Living with SFAS 121: how to avoid (or record) an asset writedown.
This article outlines the portions of SFAS 121 in which management has the ability to select and apply certain assumptions. First, the provisions of SFAS 121 which apply to assets held for use are summarized. Then, interpretations of these provisions that enable management to formulate strategies to avoid or record writedowns are explored.
Applying SFAS 121
SFAS 121 defines impairment as the firm's inability to recover the carrying value of an asset or group of assets. The process of identifying, testing, computing and recording an asset impairment writedown is specified in the statement.
An event must have occurred or a condition must exist that would cause the firm to consider that a particular asset may have experienced a decline in value. The FASB provides a listing of indicators that serve as examples of the types of events and conditions which might be indicative of a negative value change:
a. A significant decrease in the market value of the 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 (SFAS 121, ?? 5).
The FASB's purpose in providing this list of indicators was to identify long term or permanent value changes that are significant to the asset or its use within the firm. If one or more of these or similar events [TABULAR DATA FOR TABLE 1 OMITTED] occur, the firm should test for asset impairment.
The test for impairment presents a high threshold for loss recognition. An impairment loss will be recorded only if the sum of future cash flows from the asset is less than its carrying value. If this condition exists and the asset is still being held for use by the firm, management has made a decision (even though it may not be a conscious one) to continue to use the asset when they cannot recover cost. The FASB views this decision to use the impaired asset as being equivalent to a purchase decision. A new cost basis is established for the asset - fair value at the date of the impairment recognition. If the threshold test (carrying value exceeding the sum of future cash flows from the asset) is not met, no impairment loss may be recorded even though events have occurred that might suggest some impairment is possible.
The new cost basis of the impaired asset is its fair value on the date the impairment is recognized. This fair value is determined first by reference to quoted market prices, recent sales of similar assets, or by calculations of the present value of future cash flows or other models if the market values are not available or reliable. Since the fair value represents a new cost basis, no subsequent recoveries are permitted. The asset may be re-evaluated in the future, however, if it becomes apparent that additional impairment may have occurred.
SFAS 121 Adoption Strategies
The selection of assumptions as well as the business environment facing the firm may result in differential impacts of adopting SFAS 121. There are at least four areas of SFAS 121 and the related literature where the application is subject to the judgment and assumptions of management: (1) the definition of impairment indicators, (2) the estimation of future cash flows from the use of the asset, (3) the asset grouping level at which testing and measurement occur, and (4) the depreciation methods chosen for the asset. By carefully considering each of these areas, it is possible to formulate a strategy to manage the frequency with which asset impairment writedowns are recorded. These strategies are summarized in Table 1.
Definition of Impairment Indicators
The list of impairment indicators provided by the FASB is informative, but not all - inclusive. In fact, the list is sufficiently vague to allow some latitude in its application. A broad interpretation of the list could allow nearly any change in situation to be considered a possible indicator of impairment, including the mandatory adoption of SFAS 121 itself. On the other hand, a strict reading of the list would limit testing situations to those that arose because of major internal or external environmental changes. Thus, within some constraints such as consistency, management could define the indicators within a broad range.
Estimation of Future Cash Flows
Estimates of future cash flows are used to determine if an impairment loss may be recorded. They may also be used for the determination of fair value if market values are either not available or unreliable.
Theoretically, an estimate of future cash flows from an asset represents a range of possibilities and an accompanying probability distribution for each period, thus requiring estimates of the amount, timing and probability of each cash flow. If the estimates are conservative (i.e., assessing a higher probability to lower cash flow estimates), a determination of impairment is more likely. On the other hand, if estimates are optimistic (i.e., assessing a higher probability to higher cash flow estimates), a writedown is less likely.
The timing of the cash flows is irrelevant to the threshold calculation. However, once the existence of a recognizable impairment loss has been established, the timing of the cash flows becomes important if fair value is to be measured by the present value of future cash flows. The closer the cash flows are to the measurement date, the lower the recordable loss. Similarly, the farther into the future the cash flows are from the measurement date, the larger the recordable loss.
Asset Grouping Levels
If singular assets do not produce separate, identifiable cash flows, then those assets should be tested and measured for impairment as a group. SFAS 121 indicates that ". . . assets should be grouped when they are used together; that is, when they are part of the same group of assets and are used together to generate joint cash flows" (SFAS 121, ?? 95). When assets are grouped at any level, unrecognized appreciation and impairments will offset.
Generally, grouping assets at the lowest possible level will result in the recognition of more impairment losses than if the assets were grouped at higher levels because of offsetting unrealized gains and losses. At the extremes, the evaluation of single assets will yield the greatest number of impairment losses while considering the entity as the appropriate grouping level will result in the least number of impairment losses.
Selection of Depreciation Method
Although SFAS 121 does not specifically address the selection of depreciation methods and assumptions, their selection provides an opportunity to avoid or record future impairment losses. For the same asset, the use of straight line depreciation, higher salvage values or longer useful lives will result in higher carrying values and thus increased probability of recognizable impairment losses. Alternatively, the use of accelerated depreciation methods, lower or no salvage values, or shorter useful lives will decrease the frequency of impairment losses.
Table 2 illustrates the impact of the depreciation method choice on the recognition of an impairment as well as the amount of the loss. Here, an impairment loss would be recognized only in the situation where the straight line depreciation method is used, since that is the only situation where the carrying value exceeds the sum of future cash flows. In all other cases, the carrying value does not exceed the sum of future cash flows even though the fair value of the asset is substantially below carrying value.
Although SFAS 121 has provided some much-needed guidance for situations involving impaired assets and resulting loss recognition, many of its provisions allow the use of management judgment in estimating and applying the rules. Initially, this latitude in the provisions may allow firms to manage asset impairment losses. However, as the assumptions and judgments are applied consistently, variation among firms will be considerably reduced, thus fulfilling the FASB's goals in the issuance of SFAS 121.
Table 2 Example of Impact of Depreciation Method on Impairment Recognition ABC Corporation has set up a division to operate with a single asset. This division was established on January 1, 19X1 when the Division purchased its only asset for $1,200,000, financing it entirely by 6% debt. INITIAL INVESTMENT DECISION DATA, l/l/X1 Purchase price $1,200,000 Estimated useful life 6 years Estimated salvage value none Annual cash inflows $268,000 Hurdle rate (approx. weighted average cost of capital) 8% Present value of cash inflows $1,238,900 Net present value $38,900 Internal Rate of Return 9% DATA ON XYZ'S ASSET AT DECEMBER 31, 19X1 Annual cash inflows $180,000 Total cash inflows over the remaining asset life (5 yrs) $900,000 Fair market value of asset $700,000 Present value of future cash flows at an 8% hurdle rate $718,688 VALUES OF XYZ'S IMPAIRED ASSET AT DECEMBER 31, 19X1 USING DIFFERENT DEPRECIATION METHODS Straight 200% Declining 150% Declining Sum of the Line Balance Balance Years Digits CV + 1,000,000 FCF+900,000 FCF + 900,000 CV = FCF + 900,000 FCF + 900,000 CV + 847,143 CV+800,000 FV + 700,000 FV + 700,000 FV + 700,000 FV + 700,000 CV = Carrying Value (Cost less accumulated depreciation) FCF = Undiscounted future cash flows FV = Fair Value
1. SFAS 121 is effective for fiscal years beginning after December 15, 1995, although early adoption is encouraged.
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|Title Annotation:||Statement of Financial Accounting Standards 121: 'Accounting for the Impairment of Long-Lived Assets to be Disposed Of'|
|Author:||Zucca, Linda J.|
|Publication:||The National Public Accountant|
|Date:||Sep 1, 1997|
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