SFAS NO. 121 AND IMPAIRMENT OF ASSETS: THE NEED FOR PROFESSIONAL JUDGMENT

By Paul Munter

[Editor's Note: A feature article in this month's issue, "Accounting for Impairment of Long-Lived Assets" explains the basics of FASB's new accounting standard. This article complements that article by discussing some of the critical judgment areas in applying the statement.]

For assets that continue to be used in operations, SFAS No. 121 proposes a two-stage approach to recognizing impairment losses. When events or changes in circumstances indicate the carrying value of an asset may not be recoverable, the entity needs to make an impairment evaluation on those assets. The impairment evaluation would be made by making an estimate of the future cash flows projected from the use of the asset(s), including ultimate disposal, and, if the total expected future cash flows (undiscounted and without interest) are less than the current carrying value of the asset, an impairment loss would be recognized if the fair value of the asset is below the current carrying value of the asset.

This approach requires several key determinations to comply with the provisions of SFAS No. 121, including‹

* what events or circumstances should trigger an impairment evaluation?

* if warranted by the events or circumstances, what level of aggregation is needed to project the future cash flows?

* how should the future cash flows be projected and for how long a period?

* if impairment is indicated by the cash flows projection (stage one), how should fair value be determined?

Events or Circumstances

SFAS No. 121 does not attempt to provide an exhaustive list of the events or circumstances that would prompt an entity to make an impairment evaluation. In paragraph 5 of SFAS No. 121, however, the following examples are provided:

* A significant decrease in the market value of an asset;

* A significant change in the extent or manner in which an asset is used or a significant physical change in an asset;

* A significant adverse change in legal factors or in the business climate that affects the value of an asset or an adverse action or assessment by a regulator;

* An accumulation of costs significantly in excess of the amount originally expected to acquire or construct an asset; and

* Current period operating or cash flow loss combined with a history of operating or cash flow losses or a projection or forecast that demonstrates continuing losses associated with an asset.

Additionally, the FASB cites an AICPA Issues Paper entitled Accounting for the Inability to Fully Recover the Carrying Amounts of Long-Lived Assets that provides the following (very similar) examples, including the following:

* Reduction in the extent to which a plant is used,

* Dramatic change in the manner in which an asset is used,

* Substantial drop in the market value of an asset,

* Change in law or environment,

* Forecast showing lack of long-term profitability, or

* Costs in excess of amount originally expected to acquire or construct an asset.

While these examples provide a useful starting point, they still leave management with a great deal of responsibility for implementation. As a general rule, it can be argued that as management monitors its ongoing operations, it should be continually on the alert for new business opportunities and to respond to changes in external conditions (such as competitive pressures, governmental regulation, legal issues, foreign exchange risks, interest rate risk, supplier concentration risk, major customer risk, etc.). It can be argued that SFAS No. 121 also calls upon management in monitoring its operations to be aware of problems on the horizon that may lead to an impairment evaluation.

An important point to understand is that the existence of an "event or circumstance" does not automatically mean an impairment loss will be recognized on assets held for use in operations. It does mean, however, that the entity must undertake a formal impairment evaluation in accordance with SFAS No. 121.

What Level of Aggregation Is Needed?

In accordance with SFAS No. 121, once indicated by the events or circumstances, the entity should estimate the future cash flows for the long-lived asset(s) as the first stage of the recognition process. Paragraph 8 of SFAS No. 121 provides the following guidance to the level of aggregation needed for making the cash flow projections:

In estimating the future cash flows...assets shall be grouped at the lowest level for which there are identifiable cash flows that are largely independent of the cash flows of other groups of assets.

In many instances this approach to aggregation may be quite similar to the business segment level used for reporting discontinued operations. While the approach is similar, it is important to note there is not necessarily a direct one-to-one correspondence between the two. SFAS No. 121 is only applicable when the discontinued operations treatment is not applicable.

Another important point associated with the aggregation issue is that the size and sophistication of the entity will have a bearing on the level of aggregation that can be used. An entity that is large, diversified, and decentralized will likely be able to aggregate at a lower level than an entity without those characteristics. Furthermore, as we deal with smaller and smaller entities, it becomes more likely they will have only one level of operations. Consider, for example, a small business that operates in one industry and within one marketplace. Thus, small businesses may be required to make estimates for the entire organization as the basis for the impairment evaluation.

In that situation, SFAS No. 121 specifies that if the asset is expected to provide service potential, the same two-staged approach should be used. If, however, the asset is not expected to provide service potential, the provisions applicable to assets held for disposal should be used.

Other Pragmatic Questions Associated with Estimating Future Cash Flows

Once the level of aggregation is determined, future net cash flows (undiscounted and without interest) must then be estimated. Paragraph 9 of SFAS No. 121 provides general guidance on this matter:

Estimates of expected future cash flows shall be the best estimate based on reasonable and supportable assumptions and projections. All available evidence should be considered in developing estimates of expected future cash flows. The weight given to the evidence should be commensurate with the extent to which the evidence can be verified objectively. If a range is estimated for either the amount or timing of possible cash flows, the likelihood of possible outcomes shall be considered in determining the best estimate of expected future cash flows.

In evaluating the reasonableness of estimates, two existing professional standards provide guidance to management as it makes the estimate and the accountant or auditor as he or she evaluates the reasonableness of the estimates. The pertinent documents are the applicable sections of SSAE No. 1 on forecasts and projections and the accompanying AICPA guide and SAS No. 57, Auditing Accounting Estimates.

Another important question to address is for how long a future period do the estimated cash flow projections need to be made? Unfortunately, that question is not specifically addressed in SFAS No. 121. The theoretical answer, of course, is for the length of time the entity expects to use the asset. The major problem with this answer is that, in reality, an entity will be aggregating assets with differing remaining useful lives. Thus, if the company uses a time horizon longer than the remaining life of some assets, it will have to include an assumption of disposal and reinvestment in similar assets in constructing the net cash flow projections.

Measuring Fair Value

As was noted earlier, if, based on stage one, an impairment loss is indicated, it is recognized as the excess of the carrying value of the asset over the fair value of the asset. SFAS No. 121 indicates fair value can be determined based on the market value of the asset if an active market exists. Failing that, the entity should look to the selling prices of similar assets and apply available valuation techniques. Examples of possible valuation approaches are present value of estimated future net cash flows discounted at a rate commensurate with the risks involved, option-pricing models, matrix pricing, option-adjusted spread models, and fundamental analysis.

Another complicating factor is that since some level of aggregation is needed, the fair value amount (regardless of how it was determined) applies to several assets. These assets may be either identifiable or unidentifiable (goodwill) assets.

As explained in this month's feature article on SFAS No. 121, goodwill arising in a business combination treated as a purchase must be allocated to the assets being measured for impairment. The goodwill amount will be eliminated first before the carrying value of any of the individually identifiable assets (whether tangible or intangible) is reduced for an impairment.

Assets to Be Disposed of

The final question to address is the treatment of the disposal of long-lived assets that does not constitute discontinued operations. Paragraph 15 of SFAS No. 121 directs that once management with appropriate authority commits to a disposal plan for these assets, they are to be reported at the lower of carrying amount or fair value less costs to sell. Notice an important distinction between the net realizable value approach used for discontinued operations versus that employed here. The net realizable measure of Opinion No. 30 does not consider the time value of money. Under SFAS No. 121, if the fair value of an asset is measured by discounting future cash flows and if the sale is expected to occur beyond one year, the costs to sell also should be discounted.

Consider the following situation: The entity has a plan of disposal that meets the conditions for discontinued operations treatment, except that the disposal plan contemplates continuing operations for three years before the disposal. It is likely this disposal would not qualify for discontinued operations treatment (unless there were some clearly identifiable, extenuating circumstances relative to the extended disposal period). Therefore, not only would any writedowns be included in continuing operations, but the entity also would have to consider discounting in determining the fair value less costs to sell because the disposal is expected to extend beyond one year.

One final note is that, unlike impairment losses recognized for assets held for use (once recognized, the amounts are not recoverable in the financial statements), for assets held for sale, recovery of impairment losses can be recognized (not to exceed the total impairment loss). Additionally, for assets held for sale, the entity will not record depreciation or amortization.

Specialized Industry Issues and Exemptions from Requirements

While the provisions of SFAS No. 121 apply to long-lived assets, identifiable intangibles, and goodwill related to those assets, certain items are exempted from the provisions of SFAS No. 121. SFAS No. 121 does not apply to the following:

* Financial instruments,

* Long-term customer relationships
of financial institutions (such as core deposit intangibles and credit cardholder intangibles),

* Mortgage and other servicing rights,

* Deferred policy acquisition costs, and

* Deferred tax assets.

In addition to those exempted items, certain assets covered by standards applicable to specialized industries are exempted. Thus, SFAS No. 121 does not apply to assets where the accounting is prescribed by the following standards:

* SFAS No. 50, Financial Reporting in the Record and Music Industry

* SFAS No. 53, Financial Reporting by Producers and Distributors of Motion Picture Films

* SFAS No. 63, Financial Reporting by Broadcasters

* SFAS No. 86, Accounting for the Costs of Computer Software to Be Sold, Leased, or Otherwise Marketed

* SFAS No. 90, Regulated Enterprises‹Accounting for Abandonments and Disallowances of Plant Costs.

An industry issue debated by the FASB during the deliberations on this matter was the appropriate accounting in the real estate industry. SFAS No. 66, Accounting for Sales of Real Estate, specifies the appropriate profit recognition method to use in accounting for sales of real estate. SFAS No. 67, Accounting for Costs and Initial Rental Operations of Real Estate Projects, provides the accounting provisions for rental operations of real estate. SFAS No. 121 amends these two documents as follows:

* A real estate project that is substantially complete and ready for use is to be accounted for at the lower of carrying amount or fair value less costs to sell (rather than net realizable value).

* For real estate held for development and sale, including both property currently under development and that held for future development, the provisions applicable to assets held for use would be applied to determine whether an impairment loss should be recognized. In grouping these assets, the individual project level should be used.

It should be noted that in addition to amending a number of APB opinions and FASB statements, SFAS No. 121 supersedes the last question and its interpretation of AICPA Accounting Interpretation 1, Illustration of the Application of APB Opinion No. 30, relating to the disposal of a portion of a segment. *

Paul Munter, PhD, CPA, is KPMG Professor of Accounting at the University of Miami.

Editor:
Douglas R. Carmichael, PhD, CPA
Baruch College

OCTOBER 1995 / THE CPA JOURNAL