Impairment of long-lived assets: an emerging and critical issue.

In November, 1993, the Financial Accounting Standards Board (FASB) issued an Exposure Draft for a proposed Statement of Financial Accounting standards entitled, "Accounting for the Impairment of Long-Lived Assets" and asked for comments. The purpose of this article is to discuss the various issues associated with impairment in order to better understand the tentative conclusions reached in the Exposure Draft and thus be in a position to comment or propose any changes, if necessary.

An asset is said to be "impaired" when its book value exceeds some measure of its "fair" value. If a firm recognizes this impairment and records it by reducing the book value of the asset and debiting an expense, the firm has recorded a "write-off." Under GAAP, write-offs are required in various situations, such as marketable securities and inventories that are periodically compared to market and reduced, if necessary. Similarly, long-term equity investments are annually adjusted to lower-of-cost-or-market, although the reduction bypasses the income statement and goes directly to stockholders' equity. Long-term assets are another example. When disposal has been decided upon (such as for the sale of a segment of a business), the assets are adjusted to their net realizable value, as discussed in APB Opinion 30.(1)

Most write-offs that a firm records would normally fall into the above categories, and there is no lack of guidance in GAAP regarding the proper accounting treatment. The area in which guidance is lacking and where confusion reigns supreme is that of long-lived assets that the firm wishes to retain for use but has concluded are impaired. Is it permissible or perhaps required to write-down these assets?

Paragraph 25 of FASB Concepts Statement No. 6 defines assets as "probable future economic benefits obtained by a particular entity as a result of past transactions." Under current accounting practice, asset amounts recognized in the financial statements are based on historical cost. As conditions change with time, asset values also change; nonetheless, many of these changes are not recorded in the financial statements.

Some find historical cost inappropriate when an asset's value has significantly decreased, pointing out that in these cases part of the historical cost does not meet the definition of an asset. An asset is measured by its future economic benefit when that measure drops below depreciated historical cost, the difference between the two will bring no future economic benefit and, thus, no longer satisfies the asset definition. From this perspective, a write-off of this difference is the answer. Others disagree on both the recognition and the measurement of the write-off.(2)

Before the 1980s it was a rare action for a company to write down long-lived assets. However, as a result of economic downturn of the early 1980s, a significant number of companies began to write down their assets. This trend continues today as large corporate organizations struggle to remain competitive in a sluggish economy.

In 1989, the Institute of Management Accountants published a research study on impairment. The study reported a steadily increasing number of write-offs and revealed that more than $50 billion of assets were written off during the 1980-1985 period. It also noted that companies used a variety of disclosure practices for their write-offs and that the details were buried in the footnotes to the statements rather than shown as a separate line item in the body of the statements. Additional guidance clearly appears to be necessary to determine whether this procedure is in accordance with GAAP.

Historical Background

The FASB was asked to address the impairment issue as early as July, 1980, when the AICPA asked the Board to examine its Issue Paper entitled, "Accounting for the Inability to Fully Recover the Carrying Amounts of Long-Lived Assets." The FASB Emerging Issues Task Force (EITF) discussed the issue at its October, 1984, and February, 1986, meetings and noted the increase in the number of impairment write-offs and the many divergent measurement practices. The EITF urged the Board to consider adding the impairment issue to its agenda.

At the FASB's request, the Financial Executive Institute conducted a practice survey on impairment. In September, 1986, the Institute published the results of the survey, which examined 24 impairments and noted divergent recognition, measurement and reporting methods.

In May, 1987, the Institute of Management Accountants (IMA) approved a research study to investigate impairment. The IMA report, published in May, 1989, addressed 825 impairments and reported a variety of disclosure practices, valuation methods, terminology and an increasing number of impairment write-offs.

As a result of these studies, the Board added the impairment project to its technical agenda in the fall of 1988 and, in December, 1990, it published the Discussion Memorandum, "Accounting for the Impairment of Long-Lived Assets and Identifiable Intangibles." While the project did not initially address goodwill associated with these assets, it subsequently added the goodwill issue as a result of comments received on the Discussion Memorandum.

Discussion of the Issues

The American Heritage Dictionary of the English Language defines impairment as a "diminishment in strength, value, quantity or quality." When an asset has been impaired and its carrying value is higher than its future economic benefits, some believe the difference should be written off. If this is accepted as a given, then the following items need to be addressed:

* How impairments should be measured;

* When to measure for impairments;

* How to recognize impairments;

* Display and disclosure of impairments; and

* Recognition or nonrecognition of future increases in value.

The 1990 Discussion Memorandum identified several specific issues relating to these items. They are:

Issue 1: What measurement base should be used for comparison to book value in order to measure impairment? Possibilities are:

* current cost--the cost of acquiring this asset today; current market value--the amount this asset can be sold for today;

* net realizable value--current market value less disposal costs;

* present value of future cash flows--uses an appropriate discount rate; or

* future cash flows--does not discount the cash flows.

Issue 2: What particular grouping should be used, if any, to measure assets for evidence of impairment?

Assets are bought and sold individually, but future economic benefits accrue from the combined use of several assets. Should impairment be measured on individual assets, for business segments or for some other kind of business unit with identifiable cash flows?

Assets may need to be grouped to measure their value. Although assets may be bought and sold individually, they often are used in groups and thus should be measured as a group. Revenues and cash flows resulting from the combined use of various assets often cannot be measured or attributed to individual assets.(3)

Issue 3: Now often should measurement for evidence of impairment take place? Possible choices are every reporting period, annually or only when events or circumstances so indicate.

Issue 4: If the events or circumstances criterion is selected, what specific events and circumstances would trigger a need for measurement?

* reduction in the extent to which an asset is used;

* substantial change in the manner in which an asset is used;

* change in law or government policy;

* loss of market share or sudden change in business environment; or

* a combination of the above.

Issue 5: If the carrying amount of an asset exceeds the measurement base, should an economic criterion, permanence criterion or probability criterion be used in deciding whether or not to recognize the difference as a loss?

An economic criterion would recognize a loss as soon as the carrying value of the asset exceeds the measurement base, while the permanence criterion would require that the difference between the two be deemed "permanent." The probability criterion would follow the rules stated in FASB Concepts Statement No. 5 that require recognition only when the loss is probable; mere reasonable possibility would only necessitate footnote disclosure.

Issue 6: If impairment of an asset is recognized, should it be displayed as a separate line item in continuing operations, a separate line item outside continuing operations or merely disclosed in the footnotes to the statements?

Issue 7: What additional disclosures regarding the write-off should be made in the notes to the statements? Alternatives include: no additional information, a description of the impaired assets, a description of the events leading to the impairment or a description of the measurement assumptions.

Issue 8: If additional disclosures are required, should they be required only for the year of the impairment write-off or for all years for which the year of the impairment write-off is presented for comparative purposes?

Issue 9: If impairment exists but is not recognized, what disclosures should be required in the footnotes? Possibilities include:

* no disclosures;

* the difference between the carrying amount and the measurement base;

* a description of the impaired assets;

* a description of the events and circumstances leading to the impairment; or

* a description of the measurement assumptions.

Issue 10: If an impairment write-off took place and subsequently the measurement base increases and exceeds the asset's carrying amount after the write-off, should this increase be recognized by adjusting the carrying value of the asset?

Issue 11: If the answer to the previous question is yes, should the adjustment be limited to what the carrying amount would have been if the write-off never took place?

Conclusions of the Exposure Draft

With regard to recognition, the Board agreed that while management should have the responsibility to evaluate assets for impairment, constant evaluation would be cost-prohibitive. For this reason, the proposed Statement would require an evaluation and review for impairment only when events or changes in circumstances indicate that the carrying amount may not be recoverable.(4) In the Exposure Draft, the Board provided the following list of impairment indicators:

* a significant decrease in the market value of an asset;

* a significant change in the extent or manner in which an asset is used;

* a significant adverse change in legal factors or in the business climate that affects the value of an asset;

* an accumulation of costs significantly in excess of the amount originally expected to be needed to acquire or construct an asset;

* a projection that forecasts continuing losses associated with an asset.

This list is notmeant to be all-inclusive; it merely contains a set of examples of events or circumstances that would suggest the need to evaluate the recoverability of assets.(5)

If events and circumstances indicate that an asset may not be recoverable, management would then estimate the expected future cash flows attributable to the use and future disposal of the asset. The sum of these flows, undiscounted and without interest charges, would be used as the measurement base for comparison to the carrying value of the asset. If this sum is less than the carrying value, an impairment would be deemed to exist and an impairment loss would be measured and recognized. Restoration of recognized impairment losses upon subsequent increases in fair value would be prohibited.

The amount of loss to be recognized would be the difference between the asset's carrying amount and its fair value. According to FASB Statement No. 15, the fair value of an asset is measured by its market value if an active market exists for the asset. If no market exists for this asset, then market values of similar assets may be used. If none are available, a forecast of expected cash flows may be used, provided these flows are discounted at a rate commensurate with the risk involved.

For purposes of forecasting the sum of expected future cash flows, the Board requires that assets be grouped at the lowest level for which there are identifiable cash flows that are independent of cash flows from other asset groups. Assets need to be grouped only when they are used together to produce joint cash flows.

Although the original impairment project did not address goodwill, the Board, after considering comments received in response to the Discussion Memorandum, added goodwill to the extent that it is associated with long-term assets. The Board concluded that if assets have associated goodwill due to a business combination recorded under the purchase method, then goodwill should be allocated to these assets for purposes of testing for recoverability and for measuring the amount of the impairment loss. Goodwill would be allocated on a pro rata basis using the fair value of the assets at the point of acquisition. If the recognition test indicates that an impairment exists, the goodwill should be eliminated before reducing the assets to their fair value.

With regard to display and disclosure, the Board concluded that the impairment be shown as part of the expenses and losses that make up income from continuing operations. Required disclosures would include a description of the impaired assets, the segments affected, the amount of impairment loss, the circumstances of the impairment, as well as how fair value was determined. If fair value was determined using the present value of future cash flows, the discount rate must be disclosed.

The proposed Statement would apply to long-lived assets, identifiable intangibles and goodwill; it would not apply to financial instruments, software (Statement 86) and leases (Statement 13).

Figure 1 graphically summarizes the Board's conclusions with regard to all the impairment issues.

Additional Areas of Discussion

The Board has identified several areas in which it would like to receive comments regarding the proposed Statement. These areas are:

* Are there other impairment indicators besides the ones mentioned that should trigger a measurement of an asset's recoverability?

The proposed Statement requires recognition of impairment if the sum of undiscounted future cash flows is less than the carrying value of the asset. Is this an appropriate approach? Would some other approach be more appropriate?

* According to the proposed Statement, the impairment loss is measured by the difference between the asset's carrying value and its fair value. Is there a better measurement approach?

* Is it appropriate that restoration of previous impairment losses be prohibited? Should restoration perhaps be required, or at least permitted?

* The proposed Statement requires certain disclosures regarding the impairment, as discussed above. Should additional disclosures be required?

* According to the proposed Statement, no early warning disclosures of future possible impairments are necessary. Is this appropriate? If not, what disclosures should be required and what criteria would determine when to make them?

* The proposed Statement would apply to all entities, including not-for-profit organizations. Is there any reason to exclude any type of entity from the provisions of this Statement? If yes, which ones and why?

* The proposed Statement would be effective for impairments that occur in fiscal years beginning after December 15, 1994. Does this date provide sufficient time to enable entities to apply the provisions of the Statement? Is there a need for transition provisions? Should retroactive application be required?

Footnotes

1 Zucca, Linda J. and Campbell, David R., "A Closer Look at Writedowns of impaired Assets," Accounting Horizons, September 1992.

2 FASB Discussion Memorandum, "Accounting For the Impairment of Long-Lived Assets and Identifiable Intangibles," December 7, 1990.

3 Braun, Stephen and Rohan, Paul, "Asset Write-Offs: A Matter of Grouping?," Journal of Accountancy, April 1991.

4 FASB Project Outline, "Impairment of Assets," October 1993.

5. Ibid.

NOTE

A final statement on this exposure draft was expected by the fourth quarter of 1994. Unfortunately, it had not yet been released by press time. NSPA will report on it as soon as it becomes available.

Joel Hochman, JD, MBA, CPA is a professor at Hofstra University.

Martin Kiss, MBA, CPA, is a professor at Queensboro Community College.