Impaired assets: meeting users' information needs.

Is it relevant? Is it useful? When it comes to financial reporting, these are the major concerns of the accounting profession. With Financial Accounting Standards Board Statement no. 121, Accounting for the Impairment of Long-Lived Assets and for Long-Lived Assets to Be Disposed Of standard setters adopted an innovative and cost-effective approach to reporting measurement, recognition and disclosure of impairment losses. The FASB approach meets users' information needs while giving management substantial flexibility to exercise judgment in determining and reporting impairment losses.

This article traces the development of Statement no. 121, describes the controversial issues surrounding the recognition and measurement of impairment losses and focuses on the implementation requirements and issues that should concern CPAs in industry and their auditors. The article also provides insight into the evolution of accounting theory underlying the FASB's reasoning on significant issues and how public comments influenced its decisions on the recognition and measurement of impairment losses on long-lived assets.

A BRIEF LESSON IN HISTORY

The accounting profession has long had standards on the impairment of current assets, but only recently has the FASB turned its attention to long-lived assets. Statement no. 121 addresses impairment of long-lived tangible assets (generally land and depreciable assets such as plant and equipment), certain identifiable intangible assets and related goodwill. Previously, the practice for impairment of long-lived assets was diverse and no specific standard said when, how or how much. Before Statement no. 121, companies generally wrote down an asset when there was evidence of permanent impairment in the ability. to fully recover the asset's carrying amount.

The inconsistencies in measuring and reporting impairment of long-lived assets and the lack of authoritative guidance reduced the relevance and comparabilit5, of financial statements. The result was the December 1990 FASB Discussion Memorandum, Accounting for &e Impairment of Long-Lived Assets and Identifiable Intangibles, which defined impairment as the inability to recover fully the carrying amount of assets over their estimated useful lives.

The FASB issued an Exposure Draft, Accounting for the Impairment of Long-Lived Assets, in November 1993 that reviewed issues in the DM plus some additional ones. After considering numerous comments, the FASB issued Statement no. 121 in March 1995, effective for fiscal years beginning after December 15, 1995, making 1996 the first year most companies apply the standard.

NUTS AND BOLTS

The most interesting and controversial aspects of the statement are the requirements for recognition and measurement of impairment. The FASB requires a practical approach to implementing the probability criterion, which calls for loss recognition when it is probable an asset's carrying amount cannot be fully recovered. Impairment losses are recognized when the sum of the expected future undiscounted net cash flows are less than an asset's carrying amount. In effect, the FASB said that when net cash flows are less than the carrying amount, it is probable an impairment has occurred; therefore, a loss must be recognized.

The interesting aspect of this requirement is that the loss amount is not the difference between the carrying amount and the expected future undiscounted cash flows. Rather, it is the amount by which the asset's carrying amount exceeds its fair value. Statement no. 121 requires entities to apply a hierarchy to determine an impaired asset's fair value:

1. The asset's market value if an active market exists.

2. If no active market exists but such a market exists for similar assets, the selling prices in that market may help in estimating the fair value of the impaired assets.

3. If no market price is available, a forecast of expected cash flows may help estimate fair value, provided the cash flows are discounted at a rate that is commensurate with the risk involved. Exhibit 1, page 57, illustrates how this rule is applied.

FASB POSITION ON RECOGNITION AND MEASUREMENT

In adopting fair value as the measurement criterion, the FASB did not have strong support from El) respondents. Therefore, in implementing the standard it is important for practitioners and management accountants to understand the basis for the FASB's insistence on the approach.

The FASB defended itself by concluding that a company's decision to continue operating rather than sell an impaired asset essentially is a capital investment decision-- management believes operating the asset is more beneficial than selling it. The FASB felt a new cost basis had to be recognized and that fair value of the impaired asset was the most appropriate measure, because fair value generally was used when a new cost basis was established.

The FASB considered other views but concluded fair value was the best measure because it was consistent with management's decision process. The board reasoned that no entity would continue using an asset unless such use was expected to produce more in terms of future cash flows or service potential than the alternative of selling and reinvesting the proceeds. Despite respondents' comments to the contrary, the FASB believed using fair value to measure an impairment loss was not a departure from the historical cost principle. Rather, it was consistent with principles practiced whenever a cost basis for a newly acquired asset must be determined.

LESS CONTROVERSIAL REQUIREMENTS

Other requirements are not as controversial as those on recognition and measurement. One is how assets should be grouped when measuring for impairment. The standard says, "Assets shall be grouped at the lowest level for which there are identifiable cash flows .... "Timing also is not controversial. The standard says long-lived assets and identifiable intangibles should be reviewed for impairment when events or changes in circumstances indicate the carrying amount of the assets may not be recoverable and lists certain types of events as examples. The key point is that when there is reason to suspect the carrying amounts are not recoverable, a company is required to review for impairment.

The requirement for reporting impairments caused little controversy. Impairment losses must be reported as a component of income from continuing operations before income taxes. Although there is no requirement to report a subtotal such as "income from operations," any entity, presenting a subtotal must include the impairment loss.

The FASB also considered whether previously impaired and written-down assets should be increased if their value subsequently increased. Its position is that the asset's reduced carrying amount is its new cost. Accordingly, that amount must be depreciated over the asset's remaining life; restoration of a previously recognized impairment loss is not permitted.

ASSET CLASSIFICATION

Statement no. 121 classifies impaired long-lived assets into two categories--those an entity expects to use and those it expects to dispose of. A flowchart summarizing the statement's general provisions is shown as exhibit 2, page 58. The standard itself goes into significantly more detail and contains more elements.

Assets to be used. For assets an entity expects to use, impairment is considered only when events and changes in circumstances indicate the carrying amount may not be recoverable. As exhibit 2 shows, impairment indicators offer evidence of this. The standard provides five examples, which are listed in the flowchart. If impairment is indicated, the asset carrying amounts must be tested for recoverability--the carrying amount is compared with the undiscounted future cash flows (not including interest) from the asset's use and ultimate disposal. Future cash flows are the inflows expected to be generated by an asset less future outflows expected to be necessary to obtain those inflows. An asset's recoverability is impaired if its carrying amount exceeds the undiscounted net cash flows.

In conducting the recoverability test, assets are grouped at the lowest level for which there are identifiable cash flows that are largely independent of the cash flows of other asset categories. The impairment loss is the difference between the asset group's carrying amount and its fair value.

Statement no. 121 provides guidance on estimating expected future cash flows and the kind of evidence and valuation techniques that should be used to estimate fair value. Estimates of expected future cash flows should be the "best estimate based on reasonable and supportable assumptions and projections." All available evidence should be considered and weighted based on whether it can be verified objectively. Ira range is estimated for either the amount or timing of possible cash flows, the likelihood of a particular outcome should be considered.

Under Statement no. 121, entities also are required to consider the impairment of goodwill associated with impaired long-lived assets and identifiable intangibles acquired in a business combination accounted for as a purchase. If some but not all of the acquired assets are being tested for recoverability, goodwill must be allocated on a pro rata basis using the relative fair values unless evidence suggests some other method is more appropriate. When an impairment exists, an entity must first eliminate the goodwill associated with the impaired long-lived assets and identifiable intangibles before making any reductions in their carrying amount to fair value.

For entities presenting an income statement, impairment losses should be displayed as a component of income (loss) from continuing operations before income taxes. Not-for-profit organizations should present such losses in the statement of activities. The standard prohibits restoration of previously recognized impairment losses. Disclosures that must accompany an impairment loss include

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

* The amount of the loss and how it was determined.

* A caption in the income statement that includes the loss.

* The business segments affected.

Assets to be disposed of. For these assets, the recognition and measurement of impairment losses depends on whether disposal of the impaired assets is covered under Accounting Principles Board 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. When Opinion no. 30 applies, Statement no. 121 requires that the impairment loss be measured at the lower of carrying amount or net realizable value. If Opinion no. 30 does not apply, the impairment loss is measured at the lower of carrying amount or fair value less cost to dispose.

INTERNATIONAL OPERATIONS

In implementing Statement no. 121, accountants of U.S. companies with international activities must consider whether the companies' foreign operations can identify and measure potential impairment losses on long-lived assets in accordance with the standard. These CPAs need to work closely with foreign subsidiaries to ensure early warning systems are in place to identify long-lived assets that may be impaired.

International accounting standards give management considerable discretion in the timing and amount of write-downs of impaired long-lived assets. The International Accounting Standards Committee is considering developing criteria to recognize and measure impairment losses similar to those in Statement no. 121.

When they implement Statement no. 121, managers of foreign operations and their accountants must understand the standard's impact on existing accounting and early-warning systems. They must be able to identify the events or changes in circumstances--including management decisions to restructure and downsize operations--that indicate an asset's carrying amount may not be recoverable. Changes in the economic and business environments may differ among geographic areas and industry segments. Foreign operations also must devote greater attention to measurement and reporting issues relating to potentially impaired long-lived assets because published fair value estimates, especially for machinery and equipment, may not be readily available. In consolidating the operating results of foreign subsidiaries, industry CPAs must have assurance that material impairment losses on long-lived assets have been identified and recognized as required in Statement no. 121.

OTHER IMPLEMENTATION ISSUES

With Statement no. 121's effective date of fiscal years beginning after December 15, 1995, most companies will have had more than 18 months since it was issued to prepare for reporting on asset impairment. Nevertheless, new requirements of this type always present some implementation issues.

Cost. There usually is a question of the implementation cost versus the benefit. Estimating future cash flows can be time-consuming and expensive. In this case, however, many companies already have capital budgeting policies that require review of assets to determine whether original projections are being met. It is in a company's economic interest to review and dispose of nonproductive assets.

Estimating cash flows. The standard allows management considerable flexibility in how it measures cash flows. This feature is favorable because it lets management use the normal techniques and assumptions that reflect the operating environment rather than impose arbitrary procedures that might be more costly and burdensome to implement. However, such flexibility could create improper reporting problems. For example, management may want to overestimate cash flows to avoid writeoffs; at other times, management may believe a significant writeoff will benefit the company long term and underestimate cash flows. External auditors and industry CPAs must carefully review management's assumptions for reasonableness to ensure that writeoffs are made when appropriate but not unnecessarily.

Quarterly reports. The standard does not say asset impairments should be included in quarterly reports. Since such reports generally are unaudited, some companies may report asset impairment only at yearend. However, quarterly reports are important to creditors and investors; if management is aware of potential asset impairment that might affect quarterly earnings, it should consider the appropriate time to do asset impairment tests and report impairment losses. External auditors must be concerned that asset impairment writeoffs not be unreasonably delayed; there may be problems if users believe auditors knew earlier in the year of impending asset writeoffs but did not insist that management include them in a quarterly report. Similarly, industry CPAs should suggest the proper timing for reporting impairments to avoid charges the company purposely withheld important information.

Asset grouping. Statement no. 121 requires asset grouping at the lowest level for which there are identifiable cash flows that are largely independent of cash flows generated by other asset groups. Again, however, the FASB allows management considerable judgment in determining appropriate groups. Depending on grouping, unrealized gains of some assets could offset unrealized losses of others, resulting in no required writeoff. Consequently5 management may tend to group assets inappropriately at times to avoid asset impairment writeoffs. External auditors and internal accountants should review asset groups to make sure they are made up in accordance with the standard and with FASB-provided guidance.

Restructuring. Asset impairments often occur when a company restructures, yet there is confusion about how to account for such impairments. FASB Emerging Issues Task Force Issue no. 94-3, Liability Recognition for Certain Employee Termination Benefits and Other Costs to Exit an Activity (including Certain Costs Incurred in a Restructuring), addresses restructuring charges and the background information of Statement no. 121 says EITF consensuses provide useful guidance on how to account for the operating results of an asset to be disposed of when the disposal involves an exit from an activity. However, the EITF specifically says its conclusions do not apply to the disposal of a business segment accounted for under Opinion no. 30 or to asset impairments arising from an exit plan. Statement no. 121 also does not specifically address restructuring when an impaired asset is to continue in use. Presumably, the standard would be applied in the same way it would be applied to any other impaired asset still in use. This is unclear, however, and some companies have raised questions. Entities involved in restructuring must work closely with their auditors to ensure proper accounting and reporting.

What Is and Is Not Affected

FASB Statement no. 121 applies to long-lived assets, certain identifiable intangibles and goodwill related to those assets to be held and used and to long-lived assets and certain identifiable intangibles to be disposed of. It does not apply to

Financial instruments.

Long-term customer relationships of a financial institution.

Mortgages and other servicing rights.

Deferred policy acquisition costs.

Deferred tax assets.

EXECUTIVE SUMMARY

* WITH FINANCIAL ACCOUNTING Standards Board Statement no. 121, Accounting for the Impairment of Long-Lived Assets and for Long-Lived Assets to Be Disposed Of, standard setters have adopted an innovative and cost-effective approach to reporting measurement, recognition and disclosure of impairment losses.

* STATEMENT NO. 121, ISSUED IN MARCH 1995, is effective for fiscal years beginning after December 15, 1995, making 1996 the first year most companies apply the standard's provisions.

* THE MOST INTERESTING AND controversial aspects of Statement no. 121 are the FASB's requirements for the recognition and measurement of asset impairment.

* U.S. COMPANIES WITH INTERNATIONAL activities must consider whether foreign operations can identify and measure potential impairment losses in accordance with Statement no. 121. Existing international accounting standards give management considerable discretion in the timing and amount of write-downs of impaired long-lived assets.

* WHILE MOST COMPANIES WILL HAVE HAD more than 18 months to prepare for Statement no. 121, implementation issues still arise. These include the question of the cost of implementation versus the benefit, how cash flows will be estimated, whether to include asset impairments in quarterly reports and how to handle restructurings.

PIERRE L. TITARD, CPA, PhD, is professor of accounting and director of the School of Accountancy, College of Business and Industry, Mississippi State University, Mississippi State. DAVID B. PARISER, CPA, CMA, PhD, is professor of accounting, College of Business and Economics, West Virginia University, Morgantown.

EXHIBIT 1: EXAMPLE OF IMPAIRMENT RECOGNITION

An asset with a carrying amount of $1 million and a remaining life of five years is expected to provide net cash flows of $180,000 a year, or a total of $900,000.

  Carrying amount:                      $1,000,000
     Sum of undiscounted net cash flows:      900,000

Does the carrying amount exceed the sum of undiscounted net cash flows? Yes. The asset is impaired and a loss must be recognized.

Example of Impairment Measurement

From example above:

     Carrying amount                       $1,000,000

     Fair value(*) determined by
     discounting net cash flows
     at 10% for 5 years:
     $180,000 x 3.791 =                       682,380
     Amount of loss to be recognized:        $317,620

(*) The standard requires that a hierarchy approach be used. It calls for the use of the market value of the asset or similar assets before estimating fair value using a discounted cash flow approach.