One of the less glamorous and often overlooked aspects of management’s responsibility is considering the impairment of long-lived assets. That can be for capital assets such as buildings, furniture, and fixtures, or intangible assets such as naming rights, non-compete agreements, or goodwill. During normal or optimal operating conditions, this topic does not come up often. However, there are certain events that occur, for example a global pandemic, that stop us in our tracks and remind us to dust off our intermediate accounting books and revisit these rules and responsibilities when it comes to the testing for a possible asset impairment. Often times, the auditor is the first one to raise the question as to whether an asset impairment should be recorded. It is important to remember that management is responsible for documenting their assessment of whether or not impairment has incurred, and if it has, recording the appropriate loss to reflect that impairment in an entity’s financial records. The COVID-19 pandemic that is currently affecting most, if not all, industries in some way would largely be considered a triggering event, causing some documentation surrounding asset impairment. Let’s take a few moments for a quick refresher.
In any accounting period, it is necessary to consider whether events or changes in circumstances have occurred that indicate an asset or asset group’s carrying value may not be recoverable. Often times these events or changes in circumstances are referred to as “triggering events” because they trigger the start of the two-step impairment test. Accounting Standards Codification (ASC) paragraph 360-10-35-21 includes examples of triggering events such as: a significant decrease in the assets market price, significant adverse change in the asset’s use or its physical condition, significant adverse change in legal factors or business climate, including an adverse action or assessment by regulator, costs to acquire an asset that significantly exceed original expectations, current-period operations or cash flow loss combined with a history of operations or cash flow losses or a projection or forecast showing continual losses associated with an asset, or a current expectation that is more likely than not (greater than 50% likelihood) that a long-lived asset will be sold or disposed of significantly before the end of its previously estimated useful life. It is important to note that a triggering event can be a significant event occurring at a specific point in time. It could also be the result of a more prolonged period of several seemingly insignificant events that when viewed in aggregate reveals a change, more significant than the individual changes occurring over that period of time. If a triggering event is identified, management must move to step one of the previously mentioned tests for asset impairment.
Step one of the asset impairment test, performed from an insider’s perspective, is a test of the recoverability of the carrying value of the asset or asset group that has been affected by the triggering event. This is done by estimating the undiscounted future cash flows (incoming cash flows offset by outflows for related liabilities) over the existing service potential of the asset or asset group, and comparing that to the value recorded in your accounting records as of the date of the test. There are several methods for determining what the existing service potential is, including the remaining useful life, ability to produce cash flow, or ability to produce useful output. An example would be building A used to conduct programmatic functions of a large organization. If the organization is able to consolidate all of the programmatic operations from building A to building B due to an increase in the number of building B employees working from home on a permanent basis, the undiscounted future cash flows from building A could decline significantly to the point that it is below the current carrying value. If that is the case, the organization would move on to step two of the impairment test.
The current economic state of affairs does not guarantee that an organization doing this analysis will conclude failure of the recoverability test. There has been a significant amount of government relief and other stimulus funding that, when included in the analysis of future cash flows, may result in the conclusion that the carrying value is recoverable. However, to carry out management’s fiduciary duty to the organization, documentation of the triggering event and step one of the test is required.
Step two, performed from the perspective of the market, involves comparing the carrying value of the asset or asset group to its fair market value. Determining fair market value sounds like a daunting task, and often requires the use of a valuation expert. For example, in the case of a building, a realtor or appraiser may be engaged to do a market study of the building. In other cases, a suitable present value technique may be used in determining the current fair value. Once a fair market value has been determined, if the carrying value is less than the fair market value, there is no impairment loss to record, and documentation of that fact completes this step of the test. If the carrying value exceeds the fair market value of the asset or asset group, an impairment loss should be recorded based on the calculated difference. Materiality can be a consideration about whether a loss must be recorded and should be documented. In the case that it is an asset group being evaluated, the loss should be distributed pro-rata to all of the assets in the group provided that each asset’s share does not cause the asset’s carrying value to go negative. If a loss is recorded, recalculation of depreciation expense should be performed for current and future periods, reflecting the new carrying value of the asset or asset group.
The recording of an impairment loss triggers some additional disclosure requirements for entities preparing financial statements in accordance with Generally Accepted Accounting Principles (GAAP). These can be found in ASC Section 360-10-50 and include a description of the impaired long-lived asset and the facts and circumstances leading to the impairment, the amount of the impairment loss, and the caption in the statement of activities that includes the loss (if not separately presented), and the method for determining fair value.
The documentation prepared as part of the aforementioned process should be included in the items provided to your auditor as part of their information request, so the assumptions and methods used in the analysis can be evaluated for reasonableness. This documentation should also be maintained as part of your financial records for the period, as a reference for the next time asset impairment comes into question.
The information and advice we are providing for this matter relates to COVID-19 legislative relief measures. Because legislative efforts are still ongoing, we expect that there may be additional guidance and clarification from regulators that could modify some of the advice and information provided to you, after the conclusion of our engagement. We, therefore, make no warranties, expressed or implied, on the services provided hereunder.