Auditing considerations of FASB 121.
When the Financial Accounting Standards Board issues a new pronouncement, not only must companies deal with implementation issues but also auditors must decide how they will evaluate management's compliance with its provisions. Statement no. 121, Accounting for the Impairment of Long-Lived Assets and for Long-Lived Assets to Be Disposed Of, is no exception. Issued in March 1995, Statement no. 121 applies to (1) long-lived assets, certain identifiable intangibles and goodwill related to those assets to be held and used and (2) long-lived assets and certain identifiable intangibles to be disposed of.
There are important differences in accounting for each asset class, making it important to determine whether assets are to be held and used or disposed or. However, this is not always clear-cut. For example, it may be difficult to decide if there is a commitment to sell an asset an entity uses now but plans to sell later. To be considered an asset to be disposed of, management should be committed to disposing of it and marketing it actively (if disposal is by sale). Auditors should examine corporate minutes and other evidence of this commitment. Other assets should be treated as assets to be held and used.
Although management is responsible for considering whether an asset is impaired, testing assets each period is too costly. Rather, Statement no. 121 requires impairment testing of assets to be held and used only when events or circumstances indicate carrying amounts may not be recoverable. The statement lists some indicators; others are suggested by Statement on Auditing Standards no. 59, The Auditor's Consideration of an Entity's Ability to Continue as a Going Concern, and illustrated in exhibit 1, page 72.
Management should implement policies and procedures to identify these and other possible impairment indicators based on a company's operating environment. Otherwise, an impairment may not be identified in a timely manner.
If there are no such indicators, impairment testing is not required and audit testing need not be extensive. If a company is historically very profitable, the auditor may assume future profitability absent facts to the contrary. In this situation, an auditor normally documents that he or she is relying on expected future income and concludes impairment testing is unnecessary. Reviewing a budget, cash flow analysis or forecast of future income normally would not be required.
If events or circumstances indicate the carrying amount of an asset to be held and used may not be recoverable, management should test for impairment by estimating future cash flows from its use and eventual disposal. If the carrying amount exceeds undiscounted cash flows, an impairment loss equal to the difference between the carrying amount and the asset's estimated fair value is recognized. If cash flows exceed the carrying amount, the asset is not impaired and no loss is recognized. However, it may be appropriate to review depreciation policies.
ESTIMATING FUTURE CASH FLOWS
Expected future cash flows should be management's best estimates based on reasonable and supportable assumptions and projections. All available evidence should be considered. The weight given to evidence should be commensurate with the extent to which it can be verified objectively. Consistent with the American Institute of CPAs Audit and Accounting Guide Guide for Prospective Financial Information, impairment testing should be based on forecasts, not projections, because cash flow estimates should reflect an entity's actual, not hypothetical, expectations.
Statement no. 121 prescribes no specific estimation techniques. Different ones are available and new ones may be developed in the future. Probabilistic estimates may be used. Each company should choose techniques that best fit its situation. Most already estimate cash flows for budgeting and planning purposes. Estimating them for impairment testing is similar. (See exhibit 2, page 74, for an example of using estimation techniques to determine iran impairment loss should be recognized.)
Statement no. 121 does not prescribe how many years cash flows should be estimated. For a depreciable asset, the presumption is that the period equals the asset's remaining depreciable life and should not exceed remaining useful life. Auditors should review and document management's reasons for assigning a useful life longer or shorter than remaining depreciable life.
Few forecasts are reasonably objective beyond several years, whereas remaining depreciable life of long-lived assets often exceeds the forecast period auditors may report on under Guide for Prospective Financial Information. Estimating cash flows for 5 to 10 years including a residual value may be preferable to using estimates for more than 10 years.
OTHER CRITICAL FACTORS
To achieve consistency across entities with different debt capacities, Statement no. 121 excludes interest from undiscounted future cash flows when determining asset recoverability. Interest may be included in discounted future cash flows when estimating asset fair value. Income taxes may be included in cash flow estimates when reasonably allocable to assets on a consistent basis; depreciation-amortization tax deductions and available tax credits also should be considered.
Otherwise, Statement no. 121 does not indicate which costs should be included or excluded from cash flow' estimates. The analysis is similar to capital budgeting and should consider all incremental cash flows--recurring and nonrecurring. For example, if equipment requires a major overhaul every five years, the cost should be included if cash flows are estimated beyond that point. The statement does not prescribe how price and volume levels factor into estimated future cash flows.
WEIGHING THE EVIDENCE
As the weight of evidence indicating impairment increases, the amount of evidential matter and extent of audit testing also increases. Management's analysis of future cash flows should identify all major underlying assumptions and be sufficiently detailed to support its completeness. The more formal an entity's analysis and the more closely it conforms to the guidance for a financial forecast, the more weight it may be given. Independent third-party assessments of the company and the industry should be considered. If a company is publicly held, auditors should read reports prepared by external financial analysts.
Regardless of how formal an entity's analysis of future cash flows, auditors should consider management's objectivity and expertise in preparing the analysis and the reasonableness of previous ones. Analyses are more reliable for companies in relatively stable industries with mature product lines and consistent operating histories than for those in emerging industries with untested technologies or products.
Auditors should make sure management's major assumptions underlying the analysis of future cash flows are adequately supported and documented as to rationale and reasonableness. SAS no. 57, Auditing Accounting Estimates, should be considered. It requires auditors to use one or a combination of these approaches to evaluate management's estimates:
* Review and test the process used to develop the estimates.
* Develop an independent expectation to corroborate the reasonableness of the estimates.
* Review subsequent events or transactions occurring before completion of fieldwork.
Auditors should pay particular attention to assumptions that are sensitive to change or inconsistent with historical trends. If estimated cash flows approximate asset carrying amounts, small changes might obviate or necessitate large write--downs, making more detailed analyses necessary to provide sufficient evidence as to recoverability.
The auditor's considerations should be based on knowledge of the entity, its business and management. When reviewing cash flow estimates, auditors should ensure they have the expertise to make critical assessments of the company's work. If necessary, they should contact industry experts or financial consultants specializing in valuation services.
Management has primary responsibility for estimating future cash flows. It is not appropriate for auditors to prepare the forecast. Doing so may impair independence. Management should acknowledge its responsibility in its representation letter.
In estimating future cash flows, assets should be grouped at the lowest level for which there are identifiable cash flows largely independent of other assets. Assets should be grouped when they are used together to generate joint cash flows, consistent with the way management operates the assets.
Determining the lowest level of grouping requires considerable judgment. Grouping assets is situation specific and should be evaluated on a case-by-case basis. As groups become broader, more judgment is involved and the opportunity- is greater to combine assets with fair values in excess of carrying amounts with those that are impaired. Auditors should consider this when evaluating the reasonableness of groupings. See exhibit 3, page 76, for an example of the effects of asset grouping. In limited circumstances, the impairment test is applied at the entity level because the asset being tested has no identifiable cash flows largely independent of other groupings.
When a group of assets is acquired as part of a purchase-type business combination, any related goodwill is included as part of the asset grouping. If only part of the acquired assets are being tested for impairment, some of the goodwill usually is allocated to those assets based on relative fair values of acquired long-lived assets and identifiable intangibles at acquisition.
Goodwill not related to acquired assets subject to Statement no. 121 is accounted for using Accounting Principles Board Opinion no. 17, Intangible Assets, which does not prescribe a method for measuring impairments. Accordingly, companies may use the cash flow method of Statement no. 121 but are not required to do so. The Securities and Exchange Commission staff expects registrants to continue disclosing the method for determining goodwill impairment.
DETERMINING FAIR VALUE
An asset's fair value is the amount it could be bought or sold at currently in a transaction between willing parties--other than in a forced or liquidation sale. Quoted market prices in active markets are the best evidence of fair value and should be used when available. Otherwise, estimates of fair value should be based on the best available information, such as prices for similar assets or the results of valuation techniques.
There may be practical problems to determining fair value absent quoted market prices. In some circumstances, the only information available without undue cost and effort is expected future cash flows from an asset's use. An acceptable valuation technique is the present value of estimated future cash flows using a discount rate commensurate with the risks involved in similar investments.
For an asset to be held and used, an impairment loss is measured as the excess of carrying amount over fair value-which becomes the new basis. If depreciable, the new basis is depreciated over the asset's remaining useful life. It is not adjusted later except for prospective changes in depreciation estimates and methods and for further impairment losses. Recognizing gain for subsequent recovery of fair value is prohibited.
EARLY WARNING DISCLOSURES
Even if events or circumstances do not indicate a potential impairment, disclosure may still be required under Statement of Position 94-6, Disclosure of Certain Significant Risks and Uncertainties. It requires financial statements to disclose that they are based on estimates and refers to examples of events or circumstances listed in Statement no. 121 as estimates particularly sensitive to change in the near term. Discussing these events or circumstances also may be important in management's discussion and analysis. But Statement no. 121 per se does not require early warning disclosures.
ASSETS TO BE DISPOSED OF
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, certain assets to be disposed of as part of a business segment disposal are measured at the lower of carrying amount or net realizable value. Statement no. 121 measures all other long-lived assets and certain identifiable intangibles to be disposed of at the lower of carrying amount or fair value less cost to sell, with an impairment loss recognized for the difference. Fair value less cost to sell becomes the new basis. Goodwill related to assets to be disposed of is accounted for under Opinion no. 17.
Cost to sell generally includes incremental direct costs to transact the asset sale, such as broker commissions, legal and title transfer fees and closing costs. Insurance, security services, utility expenses and other costs of protecting, maintaining and operating the asset generally are excluded. Exhibit 4, below, gives an example of an impairment loss on asset disposal.
Subsequent changes in fair value less cost to sell are reported by adjusting carrying amounts and recognizing gain or loss. Revised carrying amounts should not exceed original carrying amounts (acquisition cost or unamortized cost) before adjustments were made to reflect the disposal decision. Depreciation (amortization) is not recognized on assets to be disposed o
OTHER AUDITOR CONSIDERATIONS
Going concern issues. If the auditor's report includes an explanatory paragraph discussing substantial doubt about the enterprise's ability to continue as a going concern, the auditor should be especially sensitive to problems inherent in assessing recoverability of long-lived assets. Additionally, certain entities have asset impairment problems. For example, start-up operations, entities coming out of bankruptcy and development stage companies generally require assessments of recoverability of long-lived assets absent strong offsetting evidence such as substantial sales backlogs.
Disclosure. Statement no. 121 does not require disclosure of management's basis for not recording asset impairments, but such disclosures are important to financial statement readers' understanding of realization risk. Therefore, management should be encouraged to disclose this information.
Representation letter. Where applicable, the following items should be included in management's representation letter:
* Management's responsibility for the significant assumptions used in forecasting future cash flows.
* A statement that an asset impairment of $XXX against total assets of $XXX at the balance sheet date represents management's best estimate, based on the weight of available evidence as prescribed in Statement no. 121, or a positive statement that no asset impairment need be recognized.
Communication with audit committee. Because financial statements are particularly sensitive to certain accounting estimates, SAS no. 61, Communication With Audit Committees, directs auditors to ascertain that the audit committee is informed about how management formulated these estimates and the basis for the auditors' conclusions about their reasonableness. When forecasts of future cash flows are relied on to justify recognition or nonrecognition of asset impairments, the audit committee should be informed, preferably before the financial statements are issued.
DON'T WAIT UNTIL THE LAST MINUTE
Statement no. 121 is effective for fiscal years beginning after December 15, 1995, with earlier application encouraged. It requires enterprises to identify, events and circumstances that suggest long-lived asset impairments and frequently to estimate future cash flows. Accounting systems may need to be modified to identify such events and circumstances for every reporting date and to generate required cash flow estimates. These modifications take time to make. Management cannot wait to the last moment to make them and to assess the need to recognize impairments on an ongoing basis. Similarly, auditors cannot wait too long to evaluate management's assessments. The checklist on page 73 should be helpful to auditors in determining compliance with Statement no. 121.
This is the first year auditors will be concerned with FASB Statement no. 121. Its effective date is for fiscal years beginning after December 15, 1995.
EXHIBIT 1: Examples of Asset Impairment Indicators
* During the last year, competition heightened in a cruise line's three-day segment and passenger counts fell industrywide, Management lowers projections of future operating income and hence evaluates recoverability of long-lived assets.
* Due to the loss of a patent infringement lawsuit and increased competition in generic drugs, a pharmaceutical company reviews the recoverability of its long-lived assets, including items such as patents, acquired technology and related goodwill.
* A recently acquired subsidiary has unanticipated operating problems. After investigating, the parent company sues the acquired company's former shareholders for misrepresentations and withholding information about a federal investigation of its business practices. As a result, parent company management assesses recoverability of subsidiary assets.
* Due to a temporary decline in demand and a current period operating loss, a petroleum company suspends operating one of its refineries. As a result, management assesses recoverability of the idle unit and related crude oil pipelines.
* COMPANIES ARE IMPLEMENTING FASB statement no. 121, Accounting for the Impairment of Long--Lived Assets and for Long-Lived Assets to Be Disposed Off. As they do so, auditors must decide how they will evaluate management's compliance with its provisions.
* MANAGEMENT IS RESPONSIBLE FOR considering whether an asset is impaired, Since testing assets each period is too costly, Statement no. 121 requires impairment testing of assets to be held and used only when there are impairment indicators.
* IF IMPAIRMENT INDICATORS ARE FOUND in an asset to be held and used, management should test for impairment by estimating future cash flows from the asset's use and eventual disposal. If the carrying amount exceeds undiscounted cash flows, an impairment loss is recognized for the difference between the asset's carrying amount and its estimated fair value.
* EXPECTED FUTURE CASH FLOWS SHOULD be management's best estimates. Consistent with the American Institute of CPAs Audit and Accounting Guide Guide for Prospective Financial Information, impairment testing should be based on forecasts, not projections. Statement no. 121 does not prescribe specific estimation techniques.
* AUDITORS SHOULD MAKE SURE management's major assumptions underlying the analysis of future cash flows are adequately supported and documented. Statement on Auditing Standards no. 57, Auditing Accounting Estimates, should be considered. Auditors should pay particular attention to assumptions that are sensitive to change or inconsistent with historical trends.
HUGO NURNBERG, CPA, PhD, is professor of accountancy at Baruch College of the City University of New York. NELSON W. DITTMAR, JR., CPA, is accounting & SEC consulting partner of the national office of Coopers & Lybrand in New York City.
A Checklist for Auditors:
Determining Compliance with FASB 121
1. Discuss with management the policies and procedures that are in place to help identify indicators of asset impairments.
2. Determine whether events or circumstances have occurred that would require management to evaluate whether an asset is impaired. Some possible impairment indicators include
* A significant decrease in an asset's market value.
* A significant change in the manner in which an asset is used or a significant physical change in an asset,
* A significant adverse change in legal factors or in the business climate that could affect an asset's value or an adverse action or assessment by a regulator.
* An accumulation of costs significantly in excess of the amount originally expected to acquire or construct an asset.
* 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 that is used to produce revenue.
3. If there are no asset impairment indicators, document that fact and conclude that impairment testing is not necessary. Reviewing a budget, cash flow analysis or forecast of future income normally would not be required.
4. If events or circumstances indicate an asset's carrying amount may not be recoverable, examine management's test for impairment, which would include
* Reviewing management's estimates of expected cash flows.
* Determining that the major assumptions used in the underlying analysis are adequately supported and documented as to rationale and reasonableness.
* Developing an independent expectation to corroborate the estimate's reasonableness.
* Verifying that the time period used for future cash flows is reasonable when compared with the assets' remaining depreciable life.
* Determining that the cash flow estimates are at the lowest level for which there are identifiable cash flows.
* Considering any related goodwill that may be associated with assets being tested for impairment.
* Considering management's objectivity and expertise in preparing the analysis and the reasonableness of previous ones.
* Reviewing subsequent events or transactions occurring before completion of field work.
5. If the carrying amount of the asset being tested exceeds the estimated future cash flows in management's analysis, verify that an impairment loss equal to the difference between the carrying amount and the assets' estimated fair value is recognized. (If the cash flows exceed the carrying amount, the asset is not impaired and no loss is recognized.)
6. For assets held for sale, verify that they are recorded at the lower of carrying amount or fair value less cost to sell.
7. Examine corporate minutes and other evidence of management's commitment to dispose of assets.
8. Consider whether the evaluation of the carrying value of specific productive assets or segments also has implications for evaluating the entity as a going concern under SAS no. 59.
9. Verify that all required financial statement disclosures are made in accordance with FASB Statement no. 121 and SOP 94-6.
10. Obtain written representations from management acknowledging its responsibility for the significant assumptions used in forecasting future cash flows and that the amount of any recorded impairment represents management's best estimate or a positive statement that no asset impairment need be recognized.
Exhibit 2. REcognizing Impairment Losses
A clothing design company operates four retail stores dealing in children's, students', professional and leisure wear. Several years ago, the company acquired the leisure wear store for $25 million. The fair value of the acquired identifiable net assets was $20 million and, as a result, $5 million of goodwill was recorded.
In recent years, the company's leisure wear sales have declined steadily. As a result, management assesses recoverability of the remaining $18 million carrying value of the leisure wear store assets, including unamortized goodwill of $4 million. The fair value of the assets is $15 million. The company estimates future undiscounted cash flows between $15 million and $19 million with the following probabilities:
Probability Estimated adjusted estimated cash flows Probability cash flows $15,000,000 60% $9,000,000 17,000,000 30% 5,100,000 19,000,000 10% 1,900,000 Total 100% $16,000,000
Based on the above, the $16 million probability adjusted estimated undiscounted cash flow is less than the $18 million carrying amount of the assets. A $3 million impairment loss, equal to the $18 million carrying amount less the $15 million fair value, is recognized by writing down goodwill from $4 million to $1 million.
If the probability adjusted undiscounted cash flows were $19 million rather than $16 million and all other facts were unchanged, no impairment loss would be recognized, even though the $16 million fair value is less than the $18 million carrying amount.
Exhibit 3: Grouping Assets
Assume the same information for the leisure wear store in exhibit 2 and the additional information for children's, professional and students' wear stores, as follows:
Probability adjusted Identifiable estimated assets Carrying amount Fair value cash flows Leisure wear $18,000,000 $15,000,000 $16,000,000 Children's wear 15,000,000 16,000,000 18,000,000 Professional wear 19,000,000 17,000,000 18,000,000 Students' wear 17,000,000 19,000,000 20,000,000 Total $69,000,000 $67,000,000 $72,000,000
Each store has identifiable cash flows. Although sizable marketing and advertising expenses are incurred at the corporate level, these expenses may be allocated to each store and the other cash flows from each store are largely independent of those from the other stores. Therefore, the grouping should be at the store level. But if the stores are located in the same building and managed as one unit, grouping stores is appropriate because the cash flows would no longer be independent. Thus, the outcomes may be different.
At the store level. Projected cash flows are less than carrying amounts for the leisure and professional wear stores. Therefore, the leisure and professional stores would have $3 million and $2 million asset write-downs to fair values, respectively, with the proportionate share of goodwill written off first.
in the aggregate. The $72 million projected cash flows exceed the $69 million carrying amounts for all stores. Therefore, no impairment write-off is necessary.
Exhibit 4: Impairment Loss on Asset Disposals
A software distributor has local sales and service offices in major cities throughout the world. Management determines that many offices are serving customers outside their designated markets, overlapping other offices' designated markets. Management notes that one office could adequately service an entire country, enabling the company to reduce the number of local offices to one per country. As a result, management commits itself to consolidating by closing offices and selling assets of all closed offices within the year. These assets have a carrying value of $240 million and a fair value of $215 million. Costs to sell total $10 million, including broker commissions and legal fees; costs to operate the offices until disposal total $15 million.
Accordingly, the company records a $35 million impairment loss, equal to the excess of the $240 million carrying amount over the $205 million fair value less cost to sell ($215 million fair value less $10 million cost to sell). The $15 million future operating costs is excluded from costs to sell under Statement no. 121 unless contractually required.
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|Title Annotation:||impairment and disposal of long-lived assets|
|Author:||Dittmar, Nelson W., Jr.|
|Publication:||Journal of Accountancy|
|Date:||Jul 1, 1996|
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