utility drops below its book value, the asset should be written down. The purpose of this principle is to avoid overstating asset values. A fixed asset’s value to a firm can decline for a variety of reasons. Firms in the computer and electronics industry must have state-of-the-art facilities, for instance; the PPE of these firms are particularly susceptible to loss in value due to technological obsolescence. Other facilities can lose value if the firm terminates the production of certain inventory items and the facilities are of little use for other purposes.
To illustrate the accounting for a write-down, consider General Motors Corporation (GM). GM wrote down assets by $6.4 billion in 1997. The analysis of this writedown is:
Most analysts applaud the conservative nature of write-downs; however, their implementation involves significant ambiguities. For example, GAAP requires a write down when the estimated future cash flows from using an asset are less than the asset’s book value.1 Estimating cash flows is a difficult task and involves numerous judgments. Because of this, managers enjoy a great deal of discretion and are accordingly provided with a tool for earnings manipulation. When it is in their best interest, managers can often successfully argue with their auditors to delay a write-down. Alternatively, managers sometimes engage in a big bath, which was discussed in chapter, “The Income Statement.” Recall that a big bath involves recording large charges to income in a single year. Managers do this to relieve future years’ income of these charges and to pave the way for reporting improved financial performance.