When Good Assets go Bad

By Jalal Soroosh and Jack T. Ciesielski

In Brief

Asset Writedowns Increase During Tough Times

Difficult economic conditions should always call into question the values placed on assets in corporate balance sheets. As the going gets tough, managers size up their operations and look for ways to cut costs, including costs related to asset carrying values. Many corporations, auditors, and analysts expect to see a lot of restructuring and writedowns in the near future. SFAS 144, Accounting for the Impairment or Disposal of Long-Lived Assets, revises the accounting for asset writedowns and discontinued operations. Its provisions are effective at the start of 2002 for companies with calendar year-ends.

SFAS 144 supersedes SFAS 121, replaces the accounting and reporting provisions of APB 30, and amends ARB 51 on consolidated financial statements. SFAS 144 retains the SFAS 121 requirements to recognize an impairment loss only if the carrying amount of a long-lived asset is not recoverable from its undiscounted cash flows, and to measure an impairment loss as the difference between the carrying amount and the fair value of the asset. SFAS 144 incorporates the guidance in FASB Concepts Statement 7 with regard to using present value techniques to measure fair value. SFAS 144 cleans up and modernizes SFAS 121 without changing its approach.

SFAS 144 does not apply to goodwill, intangible assets that are not amortized, long-term customer relationships of a financial institution (e.g., core deposit intangibles, credit cardholder intangibles, and servicing assets), financial instruments (including investments in equity securities accounted for under the cost or equity method), deferred policy acquisition costs, deferred tax assets, and unproven oil and gas properties accounted for using the successful-effort method of accounting. SFAS 144 also does not change the provisions established for accounting for long-lived assets in SFAS 44, Accounting for Intangible Assets of Motor Carriers, SFAS 50, Financial Reporting in the Record and Music Industry, and SFAS 63, Financial Reporting by Broadcasters.

Long-Lived Assets to Be Held and Used

SFAS 144 retains the SFAS 121 principles for recognizing and measuring an impairment loss. Indications of asset impairment at the lowest level at which independent cash flows can be identified for specific assets or groups of assets continue to be the focus of SFAS 144. If there are indications of impairment, estimates of fair value (usually future cash flows) are compared to the carrying value of the assets. For the purpose of SFAS 144, impairment exists when the carrying amount of a long-lived asset (or asset group) exceeds its fair value. An impairment loss is recognized only if the carrying amount of a long-lived asset (or asset group) is not recoverable and exceeds its fair value. If the undiscounted cash flows are less than the carrying value, then the asset must be written down to fair value.

In other words, if an asset or asset group cannot produce undiscounted cash flows over its expected service life that exceed its balance sheet carrying value, what purpose is served by presenting the excess as an asset? The historical carrying value is compared to an undiscounted cash flow figure, not one that has been reduced to present value terms. Assets are supposed to produce cash, so they should not be shown as worth more than the cash flows they will produce. The flowchart in Exhibit 1 depicts the three-step process to determine and record an impairment loss.

Three-Step Process

The first step, checking asset impairment, should be applied at the lowest level of cash flows that can be tied to specific assets or asset groups. There is one major change in the new standard: Goodwill is excluded from testing as an integral part of an asset group. Goodwill is now tested for impairments under the methodology in SFAS 142, Accounting for Goodwill and Other Intangible Assets. The only time that goodwill will be part of a long-lived asset test now is when the asset being tested is also a reporting unit.

Impairment indicators as outlined in SFAS 121 can be used to decide whether to test for asset impairment. The Sidebar provides examples of events or changes in circumstance that could indicate a potential impairment.

The second step, recoverability testing, requires determining whether an asset will generate enough cash flow to recover its carrying value. The new standard clarifies many aspects of the cash flow estimation process. Assumptions used in the estimates should incorporate the company’s own plans for using the assets. For completed in-use assets, the cash flow estimates should take into account the remaining useful life of the assets in question and should reflect their existing service potential. Future capital expenditures and related cash returns that could result if the asset is modified to do a different job should not be included. If the assets under evaluation are still in the construction or development stage, then the cash flows should be based on the future service potential of the assets once they are substantially complete. Interest payments capitalized under SFAS 34 must be included in the cash flow estimates.

The third step is to determine the amount of the impairment loss, should there be a need based on the comparison of cash flows to carrying value. The basic process is to find a fair value for the long-lived asset and record a writedown (loss) for the difference between its carrying value and its fair value. The fair value of an asset is the amount at which that asset could be bought or sold in a current transaction (not a forced or liquidation sale) between willing parties. If available, quoted market prices in active markets are the best evidence of fair value. If no fair value is observable, then it must be estimated. Discounted cash flow methods for estimating fair value of assets are acceptable under SFAS 144, as they were under SFAS 121. Because many long-lived assets are unique and without observable markets, discounted cash flow methods are likely to be the norm for valuation.

Under SFAS 144, however, the provisions of Concepts Statement 7 can be incorporated, if applicable, in determining future cash flows for recoverability testing and for determining impairment loss. If alternative courses of action to recover the carrying amount of a long-lived asset (or asset group) are under consideration, or if a range is estimated for possible future cash flows associated with the likely course of action, the likelihood of possible outcomes should be considered.

Example. The following highlights how the provisions of Concepts Statement 7 may be applied. An entity discovers that one of its facilities may be impaired (step one). The carrying value of this facility is $48 million. In order to compute the future cash flows used to test the facility for recoverability and estimate fair value, the entity anticipates that there is a 60% probability that the facility may be sold at the end of two years and a 40% probability that the facility may be used for its remaining estimated useful life of five years. Exhibit 2 shows the range and probability of possible estimated cash flows expected to result from the use and eventual disposition of the facility.

The expected future cash flow is calculated by multiplying the probability-weighted cash flow by the probability of each course of action, as follows:
Sell in—

The undiscounted expected future cash inflows of $46,870,000 do not recover the recorded value of the facility of $48 million. Therefore, an impairment loss has occurred and should be recognized. The typical approach would use the most likely cash flows of either $47 million or $45 million, which have 55% probability of occurrence. If an observable fair value exists for this facility, the impairment loss would be the difference between such value and its recorded value. In the absence of an observable fair value, SFAS 144 permits fair value estimation by either of two present value techniques: traditional or expected present value. Under the traditional approach, a company makes its single best estimate of future cash flows and discounts them back to the present, using an interest rate commensurate with the risks involved in those cash flows. The alternative expected present value method, as the above example demonstrates, requires multiple cash flow scenarios reflecting the risks in realizing the cash flows and the probabilities of each.

Then, the future expected cash flows are discounted, using a risk-free discount rate that forces risks to be articulated in the probability of the cash flow estimates.

For the example outlined above, Exhibit 3 shows the range and probability of possible annual cash flows expected to result from the use and eventual disposition of the facility over its remaining useful life of five years. The total present value of future cash inflow for the first scenario (sell in two years) is $42,895,000, and for the second scenario (sell in five years) is $40,498,000. The overall expected present value for this facility is $41,936,000 ($42,895,000 x 60% + $40,498,000 x 40%). The entity should recognize an impairment loss of $6,064,000 ($48,000,000 – $41,936,000). An impairment loss recognized for a long-lived asset to be held and used is included in income from continuing operations before income taxes in the income statement of a business enterprise, or income from continuing operations in the statement of activities of a not-for-profit organization.

The following disclosures are required in the notes to financial statements that include the period in which an impairment loss is recognized:

To avoid recognition of an impairment loss, managers may be tempted to accept a low-probability scenario as the best estimate of the asset’s expected future cash inflows when it yields a future net cash inflow higher than the asset’s carrying value. Low-probability estimates that eliminate the need for a writedown should be reviewed carefully.

Accounting for Disposal

Long-lived assets may be disposed of by abandonment, exchange for other productive long-lived assets, distribution to shareholders in a spin-off, or sale. SFAS 144 clarifies the accounting for such transactions. For assets to be disposed of in any of the above ways, impairments must be assessed the same way as for assets held for continued use. The following are some issues specifically related to the different means of disposal.

Abandonment. If an asset is abandoned before the end of its useful life, depreciation expense must continue to be recognized through the end of its useful life. A one-time hit for the undepreciated amount at the time of abandonment is not an option. If a company is going to enjoy the utility of the asset, it must record the cost of enjoying that asset through depreciation over the particular time period.

Spin-off or exchange of assets. Assets involved in spin-offs or exchanges are evaluated for impairment while they are in service. While in use, an asset’s depreciable life must reflect its service potential as if it were not to be eliminated. The same principle applies to any service life used in estimating cash flows if testing for recoverability is necessary. When the assets are spun off or exchanged, an additional charge may be recorded if the carrying value exceeds the fair value. Such a charge is not a substitute for impairment testing while the assets are in use.

Sales. SFAS 144 does not require assets to be disposed of in a sale to be accounted for much differently than assets to be retained. Such assets, however, should be presented separately in the statement of financial position. Impairment testing is the same for these assets. They must still be carried by the firm at the lower of recorded value or fair value adjusted for the costs to sell. “Costs to sell” encompass items such as broker commissions, legal and title transfer fees, and closing costs; they do not include expected future losses associated with the operations of the assets while it is classified as held for sale.

An asset to be sold will be initially classified as held for sale under SFAS 144 in the period when all of these criteria are met:

The provision that will probably have the most profound effect on firms will be the one-year limit. Publicly traded firms may find themselves talking to the SEC if they classify items as discontinued but do not find a buyer within the one-year time frame.

Accounting for Discontinued Operations

The changes wrought by SFAS 144 in the area of accounting for discontinued operations could have economic consequences. Prior to its issuance, guidance on reporting discontinued operation was provided by APB 30, Reporting the Results of Operations: Reporting the Effects of Disposal of a Segment of a Business, and Extraordinary, Unusual and Infrequently Occurring Events and Transactions. APB 30 defined a segment of a business as a “component of an entity whose activities represent a separate major line of business or class of customers.” The assets, results of operations, and activities of a segment must be clearly distinguishable—physically and operationally—from other assets, results of operations, and activities of the company in order to qualify for discontinued operations treatment. In short, a company would have to be disposing of almost an entire segment in order to provide a separate display for discontinued operations. APB 30 required that the results of operations of a segment to be disposed of be reported in discontinued operations, separately from continuing operations.

SFAS 144 changes the provisions of APB 30 in the following three areas: scope, income statement presentation, and balance sheet presentation.

Scope. SFAS 144 significantly relaxes the criteria for treating an item as a discontinued operation. Under SFAS 144, a component of an entity consists of operations and cash flows that can be clearly distinguished, operationally and financially, from the rest of the entity. It can be an operating segment, a reporting unit, a subsidiary, or just a group of assets for which identifiable cash flows are independent of other assets. This will greatly expand the possibilities for firms in deciding which operations to keep and which to dispose of.

Once a firm has decided which component will be on the block, the results of operations of that component will be reported in discontinued operations if both of the following conditions are met:

Example. Consider a manufacturer of consumer products with several product groups with different product lines and brands. Each product group is the lowest level at which operations and cash flows can be clearly distinguished operationally and financially, making each product group a component.

The company experiences losses in certain brands in the beauty care products group, and decides to sell the product group as a unit, including its operations. Management classifies the product group as held for sale at that time. If the operations and cash flows of the product group will be eliminated from the rest of the entity after the sale, and the firm will have no continuing involvement in the operations after the sale, then discontinued operations treatment will be allowed.

The company might instead decide to remain in the beauty care business but discontinue the money-losing brands. Those brands are part of the larger product group and do not represent a separate component of the entity. No discontinued operations treatment is allowed.

Income statement presentation. The results of discontinued operations may be reported in the income statement of a business enterprise as follows:

A gain or loss on the disposal of discontinued operations must be either recognized on the income statement or disclosed in the notes. The biggest change from current practice is that the discontinued operations amount will no longer include the operating losses expected through the date of disposal. Such losses will be reported in discontinued operations in the period in which they occur.

Balance sheet presentation. Under APB 30, the assets and liabilities of a segment accounted for as a discontinued operation may be offset and reported in the statement of financial position as “net.” This netting is no longer permitted under SFAS 144. Rather, the assets and liabilities of a disposal group classified as held for sale must be presented separately on the balance sheet. Exhibit 4 summarizes the differences between APB 30 and SFAS 144 with regard to accounting for discontinued operations.

Economic Consequences of SFAS 144

By relaxing the criteria for classifying a component for discontinued operation treatment, SFAS 144 will provide an opportunity for management to dispose of less productive and profitable assets and focus on their best businesses. After the merger mania of the 1990s, now may be time to clean up the balance sheet. Disposition of unwanted (unproductive) assets is made easier by SFAS 141, Accounting for Business Combinations, which eliminated the pooling of interest method and the two-year waiting period for parties in mergers and acquisitions to sell assets acquired in a business combination.

Furthermore, as companies evaluate their assets for impairments in the current economic environment, they may consider putting certain assets up for sale and discontinued-operations treatment. Once SFAS 144 becomes effective, many companies may relegate weak components into the held-for-sale and discontinued-operations categories. It is also likely that investment bankers will encourage their clientele to make cuts in marginal operations to generate more sales activity.

Under SFAS 144, smaller companies might be able to purchase operations that were unavailable to them in the past. Since the discontinued-operation provision can now be applied to the smaller parts (sub-level) of assets, the sellers (large companies) should be willing to dispose of such assets. This trade-off may provide an opportunity for a more productive use of unwanted assets, an economic benefit to all.