Asset Impairment Questions and Answers for Long-Lived Assets

Understanding the concept of asset impairment is crucial for accurate financial reporting. This blog post delves into how companies account for the situation when the book value of their long-lived assets exceeds their recoverable amount, potentially leading to a write-down and the recognition of an impairment loss. We will explore the guidelines under GAAP, specifically Accounting Standards Codification 360, which governs the testing process for these assets, including considerations for depreciation and the determination of market value.

While IFRS has its own standards, this discussion will primarily focus on GAAP and its impact on the income statement and balance sheet. Proper asset valuation is key to avoiding misstatements in financial statements. This article will guide you through identifying and assessing asset impairment, ensuring a clear understanding of this important aspect of financial accounting.

What is asset impairment?

Asset impairment means an asset’s value has decreased due to a decline in its quality, strength, or value. For financial reporting purposes under GAAP, Accounting Standards Codification 360, Property, Plant and Equipment (“ASC 360”) sets forth the testing process for long-lived assets. ASC 360 defines asset impairment as “the condition that exists when the carrying amount of a long-lived asset (asset group) exceeds its fair value.”

We will focus on the impairment of long-lived assets to be held and used in a business. This is in contrast to assets held for sale, which are also covered by ASC 360. However, assets held for sale have distinct reporting and testing requirements.

Long-lived assets held and used are tested for impairment at the asset group level. ASC 360 defines an asset group as, “the unit of accounting for a long-lived asset or assets to be held and used, which represents the lowest level for which identifiable cash flows are largely independent of the cash flows of other groups of assets and liabilities.”

What kinds of assets are covered by ASC 360?

ASC 360 covers the impairment of long-lived assets used to create and distribute an entity's products and services. Examples of these kinds include:

• Land and associated improvements
• Buildings
• Machinery and equipment
• Furniture and fixtures
• Proved oil and gas properties that are accounted for using the successful efforts method of accounting
• Long-lived intangible assets that are amortized

Several specific types of assets are not subject to the provisions of ASC 360. These include, but are not limited to, the following:

• Goodwill
• Intangible assets not being amortized
• Financial instruments, including investments in equity securities
• Unproved oil and gas properties that are accounted for using the successful efforts method of accounting
• Oil and gas properties that are accounted for using the full-cost method of accounting

When should you test a long-lived asset for impairment?

Unlike goodwill and indefinite-lived assets, which must be tested for impairment at least annually, ASC 360 does not require annual impairment testing for long-lived assets. Instead, an asset (asset group) that is held and used should be tested for recoverability whenever events or changes in circumstances indicate that its carrying amount may not be recoverable. ASC 360 sets out the following examples of such events or changes:

• A significant decrease in the market price of a long-lived asset (asset group)
• A significant adverse change in the extent or manner in which a long-lived asset (asset group) is being used or in its physical condition
• A significant adverse change in legal factors or in the business climate that could affect the value of a long-lived asset (asset group), including an adverse action or assessment by a regulator
• An accumulation of costs significantly above the amount initially expected for the acquisition or construction of a long-lived asset (asset group)
• A 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 the use of a long-lived asset (asset group)
• A current expectation that, more likely than not, a long-lived asset (asset group) will be sold or otherwise disposed of significantly before the end of its previously estimated useful life. The term more likely than not refers to a level of likelihood that is more than 50 percent.

Examples of specific events that might lead a company to test one or more of its asset groups for impairment would include:

• The loss of a significant customer, whether that customer goes out of business or is acquired
• Declines in the overall market prices of similar companies
• Sustained declines in spot and forward commodity prices
• Legislation that adversely impacts the operations of the asset group

How does the ASC 360 impairment test work?

First, the asset group's carrying amount is compared to the asset group's total undiscounted future cash flows. This is known as the recoverability test, sometimes called “Step 1” of ASC 360. The future cash flows used to test the recoverability of an asset group are measured for the remaining useful life of the asset group. The remaining useful life of the asset group is based on the remaining useful life of the primary asset within the group. The primary asset is the principal long-lived tangible asset being depreciated, or intangible asset being amortized, that is the most significant asset from which the asset group derives its cash flows. Note that, according to ASC 360, land cannot be a primary asset within an asset group. Also, an intangible asset that is not amortized cannot be a primary asset.

Next, if the sum of the undiscounted cash flows is less than the carrying amount, then the fair value of the asset group is estimated. This is sometimes referred to as “Step 2” of ASC 360. Typically, the fair value of the asset group is estimated via a discounted cash flow analysis, including an estimate of the cash flows from disposal. The impairment loss is measured as the amount by which the asset group's carrying amount exceeds its fair value.

What are some common concerns to keep in mind regarding the long-lived asset impairment test?

Companies that are performing a long-lived asset impairment test under ASC 360 should consider the following:

• Asset Group Composition: Company management should ensure that the composition of assets within the asset group is appropriate. They should also ensure that the appropriate asset is designated as the primary asset within the asset group.
• Financial Projections: Auditors will closely scrutinize the cash flow projections utilized by companies in the recoverability test and fair value estimate for ASC 360 purposes. One key element of the cash flow projections is the length of time that the forecast entails. The life of the cash flow projections should mirror the expected economic life of the primary asset within the asset group. Therefore, care should be taken to ensure that the cash flow projections reflect an appropriate economic life and that cash flows from disposal are adequately captured. The cash flow projections should also reflect market participant assumptions, particularly for “Step 2”, as you estimate fair value.
• Discount Rate: Within the fair value estimate, or “Step 2” of ASC 360, care should be taken to ensure that the discount rate adequately captures a market participant’s view of the risks associated with the projected cash flows. A weighted average cost of capital (WACC) estimate is often utilized as the basis for the discount rate. This WACC estimate should consider an appropriate set of guideline companies with operations similar to those of the tested asset group.

Corroboration with a market approach analysis

The estimated fair value of an asset group obtained under the income approach is typically the primary indication of value utilized under “Step 2”. However, through guideline companies and multiples, the market approach can be used to assess the reasonableness of the estimated fair value under the income approach. Ultimately, for both publicly and privately held companies adhering to GAAP (and considering the principles of IFRS), diligently addressing long-lived asset impairment testing is paramount. This proactive approach to asset valuation, including the potential for recognizing an impairment loss and subsequent write-down reflected in the income statement and balance sheet, ensures the financial statements accurately represent the assets’ value. Timely and thorough procedures contribute to smoother audits and enhance transparency for all stakeholders regarding potential impaired assets and fluctuations in market value.