Refer to Theory in Practice 7.1 reInco Ltd., discussing the failure of Inco to recognize impairment of its Voisey's Bay nickel mine prior to 2002. Current accounting standards in Canada require an impairment writedown if the book value of a cash -generating unit exceeds the higher of its value in use or net fair value. However, the events described in Theory in Practice 7.1 took place before Canada's 2011 adoption of IASB standards. During that time, Canadian and U.S. standards were similar, and impairment was not recognized if undiscounted expected cash flows exceeded book value.

Required

a. Based on standards in place at the time, should lnco have recognized an impairment loss before its eventual recognition in 2002? Should it have recognized a loss earlier than 2002 under current IASB standards? Explain.

b. Assume that both the market for nickel and the stock market work well, and suppose that lnco management expected that nickel prices would increase. Under current IFRS standards, would management have been justified in delaying an impairment writedown? In your answer, consider the theory of Samuelson (Section 7.2.2).

c. Suppose that management behaved as predicted by prospect theory (Section 6.2.2). Explain how this theory is consistent with lnco management avoiding the prospect of recognizing an impairment loss.

Theory in Practice 7.1

Hilton and O'Brien (2009) report on an unusual case of an impaired asset, held for use by the company, with a separate market value.

In 1996, lnco, Ltd., a Canadian nickel-mining company, purchased mining rights to a nickel deposit in Voisey's Bay (VB), Labrador. Part of the acquisition payment involved issuing a tracking stock, traded on the Toronto and New York Stock Exchanges, tied to the value of the VB mine. This gave a market valuation for the mine, separate from the rest of lnco.

Soon after the VB acquisition, nickel prices fell dramatically, and the market prices of both Inca's common stock and the VB shares fell commensurately. Despite this and other indicators of impairment, Inco management chose not to write down the asset for several years. I nco retired the tracking stock in December 2000 at 25 percent of its initial value, further confirming the impairment, but nonetheless continued to carry the asset unimpaired in its financial statements. Finally, in 2002, lnco recognized the impairment and wrote off $1.5 billion, which was 44 percent of the mine's pre-writedown book value.

Both U.S. and Canadian GAAP at the time used undiscounted cash flows as the criterion for impairment. Hilton and O'Brien estimated the undiscounted net future cash flows of the VB asset at various dates from 1996 through 2002. Figure 7.2 compares their estimate of undiscounted cash flow to the book value of the mine, and to the market value based on the VB shares. Notice that, for as long as the tracking stock was outstanding, it indicated that fair value was below Inca's book value for the asset. The more generous criterion of und is counted cash flow also indicated impairment for most of 1998-2002. The undiscounted cash flow estimates are volatile due to dramatic changes in the commodity price for the mine's major product, nickel. Except for a brief period around the end of 2000, however, undiscounted cash flow is below book value, indicating impairment under GAAP.

Hilton and O'Brien explore a variety of possible reasons for management to delay the write-down, such as fear of violating debt covenants, or of losing bonus compensation. Ultimately, they conclude that management's reluctance to admit that it had overpaid, combined with inattention by auditors and regulators, al lowed the impairment to remain unrecorded for several years. The authors note that the tracking stock gives a relatively reliable fair value for the asset for the four years it was outstanding, a highly unusual circumstance for an asset held for use. This reliable fair value did not appear to discipline the management's financial reporting, however.