Accounting for the Impairment of Long-Lived Assets

By Anthony Cocco and Tommy Moores

SFAS No. 121 sets new standards for recognition and measurement of impaired assets as well as assets an entity intends to dispose of. Entities no longer can ignore possible losses and will have to use cash flow projections when a problem arises.

Accounting principles have long prescribed the need to recognize decreases in market values on selected assets that have a readily determinable market value. For example, ARB No. 43, the grandfather of accounting principles, requires a write-down of inventory value when "the utility of the goods is no longer as great as its costs." Prior to being superseded, SFAS No. 12 required that entities report certain marketable equity securities at the lower of aggregate cost or market value. Additionally, SFAS No. 15 required the creditor to recognize a loss on a troubled debt restructuring when the total future cash receipts were less than the recorded investment in the receivable; subsequently, SFAS No. 114 changed the total future cash receipts requirement to the present value of expected future cash flows discounted at the loans' effective interest rate. However, not until November 1988 did the FASB add a project to its agenda to address accounting for the impairment of long-lived assets and identifiable intangibles. The goal of the project was to narrow the diverse practices for the recognition and measurement of impaired assets. Previously the AICPA Accounting Standards Executive Committee and the FASB Emerging Issues Task Force, among others, had addressed the issue, but no authoritative pronouncements had been issued.

At the culmination of its six-year project, the FASB issued SFAS No. 121, Accounting for the Impairment of Long-Lived Assets and for Long-Lived Assets to Be Disposed of, in March 1995. This SFAS is the first authoritative pronouncement exclusively devoted to the issue of impairment in the value of long-term tangible and intangible assets and related goodwill.

Scope

SFAS No. 121 applies to all entities including regulatory and not-for-profit organizations. The standard applies to long-lived assets, identifiable intangibles, and goodwill related to those assets. This includes regulatory assets (assets that nonregulated entities would expense as incurred). The statement does not apply to financial instruments, core deposit intangibles of financial institutions, deferred tax assets, equity investments, or mortgage servicing rights. Assets whose accounting is prescribed by standards covering certain specialized industries are also not included. Nor does it apply to assets being disposed of as part of discontinued operations in accordance with APB No. 30, Reporting the Results of Operations. According to APB No. 30, the entity must report these assets at the lower of cost or net realizable value.

Under SFAS No. 121, an entity has different accounting treatments for assets it intends to hold and use and those assets it intends to dispose of.

When and How to Test for Impairment

The FASB concluded that management has the responsibility to consider whether an asset is impaired but to test each asset each period would be cost prohibitive. Consequently, SFAS No. 121 requires assets be tested for impairment only when certain indicators exist. The principal evidence available to management in determining whether an impairment exists is the information and analysis developed for management's review of the entity and its operations.

The FASB defines impairment as the inability to recover fully the carrying amount of an asset over its estimated useful life. In other words, an asset is considered impaired when its carrying value, which will generally be cost less accumulated depreciation (amortization), exceeds the sum of the expected future net cash flows the asset is expected to generate.

Assets Held for Use in The Business

Because of the inherent uncertainty involved in forecasting future cash flows, the FASB decided to establish a relatively high threshold for an entity to declare a long-lived asset is impaired. Therefore, in testing for an impairment loss, future cash flows are not discounted; in essence, the entity implicitly assumes a zero-percent interest rate.

Once management determines an asset is impaired, the impairment loss is measured as the amount by which the carrying value of the asset exceeds the asset's fair value. If an active market exists either for that asset or for similar assets, management may consider that market value as the fair value. If a market price is unavailable, however, the fair value may be estimated using the best available information. For example, management may use the present value of the forecasted future cash flows the asset is expected to generate, using a discount rate commensurate with the risk involved. SFAS No. 121 defines this discount rate as the expected rate of return for investments with similar risk characteristics. The impairment loss is reported as a component of income from continuing operations before income taxes. Exhibit 1 shows the calculation of the impairment loss.

After recognizing the impairment, the reduced carrying value of the asset becomes the asset's new cost. If the asset is a depreciable asset, the new cost is depreciated over the asset's remaining useful life. The standard prohibits the recovery of previously recognized impairment losses for assets held for use in the business.

A unique result of the different methods used to determine if there is a loss and to measure the amount of the loss is the possibility that an asset with a carrying value in excess of fair value may not be written down to fair value. Using the information from Exhibit 1, if the expected future cash flows are increased to $60,000 per year the entity would not recognize an impairment loss. The sum of the expected future cash flows of $240,000 is greater than the $200,000 carrying value of the asset. Thus, the asset is not considered to be impaired. Applying the 10% discount rate, however, the present value of expected cash flows, or fair value, is $190,200. So, even though the fair value is $9,800 less than the carrying value, an impairment loss is not recognized because the sum of the expected future cash flows exceeds the carrying value of the asset.

Accounting for Related Goodwill

If the entity has acquired assets in a business combination in which the purchase accounting method was used, the goodwill associated with the asset must be considered in the impairment test. Specifically, the related goodwill is added to the carrying value of the asset(s), and that total is compared to the undiscounted sum of future cash flows to determine if there is an impairment loss. If some, but not all, of the assets acquired in the purchase transaction are being tested, goodwill is apportioned to the assets on a pro rata basis using the relative fair value of the net assets acquired at the acquisition date, unless there is evidence to suggest some other method of allocation is more appropriate. If a loss is determined, the carrying amount of the associated goodwill is written off before the assets are written down to fair value. Exhibit 2 shows the calculation and recognition of an impairment loss involving goodwill.

A little different situation arises if the carrying value of the goodwill is more than the impairment loss. In this situation the goodwill is reduced by the amount of the impairment loss and the carrying value of the asset is not affected. Exhibit 3 uses the information from Exhibit 2, except the appropriate interest rate is 6%.

Assets to Be Disposed of

If, instead of intending to use the asset in the business, management has committed to dispose of the asset, the accounting treatment differs. As previously mentioned, APB No. 30 requires measurement of certain assets to be disposed of at the lower of cost or net realizable value. Specifically, those assets included in the disposal of a business segment as defined in APB No. 30, paragraph 13 are not within the scope of SFAS No. 121. All other assets to be disposed of, for which management has committed to a plan of disposal, whether by sale or abandonment, shall be reported at the lower of carrying value or fair value less estimated disposal costs. The fair value of the assets is determined in the same manner as for assets to be held and used. If the cost incurred in selling the asset is expected to be incurred beyond one year, the cost must be discounted. In this instance, the recovery of carrying value in not a factor in determining if an impairment loss has been incurred. The accounting for assets to be disposed of is presented in Exhibit 4.

Note in Exhibit 4 that the sum of the future cash flows ($240,000) exceeds the carrying value of the asset ($200,000). This does not matter because the impairment test does not apply to assets to be disposed of. Simply compare the fair value less disposal costs to the carrying value of the asset and use the lower amount as the cost basis.

Assets to be disposed of are not depreciated during the period they are held. Because the assets will be recovered through sales rather than through operations, accounting for these assets is a process of valuation rather than allocation. The asset should be revalued at the lower of cost or fair value less disposal cost each period. If the fair value less disposal cost increases in future periods, a gain will be recognized for the recovery. The asset, however, can only be written up to the carrying value in effect at the time the decision was made to dispose of the asset ($200,000 in Exhibit 4). For instance, if fair value increased to $230,000 in the future, the asset's carrying value would be restored to $200,000 and a recovery gain of $5,000 would be recognized.

Disclosures and Transition

The impairment loss (or gain, for assets to be disposed of), regardless of whether it is from assets to be held and used (including goodwill) or assets to be disposed of, is reported as a component of income from continuing operations before income taxes. The note disclosures that must accompany the recognition of an impairment loss are presented in Exhibit 5.

The initial application of SFAS No. 121 to assets held for disposal at the date of adoption should be reported as the cumulative effect of a change in accounting principles in accordance with APB Opinion No. 20, Accounting Changes. The standard is effective for financial statements issued for fiscal years beginning after December 15, 1995. Earlier adoption is encouraged; however, previously issued financial statements may not be restated. *

Anthony Cocco, PhD, is an assistant professor of accounting and Tommy Moores, PhD, CPA, an associate professor of accounting, both at the University of Nevada, Las Vegas.

The authors gratefully acknowledge the support of the F.I.B. Institute for Business Leadership.

OCTOBER 1995 / THE CPA JOURNAL

At December 31, 19x1, an entity has an asset with a cost of $250,000 and accumulated depreciation of $50,000. Management estimates that the asset will generate cash flows of $40,000 per year over the next four years, a total of $160,000. Therefore, because the carrying value of $200,000 is greater than the expected future cash receipts of $160,000, the asset is impaired.

Next, management must calculate the amount of the impairment loss. The loss is not the $40,000 difference between carrying value and the sum of the expected future cash flows used to determine that a loss existed. Instead, if no market price is available for the asset or for similar assets, the expected future cash flows need to be discounted. If management determines the appropriate discount rate is 10%, the present value of the expected future cash flows is $126,800. The amount of the loss is computed as follows:

Carrying value $200,000

Fair value 126,800

Impairment loss $73,200

Management would record the loss as follows:

Impairment loss 73,200

Asset (73,200)

Thus, the carrying value of the asset is now $126,800. This adjusted carrying value is depreciated over the remaining four-year life of the asset.

Equipment $150,000

Building 275,000

Identifiable intangibles 75,000

$500,000

The acquisition resulted in the recognition of $120,000 in goodwill.

At December 31, 19x1, when the carrying value of the equipment and goodwill is $125,000 and $100,000, respectively, management decides to test the plant equipment for impairment. Before testing for impairment, management must allocate $30,000 of the goodwill to the equipment [($150,000/$500,000) x $100,000], thereby increasing the carrying value of the equipment to $155,000.

If the expected future cash flows are $37,500 per year for each of the next four years, there is an impairment because the carrying value of the equipment plus the allocated goodwill ($155,000) is more than the sum of the expected future cash flows ($150,000).

If management determines the appropriate discount rate is 10%, the present value of the expected future cash flows is $118,870. The amount of the loss is computed as follows:

Adjusted carrying value $155,000

Fair value 118,870

Impairment loss $36,130

Management would record the loss as follows:

Impairment loss 36,130

Goodwill (30,000)

Equipment (6,130)

The carrying value of the asset is now $118,870. This amount is depreciated over the remaining four-year life of the asset. The remaining goodwill of $70,000 continues to be amortized over its remaining useful life.

Using a revised discount rate of six percent, the present value of the expected future cash flows is $129,940. Recall that the adjusted carrying value of the equipment is $155,000. The amount of the loss is computed as follows:

Adjusted carrying value $155,000

Fair value 129,940

Impairment loss $25,060

Management would record the loss as follows:

Impairment loss 25,060

Goodwill (25,060)

The carrying value of the equipment is not affected by the recognition of the loss. However, the recognition of the impairment loss reduces the carrying value of the goodwill to $74,940 which continues to be amortized over the remaining life of the goodwill.

26OCTOBER 1995 / THE CPA JOURNAL

As of December 31, 19x1, management has agreed to a plan to dispose of some used machinery. The machinery cost $500,000 and has a carrying value of $200,000. The sum of the expected future cash flows is $240,000. The price of similar equipment that normally sells for $205,000, is used to determine the fair value. Management estimates the disposal costs to be $10,000.

Management calculates the impairment loss and adjusted carrying value of the machinery as follows:

Carrying value $200,000

Fair value $205,000

Less: Estimated disposal costs 10,000

Adjusted fair value 195,000

Impairment loss $5,000

Management would record the loss as follows:

Impairment loss 5,000

Machinery (5,000)

Thus the equipment's carrying value is reduced to $195,000.

Source: Adapted from SFAS No. 121, paragraphs 14 and 19.

Assets to Be Held and Used:

* A description of the assets impaired and the facts and circumstances leading to the impairment

* The amount of the impairment loss and how fair value was determined

* The caption in the income statement or the statement of activities in which the impairment loss is aggregated if that loss has not been presented as a separate caption or reported parenthetically on the face of the statement

* If applicable, the business segment(s) affected

Assets to Be Disposed of:

For each statement of financial position presented--

* a description of assets to be disposed of, the facts and circumstances leading to the expected disposal, the expected disposal date, and the carrying amount of those assets.

* if applicable, the business segment(s) in which assets to be disposed of are held.

For each period for which a statement of income is presented--

* the loss, if any, resulting from the application of the statement.

* the gain or loss, if any, resulting from the changes in the carrying amount of assets to be disposed of that arise from application of the statement.

* the caption in the income statement or statement of activities in which the gains or losses are aggregated if those gains or losses have not been presented as a separate caption or reported parenthetically on the face of the statement.

* the results of operations for the assets to be disposed of to the extent that those results are included in the entity's results of operations for the period and can be identified.

Source: Adapted from SFAS No. 121, paragraphs 14 and 19.

OCTOBER 1995 / THE CPA JOURNAL