Optimal Impairment Rules

Abstract

We analyze the optimal accounting policy of a financially constrained firm that needs to pledge assets in order to raise debt capital to finance a risky project. The accounting system provides information about the value of the collateral. We show that, absent any accounting regulation, the firm finds it optimal to commit to an accounting system that is conditionally conservative in that it recognizes an impairment loss if the asset value is below a certain threshold, but never reports unrealized gains. We describe the optimal impairment rule and the optimal precision of the accounting information, and we provide comparative statics that lead to testable predictions on the determinants of impairment rules.

Keywords: Conservatism, Impairment, Debt contracting, Asset measurement, Accounting information

JEL Classification: G32, M41, M44, M47