The Challenge of Business Impairment Testing
Jonathen D. Scalzitti, CPA, Cecilia Kao, CPA, and Ryan Dolan, CPA
3.8.21 | Industry Insights
Among the many detrimental consequences of COVID-19 were business and production disruptions, supply chain interruptions, negative impacts on customers, volatility in the equity and debt markets, reduced revenue and cash flows, among other economic consequences. COVID-19 has also caused a significant deterioration in economic conditions for many companies, and an increase in economic uncertainty for others, all of which may constitute impairment triggering events. The real estate industry, in particular, has been tremendously impacted – hospitality, retail, office, and restaurants are among the industry segments hit hardest during the pandemic. As a result of the current economic conditions, many predominant real estate groups are facing write down values of their real estate assets, which may result in noncash impairment charges in current and future periods, where the impact could be material. Companies that prepare financial statements using accounting principles generally accepted in the U.S. (GAAP) must evaluate whether there has been an impairment of their real estate and other long-lived assets and, if so, record an impairment charge in earnings.
What Is an Impairment Test?
When triggering events develop, such as those associated with the COVID-19 pandemic, impairment testing may need to be performed. An impairment test is an accounting test to determine whether the economic benefits that the asset embodies have materially decreased. When is an asset considered impaired? The regulations are complex, but the fundamentals are relatively easy to understand. Assets are considered impaired when the book value, or net carrying value of the asset, exceeds its expected future cash flows or fair value. The general threshold for impairment, as described under GAAP, is a lack of recoverability of the net carrying amount. FASB ASC 360-10-35-17 states that an impairment loss should be recognized only if the carrying amount is not recoverable and exceeds fair value. The carrying amount is considered not recoverable if it exceeds the sum of the undiscounted cash flows from the use and eventual disposal (sale) of the asset. If the fair value is less than the carrying value, the asset is deemed impaired and must be charged off or written down. This charge reduces the value of the assets to the fair market value and represents a “mark-to-market” charge.
Cash flow forecasts (typically over 10 years) generated by businesses should be reassessed and updated to reflect the impact of COVID-19. This will be challenging due to the increased economic uncertainty, but the projected cash flows are critical to determining whether asset impairment has occurred. Similar GAAP concepts require other assets to be assessed for impairment, such as, intangibles, goodwill, and investments or potential adjustments for allowances, such as accounts receivable and inventory.
Determining Asset Groups
To determine whether there are triggering events or other key indicators, the entity first needs to determine asset groups that could be subject to impairment. An “asset group” is the grouping of assets and liabilities that represents the lowest level of identifiable cash flows that are largely independent of the cash flows of other groups of assets and liabilities (ASC 360-10-35-23). This is judgmental and will depend on the specific facts and circumstances of the entity. In the case of a rental real estate entity, this would generally include land, building, and improvements.
In certain limited situations, a long-lived asset (such as a corporate headquarters) may not have identifiable cash flows that are largely independent of the cash flows of any other asset groups, in which case the asset group for that long-lived asset would include all assets and liabilities of the entity (ASC 360-10-35-24).
After the asset group is determined, the entity should determine whether events or changes in circumstances indicate that the asset group’s carrying amount may not be recoverable. Examples of these impairment indicators include, but are not limited to:
- A significant decrease in the market price of a long-lived asset (asset group);
- A significant adverse change in the extent or manner in which a long-lived asset (asset group) is being used or in its physical condition;
- A significant adverse change in legal factors or in the business climate that could affect the value of a long-lived asset (asset group), including:
- An adverse action or assessment by a regulator;
- An accumulation of costs significantly in excess of the amount originally expected for the acquisition or construction of a long-lived asset (asset group); or
- 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 the use of a long-lived asset (asset group).
Impairment indicators in the current environment include consequences of the COVID-19 pandemic, which have potentially impacted asset valuation, effects of geographic concentration, governmental and political factors, decline in operating activity, downturn in markets, along with extreme volatility, or reduced/idle production levels.
If it is determined that impairment indicators are present, companies should perform a recoverability test. Such a test is performed by comparing the sum of the estimated undiscounted future cash flows attributable to the asset group from its operations and disposal to its carrying amount. The undiscounted cash flows used should include future cash flows directly associated with and that are expected to arise as a direct result of the use of the asset group and its eventual disposition. It generally should be determined on a pretax basis and exclude cash outflows for interest expense. Cash flow estimates should be generated based on the entity’s intended use of the asset group and its existing service potential or capacity (exclusive of additional capital expenditures to increase capacity). Capital expenditures to maintain existing service potential or capacity should be included. As mentioned earlier, any existing cash flow projections should be fully reassessed if the entity’s operations have been impacted due to COVID-19. If the carrying amount of the asset group is not recoverable, an impairment loss should be measured based on the excess of the carrying amount of the asset group over its fair value.
Testing in the Appropriate Order
It is also important to note that impairment testing should be performed in the appropriate order. Consistent with FASB ASC 360-10-35-27, impairment testing should be performed as follows:
- Adjust the carrying amounts of any assets (such as accounts receivable and inventory) and liabilities (such as accounts payable, long-term debt, and asset retirement obligations) not covered by FASB ASC 360-10 that are included in an asset group in accordance with other applicable GAAP.
- Test for impairment and adjust carrying amounts of indefinite-lived intangible assets that are included in an asset group under FASB ASC 350-30.
- Test long-lived assets (asset group), such as real estate and amortizable intangible assets, under FASB ASC 360-10.
- Test goodwill of a reporting unit (or for private companies, an entity) that includes the aforementioned assets under FASB ASC 350-20.
How to Recognize an Impairment Loss
If an asset is deemed to be impaired, the impairment loss is equal to the difference between the net carrying amount and the fair value of the asset, which is reported as part of operating income while reducing the carrying amount of the asset. Impairment loss should reduce only the carrying amounts of the long-lived assets of the asset group, excluding goodwill and indefinite-lived intangibles. The loss should be allocated to the long-lived assets of the group on a pro-rata basis using the relative carrying amounts of those assets and should not reduce the carrying amount of those assets below their fair value. The carrying amount of the long-lived asset, after allocating impairment loss, is depreciated over the remaining useful life of that asset. Once the asset’s net carrying amount is adjusted for impairment loss, the entity is not permitted to write up the value of the long-lived assets in the future, even if circumstances change.
Considerations/Impacts in Impairment Testing
As impairment testing is a requirement under GAAP, it could create some future issues for companies that require write-down of impaired assets. When performing impairment testing, management should carefully consider interpreting the impairment test results and analyze the underlying business model in determining if a company has impaired assets. Budgeting and modeling that are not performed correctly could result in inaccurate results. Certain components of impairment testing are subjective; assets that are potentially performing well and generating sufficient cash flows may be considered impaired if these considerations are not taken into account.
Potential impacts to consider when recording an impairment loss include debt covenant ratio violations, impact on future operations, and the inability to write up the asset when conditions improve.
Questions? If we have raised questions relating to your particular business, contact Jonathen Scalzitti at 212.331.7579 | firstname.lastname@example.org.
Berdon LLP New York Accountants