The practitioner's role in accounting for asset impairments.

In December 1994, the Financial Accounting Standards Board (FASB) issued Statement of Financial Accounting Standards (SFAS) No. 121, Accounting for the Impairment of Long-Lived Assets and for Long-Lived Assets to Be Disposed Of. This Statement was the result of many years' discussion by the FASB and other professional accounting associations, including the Emerging Issues Task Force, the Financial Accounting Standards Advisory Council, the Financial Executives Institute and the Institute of Management Accountants. SFAS No. 121 is effective for all financial statements for all entities (except where specifically excluded in Appendix B of the Statement) for fiscal years beginning after December 31, 1995. Earlier application of the Statement is encouraged, but restatement of previously issued financial statements is not permitted.

In applying SFAS No. 121, estimates of future cash inflows and fair value of assets are required. These estimates can provide a fertile ground for possible management manipulation and litigation after the fact by the investor/creditor community. Disagreements between management and accountants can arise when management does not want to recognize an asset impairment loss but the accountant believes it necessary, or when management desires a write-off but the auditor does not believe it is justified under SFAS No. 121. This article reviews the assumptions required under SFAS No. 121 and suggests techniques practitioners should follow in assessing the reasonableness of management's assumptions and projections. In this litigious age, practitioners could be sued for an excessive write-off or for the lack of a sufficient asset impairment write-off. Therefore, ignoring SFAS No. 121 clearly is not a viable alternative for the practitioner.

Basic Provisions of SFAS No. 121

Essentially, SFAS No. 121 requires companies to estimate the future cash inflows expected to result from the use of an asset (or a group of assets), if events or changes in circumstances indicate that the carrying amount of the asset(s) may not be recoverable. The carrying value of the asset(s) is considered not recoverable (and thus the asset[s] is considered impaired) when the sum of the expected future cash inflows (undiscounted and without interest charges) is less than the asset's carrying value. The asset's carrying value should then be written down to fair value and an asset impairment loss recognized for the difference. Fair value of the asset is the amount at which the asset could be bought or sold in a current transaction between willing parties. The reduced carrying value of the asset becomes its new cost basis, and restoration of previously recognized impairment losses is prohibited. The. accounting for long-lived impaired assets to be held is much the same as the lower-of-cost-or-market method for inventories.

The indicators in SFAS No. 121 that would trigger a company to assess whether or not there is an asset impairment are:

a. A significant decrease in the market value of an asset;

b. A significant change in the extent or manner in which an asset is used or a significant physical change in an asset;

c. A significant adverse change in legal factors or in the business climate that could affect the value of an asset or an adverse action or assessment by a regulator;

d. An accumulation of costs significantly in excess of the amount originally expected to acquire or construct an asset;

e. 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 an asset used for the purpose of producing revenue.

All long-lived assets to be disposed of that are not covered under 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, should be reported at the lower of carrying amount or fair value less cost to sell. These assets are not to be depreciated (amortized) while they are held for disposal. Similar to trading securities under SFAS No. 115, Accounting for Certain Investments in Debt and Equity Securities, gains or losses from revaluations of long-lived assets to be disposed of are included as a component of income from continuing operations. Contrary to SFAS No. 115, however, subsequent revisions in estimates of fair value less cost to sell are limited to the amount of previously recognized losses; that is, the revised carrying amount of the asset cannot exceed the original carrying value prior to applying the provisions of SFAS No. 121.

Determining Future Cash Flows and Fair Values

SFAS No. 121 grants significant flexibility to management in determining the asset's future cash inflows. To assess future cash inflows, management must first group assets at the lowest level for which there are identifiable cash flows that are largely independent of the cash flows of other groups of assets. Management must then determine the best estimate of future cash inflows based on reasonable and supportable assumptions and projections, considering all available evidence and the likelihood of possible outcomes for ranges of possible cash values. If management determines that the asset is impaired because the asset's future cash inflows are less than the asset's carrying value, further estimates are involved in determining its fair value. Fair value shall be determined by quoted market prices in active markets, if available. Otherwise, management can assess fair value using prices for similar assets or other valuation techniques, including the present value of expected future cash flows, option-pricing models, matrix pricing, option-adjusted spread models, and fundamental analysis.

Financial Statement Implications

SFAS No. 121 will probably be cherished by some companies and frowned upon by others. Most companies have already decided whether they favor current as opposed to future loss recognitions. Consequently, accountants must be aware of management biases when determining whether an asset impairment is justified (for those companies favoring asset write-offs) or required (for those companies opposing asset impairment losses).

Many companies may want to take an asset impairment loss. An asset impairment loss is frequently deeemed as a signal to shareholders that management is aware of the situation and is taking steps to correct the problem. Moreover, asset impairment losses are noncash charges. Although shareholders usually do not like losses, their recognition is frequently viewed positively. The tendency of management to favor current loss recognition so the prospects of future profits are more favorable (as future charges against revenues equal to the amount of the writedown will not be required) is known as the "big bath" theory. SFAS No. 121 is consistent with that theory since it allows management to position the company for future profits as the future will not have to absorb this loss. For example, PepsiCo, Inc., in its 1995 annual report, took a $520 million pretax charge, mostly related to its Taco Bell, Pizza Hut and KFC restaurants. Despite writing off 7% of their long-lived assets as impaired, these restaurants, according to Wayne Calloway, PepsiCo's chairman, had a good year and a "dramatic" improvement in their cash flows. This write-off had no cash impact, but since the carrying value of those assets are now less, future depreciation will decrease. It, in essence, "gives companies [like PepsiCo] a blueprint for creating future earnings," according to Bear Stearns' Pat McConnell (Lowenstein, 1996). And according to Dennis Beresford, FASB's Chairman, SFAS No. 121 "will make it more difficult to understand the quality of earnings."

Justification for An Asset Impairment Loss

Clearly, SFAS No. 121 provides the possibility for management manipulation of income and for misunderstanding by the investor/creditor community. The significant estimates involved in determining both future cash inflows and fair values of assets and how those assets should be grouped together are areas of concern to accountants. Moreover, management biases favoring or opposing asset write-offs should be assessed to determine the likelihood of management voluntarily following the provisions of SFAS No. 121.

SFAS No. 121 essentially entails a three step process: 1) reviewing long-lived assets and certain identifiable intangibles to be held and used for impairment whenever events or changes in circumstances indicate that the carrying amount of an asset may not be recoverable; 2) determining if an asset is impaired by computing whether its carrying value exceeds its future cash inflows; and 3) recognizing an impairment loss at the amount by which the carrying amount of the asset exceeds the fair value of the asset. Accountants must be involved in all three steps to ensure that the provisions of SFAS No. 121 are faithfully followed and to limit liability exposure.

Identification of Possible Asset Impairments

In addressing the first step, in SFAS No. 121 the FASB provides five examples, discussed earlier, of events or changes in circumstances that may indicate that the carrying amount of an asset may not be recoverable. These five events or changes in circumstances are to serve as examples of possible asset impairment rather than constituting a complete list of possible scenarios. The FASB believes that management has the responsibility to determine if an asset is impaired but to test each asset each period would not be cost effective. Consequently, accountants must be familiar with the company's business, real estate trends, and the greater business, legal and regulatory environment when assessing whether any of the five examples are present for a particular company.

For example, knowledge of the real estate market is needed to assess whether a significant decrease in the market value of an asset has occurred. Regulatory, legal and environmental knowledge is needed to determine whether any changes in legal or regulatory factors may significantly affect the value of an asset. Knowledge of the company's internal business operations is needed to identify:

a) any significant changes in the extent or manner in which an asset is used or a physical change in the asset,

b) an accumulation of costs significantly above those expected to acquire or construct an asset, and

c) current period operating or cash flow losses combined with a history of operating or cash flow losses or a projection or forecast that demonstrates continuing losses associated with an asset used for the purpose of producing revenue.

The five examples that should trigger an investigation of asset impairment in SFAS No. 121 require accountants to be fully aware of both internal company business operations and the greater business, legal and regulatory environment that impact a company's assets and operating results. This knowledge is especially critical for companies whose managements are opposed to asset impairment losses and reluctant to determine whether any of the five examples are present.

Testing for Asset Impairment

When management believes, either independently or with the help of the accountant, that conditions are present for a possible asset impairment, estimates of cash inflows are required to determine whether or not an actual impairment exists. That is, an impairment loss exists whenever the sum of the expected future cash flows (undiscounted and without interest charges), resulting from the use and ultimate disposal of an asset, is less than the carrying amount of the asset. Unfortunately, these future cash flow estimates can be tenuous. Managements desiring asset impairment losses may be overly pessimistic in their cash flow projections while those opposing impairment losses may be overly optimistic. The accountant must act as an independent referee in assessing management's estimates of future cash inflows from using and disposing of an asset.

Acting as the referee, accountants should initially review management's grouping of assets for impairment consideration. SFAS No. 121 requires that assets be grouped at the lowest level for which there are identifiable cash flows that are largely independent of the cash flows generated by other asset groups. That is, assets should be grouped together when they are a part of a group of assets and are used together to generate joint cash flows. The accountant's review of management's grouping of assets must determine whether it meets two parameters: the assets are at the lowest level for which there are identifiable cash flows; and those cash flows are largely independent of the cash flows of other groupings of assets. Determining that lowest level, however, requires considerable judgement. For example, PepsiCo's restaurants as a group were worth more than their carrying value. However, when PepsiCo evaluated them on a restaurant-by-restaurant basis, a $520 million pretax charge resulted. PepsiCo conceded that a grouping of restaurants by region would have resulted in a smaller write-off. Given the wide latitude permissible, consistency in asset grouping - rather than the exact grouping - may be more critical.

Once the asset groupings are determined to be proper, the estimated cash inflows from those assets must be reviewed for reasonableness. Cash flow estimates can provide management even greater latitude than the initial asset groupings. Cash flow estimates require judgements and almost, by definition, have limited verifiability. Accountants could initially check management's cash flow estimates for reasonableness by determining a possible range of cash flow estimates, from the most pessimistic to the most optimistic. Management's estimated cash inflows should fall within that range and can enable the accountant to determine whether an appropriate number of asset impairments have been identified. Secondly, the accountant should investigate whether management has maintained adequate documentation of its assumptions, projections and estimates. Finally, accountants should insist on a neutral third party evaluation and opinion on the reasonableness of management's projected cash flow estimates if the asset impairment loss results in a material financial statement loss.

Measuring the Impairment Loss

Once an asset impairment is identified, the amount of the impairment loss must be determined. In evaluating management's impairment loss determination, accountants should initially investigate whether fair value was determined by quoted market prices in active markets, since these prices, according to SFAS No. 121, are the best evidence of fair value and should be used as the basis for measurement, if available. If other measures of fair value are used, management should adequately document that quoted market prices in active markets are not available. If other valuation methods are used in determining fair values, accountants should verify that those methods are properly determined and consider prices for similar assets. If the present value of expected future cash flows is used to determine fair value, the rate used should be verified to determine whether it is commensurate with the risks involved. Finally, a working knowledge of alternative valuation techniques, such as option - pricing models, matrix pricing, option - adjusted spread sheets and fundamental analysis, may be needed. Exhibit 1 is provided as a guide for implementing SFAS No. 121.

In summation, SFAS No. 121 allows entities significant latitude both in determining whether an asset impairment exists and the determination of that impairment loss. This latitude can enable management to"cleanup" the balance sheet through write-downs of unproductive, aging, ill-attended, or contaminated assets and position the company for future profits. From the accountant's standpoint, however, SFAS No. 121's flexibility can cause frictions. The accountant must determine whether management has faithfully recognized and measured these impairment losses. And with the latitude provided, that determination can be extremely difficult to defend. Clearly, accountants must scrutinize all assumptions, projections and estimates implicit in asset impairment losses and insist on adequate documentation. Third party opinions and reviews can be beneficial, especially if the asset impairment losses are material. Given the potential for litigation and second guessing by the investor/creditor community, the provisions of SFAS No. 121 must be fully followed in all engagements.

Exhibit 1: Guide to Recognizing Long-Lived Asset Impairments

Look for indicators of possible asset impairments such as:

1. A significant decrease in the market value of an asset.

2. A significant change in the extent or manner in which an asset is used or a significant physical change in an asset.

3. A significant adverse change in legal factors or in the business climate that could affect the value of an asset or an adverse action or assessment by a regulator.

4. An accumulation of costs significantly in excess of the amount originally expected to acquire or construct an asset.

5. 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 an asset used for the purpose of producing revenue.

Determine if an impairment has occurred:

1. Estimate the future undiscounted cash flows expected to result from the use of the asset and its eventual disposition.

In estimating the expected future cash flows the assets are to be grouped at the lowest level for which there are identifiable cash flows that are largely independent of the cash flows of other groups of assets.

2. Compare the total undiscounted cash inflows with the carrying value of the asset. If the sum of the estimated cash inflows is less than the carrying value of the asset the entity should recognize an impairment loss.

Measure the amount of the impairment:

To calculate the amount of the asset impairment loss, the accountant must:

1. Estimate the fair market value of the impaired asset. The fair value is the market value of the asset. If there is no active market, other asset valuation methods such as the present value of the expected future net cash flows, are to be used.

2. The impairment loss is the excess of the carrying value over the fair market value of the asset.

References

Statement of Financial Accounting Standards No. 121, Accounting for the Impairment of Long-Lived Assets and for Long-Lived Assets to Be Disposed Of. Financial Accounting Standards Board, 1994.

Lowenstein, Roger, "Earnings Not Always What They Seem," The Wall Street Journal, Feb. 15, 1996.