Asset impairment and disposal: new accounting guidance for long-lived assets.

EXECUTIVE SUMMARY

* TO ESTABLISH A SINGLE MODEL BUSINESSES CAN follow, FASB issued Statement no. 144, Accounting for the Impairment or Disposal of Long-Lived Assets. FASB intends it to resolve implementation issues that arose from its predecessor, Statement no. 121, Accounting for the Impairment of Long-Lived Assets and for Long-Lived Assets to Be Disposed Of,

* IMPAIRMENT EXISTS WHEN THE CARRYING AMOUNT of a long-lived asset or asset group exceeds its fair value and is nonrecoverable. CPAs should test for impairment when certain changes occur, including a significant decrease in the market price of a long-lived asset, a change in how the company uses an asset or changes in the business climate that could affect the asset's value.

* FAIR VALUE IS THE AMOUNT AN ASSET COULD be bought or sold for in a current transaction between willing parties. Quoted prices in active markets are the best evidence of fair values. Because market prices are not always available, CPAs should base fair-value estimates on the best information available or use valuation techniques such as the expected-present-value method or the traditional-present-value method.

* WHEN A COMPANY RECOGNIZES AN IMPAIRMENT loss for an asset group, it must allocate the loss to the assets in the group on a pro rata basis. It must also disclose in the notes to the financial statements a description of the impaired asset and the facts and circumstances leading to the impairment.

* COMPANIES MUST PRESENT LONG-LIVED ASSETS HELD for sale separately in the financial statements and not offset them against liabilities. Statement no. 144 requires certain disclosures in the notes to the financial statements including the circumstances leading to the disposal, the manner and timing and the gain or loss on sale.

For many years, companies and other entities accounted for the disposal or expected disposal of long-lived assets that were a segment of a business using one set of rules and the disposal of long-lived assets that were not a segment of a business using another standard. To establish a single model for all long-lived assets, FASB issued Statement no. 144, Accounting for the Impairment or Disposal of Long-Lived Assets.

The new standard supersedes Statement no. 121, Accounting for the Impairment of Long-Lived Assets and for Long-Lived Assets to Be Disposed Of and a portion of APB Opinion no. 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. FASB intends Statement no. 144 to resolve significant implementation issues that arose from Statement no. 121. This article explains the new guidance and how CPAs can implement it.

LONG-LIVED ASSETS TO BE HELD AND USED

Businesses recognize impairment when the financial statement carrying amount of a long-lived asset or asset group exceeds its fair value and is not recoverable. A carrying amount is not recoverable if it is greater than the sum of the undiscounted cash flows expected from the asset's use and eventual disposal. FASB defines impairment loss as the amount by which the carrying value exceeds an asset's fair value.

CPAs need not check every asset an entity owns in each reporting period. When circumstances change indicating a carrying amount may not be recoverable, CPAs should test the asset for impairment. A test may be called for when one or more of these events occur:

* A significant decrease in the market price of a long-lived asset.

* A significant change in how a company uses a long-lived asset or in its physical condition.

* A significant change in legal factors or in the business climate that could affect an asset's value, including an adverse action or assessment by a regulator (such as if the EPA rules that a company is polluting a stream and must change its manufacturing process, thereby decreasing the value of its plant or equipment).

* An accumulation of cost significantly greater than the amount originally expected to acquire or construct a long-lived asset.

* A current-period operating or cash flow loss combined with a history of such losses or a forecast demonstrating continued losses associated with use of a long-lived asset.

* An expectation the entity will sell or otherwise dispose of a long-lived asset significantly before the end of its previously estimated useful life.

Companies must group long-lived assets with other assets and liabilities at the lowest level for which there are identifiable cash flows. An asset group to be tested for impairment must include goodwill only if the group is, or includes, a reporting unit, as defined in FASB Statement no. 142, Goodwill and Other Intangible Assets. An asset group that comprises only part of a reporting unit should exclude goodwill. Entities must adjust assets such as accounts receivable and inventory and liabilities such as accounts payable, long-term debt and asset retirement obligations according to other applicable GAAP before testing the group for recoverability.

TESTING LONG-LIVED ASSETS FOR RECOVERABILITY

CPAs should test an asset for recoverability by comparing its estimated future undiscounted cash flows with its carrying value. The asset is considered recoverable when future cash flows exceed the carrying amount. No impairment is recognized. The asset is not recoverable when future cash flows are less than the carrying amount. In such cases the company recognizes an impairment loss for the amount the carrying value exceeds fair value.

The estimated cash flows a CPA uses to test for recoverability must include only future flows (cash inflows less cash outflows) directly associated with use and eventual disposal of a given asset. The company should exclude interest charges it will expense as incurred. Cash flow estimates are based on the entity's assumptions about employing the long-lived asset for its remaining useful life.

When an asset group consists of long-lived assets with different remaining useful lives, determining the group's life is critical to estimating cash flows. Remaining useful life is based on the life of the primary asset--the most significant asset from which the group derives its cash flow generating capacity. The primary asset must be the principal long-lived tangible asset being depreciated (or intangible asset being amortized).

CPAs should consider these factors when determining which is the primary asset:

* Whether the entity would have acquired other assets in a group without this asset.

* The investment required to replace the asset.

* The asset's remaining useful life relative to other assets in the group.

If the primary asset does not have the longest remaining life of the group, the cash flows from operating the group still are based on that asset's estimated life--on the assumption the company will dispose of the entire group at the end of the primary asset's life.

Example. An asset group consists of asset X with an estimated remaining life of five years, asset Y with an estimated life of seven years and asset Z (the primary asset) with a four-year life. The cash flows a CPA uses to test for impairment would assume the company uses the asset group for four years and disposes of it. To test for impairment, CPAs would include the group's salvage value at the end of year 4 in the cash flow computations.

Future cash flows must be based on the asset group's current service potential (four years for the three assets above) at the date of the impairment test. Future cash flows should include expenditures to maintain the current service potential, including replacing component parts of the long-lived asset and assets other than the primary one. CPAs should exclude cash flows that increase service potential but include maintenance costs.

ESTIMATING FAIR VALUE

Fair value is an asset's purchase or sale price in a current transaction between willing parties. The best evidence of fair value is prices quoted in active markets, such as the price for a stock listed on a stock market. CPAs must use this amount to value assets if it is available. Because market prices are not available for many long-lived assets such as equipment, fair value estimates must be based on the best information available, including prices for similar assets. While CPAs can use other valuation techniques, present value is often the best for estimating fair value. FASB Concepts Statement no. 7, Using Cash Flow Information and Present Value in Accounting Measurements, discusses two present-value techniques CPAs may use.

DISCLOSING IMPAIRMENT LOSSES

When a company recognizes an impairment loss for an asset group, it must allocate the loss to the long-lived assets in the group on a pro rata basis using their relative carrying amounts. There is an exception when the loss allocated to an individual asset reduces its carrying amount below fair value. If CPAs can determine fair value without undue cost and effort, the asset should be carried at this amount. This requires an additional allocation of the impairment loss (explained below). The adjusted carrying value after the allocation becomes the new cost basis for depreciation (amortization) over the asset's remaining useful life.

A business must include an impairment loss in the income from continuing operations before income taxes line on its income statement. (A not-for-profit organization (NPO) would include the loss in income from continuing operations in the statement of activities.) When a subtotal such as income from operations is present, CPAs should include the impairment loss in determining that amount.

Other required information companies must disclose in the notes to the financial statements includes

* A description of the impaired long-lived asset and the facts and circumstances leading to its impairment.

* If not separately presented on the face of the statement, the amount of the impairment loss and the caption in the income statement or the statement of activities that includes the loss.

* The method or methods used to determine fair value.

* If applicable, the segment in which the impaired long-lived asset is reported under FASB Statement no. 131, Disclosures about Segments of an Enterprise and Related Information.

Example. There is a significant adverse change in the business climate in one of the industries North Bay Inc. operates in. The company believes this change could impair some of its long-lived assets. The company groups assets at the lowest level with identifiable cash flows and tests them for impairment. One group is the ScioTech operation, which is not a reporting entity. Current conditions have reduced the fair value of inventory, which has a carrying value of $175,000. Using applicable GAAP (lower of cost or market rule), North Bay determines the inventory's fair value is $150,000. It must make inventory adjustments before testing for long-lived asset impairment. It adjusts inventory down by $25,000 and reports this amount in the income statement.

ScioTech's long-lived assets consist of A, B, C, D and E; D is the primary asset. Exhibit 1, at left, shows the assets' individual carrying value and remaining lives. They are deemed impaired because their fair value and future undiscounted value are less than their carrying value. If future undiscounted cash flows were greater than carrying value, North Bay would recover the carrying value by using the asset group and would not recognize an impairment.

Asset D, the primary asset, has a remaining life of eight years. This determines the period over which the company will estimate cash flows to see if the carrying amount is recoverable. Assume future cash flows for the next eight years are $1,700,000 with an additional $75,000 realized from disposing of the group at the end of the period.

Since the $1,775,000 cash flow is less than the $2,200,000 carrying amount and the group's fair value is $1,450,000--also less than the carrying amount--the company should recognize a $750,000 impairment loss in income from continuing operations before taxes on its income statement. In exhibit 2, below, the $750,000 impairment loss is allocated pro rata to assets A, B, C, D and E.

The impairment loss allocated to a long-lived asset should not reduce its carrying value below fair value. Assuming asset B's fair value is $160,000, the pro rata allocation reduces its carrying value below fair value (carrying value is $132,500--$27,500 below fair value). The company needs to increase B's fair value by $27,500 to $160,000 and allocate an additional $27,500 loss pro rata to assets A, C, D and E. Exhibit 3, page 52, shows the assets' new cost basis.

CPAs should review depreciation estimates and methods for the assets according to the requirements of APB Opinion no. 20, Accounting Changes.

ASSETS DISPOSED OF OTHER THAN BY SALE

A company must continue to classify long-lived assets it plans to dispose of by some method other than by sale as held and used until it actually gets rid of them. Other disposal methods include abandonment, exchange for a similar productive asset or distribution to owners in a spin-off.

A company should report long-lived assets to be abandoned or distributed to owners that consist of a group of assets (and liabilities) that are a "component of an entity" in the income statement as discontinued operations. If the assets are not a component, CPAs should report their disposal as part of the company's income from continuing operations.

Statement no. 144 defines a component of an entity as operations and cash flows that can be clearly distinguished both operationally and for financial reporting purposes from the rest of the entity. A component may be a

* Reportable segment or an operating unit, as defined in Statement no. 131.

* A reporting unit, as defined in Statement no. 142.

* A subsidiary or an asset group. Statement no. 144 defines asset group as "assets to be disposed of together as a group in a single transaction and liabilities directly associated with those assets that will be transferred in the transaction."

A long-lived asset a company will abandon is considered disposed of when the company stops using it. A temporarily idle asset is not accounted for as abandoned. If an entity plans to abandon a long-lived asset before its estimated useful life, it will treat the asset as held and used, test it for impairment and revise depreciation estimates in accordance with Opinion no. 20. Continued use of such a long-lived asset demonstrates service potential (the unit is useable), and hence, fair value would be zero only in unusual circumstances. During use before abandonment, the company should depreciate the asset so that at disposal or abandonment, its carrying value equals its salvage value. This amount should not be less than zero.

A long-lived asset to be distributed to owners or exchanged for a similar productive asset is considered disposed of when it is distributed or exchanged. When the asset is classified as held and used, any test for recoverability must be based on using the asset for its remaining useful life, assuming disposal will not occur. If the carrying amount exceeds fair value at disposal, the company must recognize an impairment loss.

LONG-LIVED ASSETS TO BE SOLD

A company must classify a long-lived asset it will sell as held for sale in the period it meets all of these criteria:

* Management with the authority to approve the action commits to a plan to sell.

* The asset is available for immediate sale in its present condition, subject only to terms that are usual and customary when selling such assets.

* The company has initiated an active program to locate a buyer.

* The sale is probable and the asset transfer is expected to qualify as a completed sale within one year (there are some circumstances beyond the entity's control that may extend the time for completion beyond one year).

* The company is actively marketing the asset at a reasonable price in relation to its current fair value.

If the company meets the above criteria after the balance-sheet date but before it issues its financial statements, it must continue to classify the asset as held and used. In the notes to the financial statements, the company must disclose the facts and circumstances leading to the expected disposal, the likely manner and timing of the disposal and--if not separately shown on the face of the statement--the carrying amount(s) of the major classes of assets and liabilities included in the disposal group. If the company tests the asset for recoverability at the balance-sheet date, it should do so on a held-and-used basis. Future cash flow estimates used to test for recoverability must take into account the possible outcomes that existed at the balance-sheet date, including a future sale. CPAs should not revise this assessment for a sale decision made after the balance-sheet date and should collect documentation and supporting evidence on a timely basis for events near such a date. An impairment loss is calculated and reported in the same way it is for assets held and used because this is the asset's status at the balance-sheet date.

Companies must adjust the carrying amounts of assets (including goodwill) that are part of a disposal group classified as held for sale not covered by Statement no. 144 in accordance with other applicable GAAP before measuring the group's fair value. A long-lived asset held for sale must be measured at the lower of its carrying amount or fair value less cost to sell--the incremental direct costs the company would not have incurred if not for the decision to sell. Examples of such costs include broker commissions, legal and title transfer fees and closing costs necessary to transfer tide. Exclude expected future losses from operations. Assets classified as held for sale are not depreciated or amortized.

Example. ABC Corp. decides in October of year 1 to dispose of an asset group that is a component of an entity. It meets all the requirements to classify the group as a long-lived asset to be disposed of by sale. The group's carrying amount is $750;000, its fair value $600,000 and the estimated cost to sell is $45,000. The loss to be recognized in October of year 1 is $750,000 - ($600,000 - $45,000) = $195,000. The new carrying amount is $555,000.

If ABC is a calendar-year corporation, on December 31 of year 1 it needs to review the fair value and cost to sell to see if it needs to adjust the group's carrying amount. If at that date the fair value has fallen to $575,000 with an estimated cost to sell of $45,000, the company would recognize an additional $25,000 loss. The carrying amount is now $530,000. ABC would report a total loss of $220,000 on its year 1 income statement. It sells the disposal group in May of year 2 for $595,000 with a $50,000 cost to sell. The disposal proceeds are $545,000--$15,000 more than the carrying value. ABC would report this gain on its income statement, as described in the next section.

REPORTING DISCONTINUED OPERATIONS

An entity must report the results of operating a component it has either disposed of or classified as held for sale in discontinued operations if it meets both of these conditions:

* The component's operations and cash flows have been or will be eliminated from the ongoing operations as a result of the disposal.

* The entity will not have any significant continuing involvement in the component's operations after the disposal.

In a period when an entity disposes of a component, the income statement of a business or the statement of activities of an NPO must report the results of the component's operations as discontinued operations. The entity would recognize the gain or loss from classifying the component as held for sale or disposal in discontinued operations. If the disposal group is a component of an entity, as in the earlier ABC example, the component's operations results (a $400,000 loss) are included in discontinued operations for year 1. The $220,000 loss on the disposal group is part of discontinued operations in year 1. The year 2 income statement will include--as discontinued operations--the component's operations for January through disposal in May, with the $15,000 gain on disposal also reported here. Discontinued operations less applicable taxes or benefits must be reported as a separate component of income before extraordinary items and the cumulative effect of accounting changes. ABC will report the results of discontinued operations in its year 1 income statement, as shown in exhibit 4, at right.

A company must disclose the gain or loss it recognizes when it classifies an asset as held for sale or disposal on either the face of the income statement or in the notes. Adjustments related to disposing of a component of an entity in a prior period, which the company reported as discontinued operations, must be classified separately in discontinued operations in the current period.

A gain or loss on a long-lived asset that is not an entity component must be included in income from continuing operations before income taxes in the income statement. If the entity uses a subtotal such as "income from operations," it must include the gains or losses there.

PRESENTATION AND DISCLOSURE

A company must present a long-lived asset held for sale separately in its financial statements. Major classes of assets and liabilities held for sale must not be offset and presented as one amount, they must be separately disclosed either on the face of the statement itself or in the notes.

Statement no. 144 requires a company to disclose information in the notes for a period in which it either sells a long-lived asset or classifies it as held for sale. Companies must disclose

* The facts and circumstances leading to the expected disposal, the likely manner and timing and, if not separately presented, the carrying amount(s) of major classes of assets and liabilities included in the disposal group.

* The loss recognized for any initial or subsequent write-down to fair value less cost to sell or a gain not more than the cumulative loss previously recognized for a write-down to fair value less cost to sell.

* The gain or loss on sale of the long-lived asset. CPAs should do this if these gains and losses are not separately presented on the face of the income statement, the caption in the income statement or statement of activities.

* If applicable, the revenue and pretax profit or loss reported in discontinued operations.

* If applicable, the segment in which the long-lived asset is reported under Statement no. 131.

If an entity decides not to sell a long-lived asset previously classified as held for sale, or removes an asset or liability from a disposal group, it must describe in the notes the facts and circumstances leading to the change in plan and its effect on operations for that period and any prior period presented.

IMPLEMENTATION AND EFFECTIVE DATE

The flowchart in exhibit 5, pages 56 to 60, provides CPAs with a process to follow in implementing the provisions of Statement no. 144. The new statement is effective for financial statements issued for fiscal years beginning after December 15, 2001, and interim periods within those fiscal years. FASB encourages early application.

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Exhibit 1: Asset Carrying Values and
Remaining Lives

      Long-lived           Carrying    Remaining
         asset              value        life

        Asset A             $100,000    6 years
        Asset B             $200,000   10 years
        Asset C             $600,000    9 years
Asset D (Primary asset)     $950,000    8 years
        Asset E             $350,000   12 years

         Total            $2,200,000
Exhibit 2: Loss Allocation

                                         Pro     Alloca-
                                        rata     tion of
                           Adjusted    alloca-   impair-     Adjusted
      Long-lived           carrying     tion       ment      carrying
         asset              value      factor      loss       value

        Asset A             $100,000     .05      $37,500      $62,500
        Asset B             $200,000     .09      $67,500     $132,500
        Asset C             $600,000     .27     $202,500     $397,500
Asset D (Primary asset)     $950,000     .43     $322,500     $627,500
        Asset E             $350,000     .16     $120,000     $230,000
         Total            $2,200,000    1.00     $750,000   $1,450,000
Exhibit 3: New Cost Basis of Assets

                                         Pro      Alloca-
                                        rata      tion of
                           Adjusted    alloca-    impair-     Adjusted
      Long-lived           carrying     tion       ment       carrying
         asset              value      factor      loss        value

        Asset A              $62,500     .05     $ (1,375)      $61,125
        Asset C             $397,500     .30     $ (8,250)     $389,250
Asset D (Primary asset)     $627,500     .48     $(13,200)     $614,300
        Asset E             $230,000     .17     $ (4,675)     $225,325
       Subtotal           $1,317,500    1.00     $(27,500)   $1,290,000
        Asset B             $132,500               $27,500     $160,000
         Total            $1,450,000                --       $1,450,000
Exhibit 4: ABC Corp. Year 1 Income Statement

Income from continuing operations
  before income taxes                          $4,580,000
Income taxes (30% rate)                         1,374,000
  Income from continuing operations                         $3,206,000
Discontinued operations (Note T)
  Loss from operations of discontinued
  Component Z (including $220,000
    loss on classification as held for sale)      620,000
  Income tax benefit                              186,000
  Loss on discontinued operations                              434,000
Net Income                                                  $2,772,000

DAVID T. MEETING, CPA, DBA, is professor of accounting at Cleveland State University. His e-mail address is [e-mail]. RANDALL W. LUECKE, CPA, CMA, CFM, is vice-president, finance, at CSA Group in Toronto. His e-mail address is [e-mail].