The CFA text says that an impairment loss will not affect cash flows. I do not see it explain this point further. Earnings are reduced, so why are taxes not reduced and therefore operating cash flow increased?
When looking at accelerated depreciation vs. straight line, I believe CFO would be increased if switching to accelerated so I am just not understanding why an impairment loss would not also increase CFO.
An impairment loss is a non-cash event (like depreciation or a gain on the sale of an asset). Yes, it’s reported in earnings, but each of the those situations are then added/subtracted from Net Income on the Statement of Cash Flows to get to CFO. CFO is ACTUAL CASH, net income is just an accounting measure and isn’t indicative of your cash earnings.
Of this I’m a little less certain - but accelerated and SL depreciation result in the same CFO because cash tax savings are based on the tax depreciation method (which is MACRS for many US firms).
Eveyone seems to be of the same opinion that depreciation doesn’t affect cash flows. If it does not, why do companies use accelerated depreciation for tax purposes? I understand that depreciation itself is a non-cash charge, but higher depreciation leads to lower EBT, which leads to lower taxes. As the company is paying lower taxes, CFO is higher.
Take a look at the answer in the CFA EOC for #2 (P.101). “Switcing to an accelerated depreciation method would increase depreciation expense and decrease income before taxes, taxes payable and net income. Cash flow from operating activities would increase because of the resulting tax savings”.
So I am wondering why impairment loss would not have a similar effect as depreciation (if you agree with me on depreciation).
Ahhh, the problem states that depreciation method is changed for both financial and tax reporting purposes. I originally assumed it just changed from one to the other for financial reporting. In that case, you’re correct regarding your conclusion about the effect on taxes.
Impairments do not reduce taxable income (tax reporting). Thus, cash taxes paid will not be less than if the company had not recorded an impairment loss in the financial statements. Just remember that there will be a disparity between income for tax reporting and financial reporting, all else equal, if there is an impairment.
Ok, so I guess the key (as you say above) is that EBT will be higher for tax reporting purposes, as the impairment charge is included in the financial reporting statements but excluded for tax reporting purposes. Thanks all for the help.