Depending on your organization’s industry, the coronavirus pandemic may have significant impacts on 2020 financial reporting considerations. During this period of global uncertainty, whether an organization is large or small, public or private, the following may be topics for consideration:
- Analysis of future cash flows
- Re-evaluation of budget/forecast
- Sustaining operations
- Debt restructuring or application under federal relief programs (i.e. CARES Act)
- Impairments of long-lived assets
This article will discuss the impairment considerations for long-lived assets, with focus on lease assets under US GAAP and IFRS.
In accounting, an impairment loss occurs when the cash flows expected to be generated from an asset over its useful life can no longer support the carrying value of that asset. When this occurs, the carrying value of the asset is reduced to its fair value. Impairments are applicable to both tangible and intangible assets including property, plant, equipment, goodwill, software, or right-of-use (ROU) assets.
Under US GAAP and IFRS, a company should evaluate long-lived assets for indicators of impairment if a significant change to its operations or the asset has occurred. In other words, if an organization is experiencing a change in its financial circumstances—such that its long-lived assets may be overvalued—an impairment analysis is in order.
Once you’ve determined there’s an indication of impairment, ASC 360 Property, Plant, and Equipment (ASC 360) specifies these steps to be completed in the calculation of an impairment:
- If impairment indicators are identified, test the recoverability of the asset by comparing the cash flows expected to be generated over the asset’s life against its current carrying value.
- If warranted by the recoverability test, calculate the impairment loss as the difference between the carrying value recorded and the fair value of the asset.
Similarly, IAS 36 Impairment of Assets (IAS 36) identifies how to calculate and record impairments of long-lived assets. However, IAS 36 does not use the two-step impairment test found in ASC 360. If impairment indicators are present, the carrying value of the asset is compared to its recoverable amount. The recoverable amount is defined as the higher of:
- The fair value of the asset (or asset group) less costs of disposal
- The value in use (VIU); VIU equals the expected future cash flows of the asset (or asset group) discounted to their present value
If the carrying value of the asset is greater than its recoverable amount then the impairment loss is calculated as the overage.
An organization’s first responsibility is to be aware of potential impairment indicators, which occur when the carrying value of an asset may need to be permanently decreased in comparison to its fair value or recoverable amount. ASC 360-10-35-21 and IAS 36 paragraph 12 provide some examples of internal and external changes in events or circumstances that might drive an evaluation of impairment.
Impairment indicators include:
- Significant changes specific to the company such as a decrease in the market price of the asset, the way the asset is being used or its physical condition
- Significant changes in the operations or cash flows of the asset
- Legal proceedings that impact the future use or value of the asset
- Other general impacts such as adverse changes to the economy or business climate
As part of their quarterly and annual financial reporting processes, organizations with long-lived assets must have internal controls in place to monitor impairment indicators. The adoption of ASC 842 for public companies and IFRS 16 for international companies resulted in lease liabilities and ROU assets being recorded on an organization’s books for nearly all leases. Therefore, organizations should ensure that leased assets are now included on its list of long-lived assets to evaluate for impairment.
Both ASC 842 and IFRS 16 became effective for reporting periods beginning after December 15, 2018 (under ASC 842 that effective date is only for public companies). The affected companies first transitioned to and reported under the new lease accounting standards during 2019, and 2020 is the first year of steady-state. Companies using a checklist of items to analyze during an economic downturn created in previous years need to include ROU assets recorded under the new lease accounting guidance.
Organizations are examining the major impact the coronavirus pandemic is having on their business. For some, these impacts were felt before the end of the first quarter and for others, it may have taken longer. In either instance, however, the current global economic situation warrants further look at long-lived assets as several indicators to possible impairment exist. Impairment is triggered by a variety of reasons—some specific to a company or industry and some pervasive to the economy as a whole. Determining whether a leased asset’s value needs to be analyzed further requires reviewing several factors.
Businesses subject to Sarbanes-Oxley or local authority internal control evaluations need to document the internal control procedures performed to consider potential impairment indicators. Further, you should expect that your auditors may want to see an impairment analysis of your long-lived assets, including any ROU assets. Analysis during this period may be as simple as recognizing the presence of impairment indicators due to COVID-19 and using a high-level analysis to show no impairment because the reduction in cash flows is temporary for the business. Conversely, the initial assessment may show additional analysis is required to know whether or not an asset should be impaired.
Examples of impairment indicators
Consider a chain of pizza restaurants with delivery and dine-in options. The chain has closed its dining rooms but still offers delivery. In this instance, the leased kitchen equipment for making the pizzas is being used and may not be impaired. However, the dining space is not being used. If the restaurant does an analysis of future cash flows, the future cash flows may likely be decreased (due to less business, less sale of drinks with the orders), but it’s also likely the future cash flows will still exceed the carrying value of the equipment.
Now let’s examine businesses in the travel industry. A chain of leased hotels impacted by self-quarantine can make the following case for certain assets: the current conditions are temporary and they expect to resume business as usual such that future cash flows over the life of the leased buildings exceed their carrying value. In contrast, situations in other regions could potentially result in some locations remaining closed and the company will need to consider if impairment is necessary.
Cruise lines, on the other hand, have a different case to make. The time for cruises to resume pre-pandemic operations is likely longer. Cruise lines may also offer significant reductions to travel fares to drive volume. As a result, an analysis of future cash flows for cruise lines over the remaining lease term may indicate the carrying value of a cruise ship is not recoverable. The analysis might include projecting when an increase in operations is expected and how much. Based on the composition of the asset groups identified, impairment might be evaluated for the assets of the entire business or specific ships for specific routes. In the example of the pizza chain above, financial results might appear fairly steady since the loss of dine-in customers is partially offset by the rise of delivery service. An organization will still need to review financial results, operations, and sustainability to make an accurate assessment of whether or not leased assets need to be analyzed for impairment. If financial results and operations have decreased for a specific product line, location, or business, that organization should also review sustainability and consider future plans specific to the affected asset group. If a space or equipment is being used less or not at all, options include closing a location, reducing the production of a product line, or decreasing the amount of space being used for a particular activity. When these types of reductions are considered, impairment may also be considered.
Under US GAAP, once you have reviewed the current economic and operational circumstances to determine that an impairment may be triggered in your asset (or asset group), you must perform the recoverability test specified by ASC 360-10-35-17 to determine whether impairment analysis is required.
Recoverability requires evaluating if the undiscounted future cash flows generated from the use of an asset (or asset group) is estimated to equal or exceed the recorded amount (i.e. carrying value) of the asset (or asset group).
- If the expected cash flows are greater than the net book value of the asset, the asset is “recoverable” and impairment is not indicated.
- If the net book value of the asset is greater than its estimated future cash flows, the asset (or asset group) does not pass the recoverability test and must be further evaluated to quantify the impairment loss.
Under IFRS, the test for recoverability and the calculation of the impairment is completed in one step. Once you determine that impairment indicators exist for a specific asset (or asset group), you compare the carrying value of the asset (or asset group) to its recoverable amount. The recoverable amount is defined as the higher of (1) fair value of the asset (or asset group) less costs of disposal or (2) the VIU, equalling the expected future cash flows of the asset (or asset group) discounted to their present value.
Where should I get these cash flows?
When assessing the future cash flows of an asset group, an organization should perform the analysis using current company data. For example, if your company has a five-year sales or operational forecast, use that information to analyze recoverability. However, in the current economic environment, it would be appropriate to understand if any changes to the forecast have been incorporated as a result of the economic events of the COVID-19.
Identify asset or asset group
There are several details that need to be determined to perform the recoverability test under ASC 360. An asset is analyzed as either a specific asset, an asset class, or an asset group. ASC 360 defines an asset group as long-lived assets separated into “the lowest level for which identifiable cash flows are largely independent of the cash flows of other groups of assets and liabilities.”
A company must analyze assets for recoverability at the lowest level cash flows are identifiable. The key factor here will be cash flows. For example, a company might view a store and its leasehold improvements or a manufacturing plant and its equipment as one asset group because the cash flows generated from those assets may not be able to be further allocated between the store and its leasehold improvements or the plant and its equipment. FASB recognizes that significant judgment will need to be applied by organizations to determine appropriate asset groups for recoverability.
IFRS uses a similar approach to identifying the asset (or asset group). IAS 36 uses the term cash-generating unit (CGU) but the concept is largely the same. An individual asset cannot be reviewed for recoverability if it is not able to generate cash inflow independently of other assets, and therefore a CGU is the lowest level at which cash inflows are generated. The IASB also recognizes that organizations may use significant judgment to allocate CGU’s appropriately and also provides guidance to use the company’s approach to managing operations (i.e. by business segment, product, location, or geographic area) to assist with identifying CGUs.
What cash flows should be included in the asset group or CGU?
When estimating the future cash flows attributable to an asset group under ASC 360 the company should evaluate the asset group over its remaining useful life. The future cash flows are not discounted during this analysis because the aim is not to assess the fair value of the assets or the net present value of the cash flows, but whether the asset group will generate cash greater than its carrying value. Additionally, if the lowest level of identifiable cash flows is for a product line or region of the business, you must analyze the costs directly related to the product line or region.
Because overhead costs—such as executive salaries—are for the whole company and cannot be directly tied to a specific portion of the business, they are typically not included under US GAAP. The same can be said for debt and interest payments. Generally, a debt agreement is entered into for the organization as a whole and secured by all the assets of a company, not a specific product or regional business. Again, FASB recognizes that judgment may need to be applied by organizations to determine the cash flows attributable to a specific asset group.
Under IAS 36 the estimated cash flows for a CGU are used to determine the VIU which is then compared against the fair value less disposal costs of the CGU to ultimately calculate an impairment loss. These cash flows should also be for the remaining useful life of the asset or CGU and should include estimated:
- Cash inflows
- Cash outflows required to ready the asset or CGU for use and required to generate its cash inflows
- Net cash flows related to the sale or disposal of the asset or CGU at the end of its useful life
Overhead costs, to the extent they can be allocated on a reasonable and consistent basis, should be included in the estimates, but cash flows from financing activities or taxes should not.
Should I include the corresponding lease liability?
ASC 842-20-35-9 states ROU assets will need to be considered for impairment in accordance with ASC 360-10-35. Guidance for ASC 360 provides for generally excluding financial liabilities (such as long-term debt) and including operational liabilities (such as accounts payable) in the cash flows used to test recoverability. The exclusion of long-term debt supports the FASB’s decision to not use financing activities to assess an impairment and leads to the conclusion that financing leases are also excluded because of their similarity to debt.
The question of whether to include operating lease liabilities in determining the asset group is more complicated. An operating lease agreement is generally for a specific asset group, and it may be relatively easy for an organization to directly link those cash outflows to the asset. Additionally, ASC 842 looks at operating leases as operating liabilities. However, as stated above, the FASB does not wish for the results of the recoverability test to be impacted by a company’s financing decisions. Therefore, the decision to exclude or include operating lease outflows from the recoverability testing of an asset or asset group is up to the discretion of each organization. Because ASC 360-10-35-29 specifically prohibits the inclusion of interest expense in the estimation of recoverability cash flow, only the principal portion of the operating lease payments should be included as cash outflows.
Once an organization has made the decision to include or exclude an operating liability in a leased asset evaluation, they must document and apply that decision consistently across the company. If an entity elects to include operating lease cash flows in a test of asset recoverability, they should also be included in the impairment analysis.
Under IAS 36, the lease liability and its related cash flows are not included in the calculation of the VIU because similar to ASC 360, financing decisions such as a company’s decision to lease or buy are excluded from the asset group being tested for recoverability. Under IFRS 16’s single-model approach to lease accounting, for all lessees, the lease arrangements are classified as finance leases, and therefore the lease liabilities are excluded from the analysis.
As discussed above, under IFRS the recoverability and the impairment of an asset (or CGU) are determined at the same time by comparing the carrying value of the asset (or CGU) to its recoverable amount. The recoverable amount is the higher of the fair value of the asset (or CGU) less costs of disposal or the VIU. Finally, the VIU of an asset (or CGU) equals the expected future cash flows of the asset (or CGU) discounted to their present value. Now that we have discussed some of the inclusions and exclusions for cash flows, let’s tackle the applicable discount rate.
When calculating the VIU, the discount rate used should reflect the time value of money and the risk premium associated with the asset. The appropriate discount rate can also be estimated by looking at the weighted average cost of capital for an asset (or CGU) that has a similar set of facts, in terms of service potential and risks, to the asset (or CGU) being reviewed.
Documentation of recoverability testing
Regardless of what information a company uses to analyze the recoverability of an asset group, documentation of the analysis and reasoning is imperative. The decisions a company makes regarding key inputs to the recoverability testing of an asset group need to be consistent within the company and documented.
The final point to make regarding the test of recoverability of an asset group is that it can become fairly nuanced, especially in times of a broad economic downturn. The majority of companies are facing indicators that the economy and possibly their businesses are or will be negatively impacted by the coronavirus pandemic. However, assessing recoverability is not as black and white. Businesses may be able to prove they are established enough to withstand shorter term impacts to their operations, but there may be specific assets, product lines, or business divisions where it is harder to prove recoverability over their useful lives. In these cases an entity needs to perform a more in depth analysis of recoverability to prove impairment is not required. If a company is unable to demonstrate the recoverability of an asset group over its remaining useful life, this results in an impairment loss. If your assessment shows that the asset group is unable to generate enough undiscounted cash flows over its remaining useful life to cover its net book value, it needs to be impaired to the fair value of the asset.
Under ASC 360 when the carrying value of an asset group is not deemed to be recoverable, it is typically impaired. The amount of the impairment loss is calculated separately from the recoverability analysis as the excess of an asset group’s fair value over its net book value. The entry to record the impairment loss is a debit to impairment loss and a credit to the asset’s carrying value.
Similarly, under IAS 36 an asset (or CGU) is impaired when its carrying value is greater than its recoverable amount. The amount of the impairment loss is calculated as the difference between the carrying value and the recoverable amount and is also recorded as a debit to impairment loss and a credit to the asset’s carrying value.
The impairment loss calculation can be complex. In the case of a product line or regional business, the company needs to identify the fair value of the lowest group of assets to which a cash flow value may be assigned. The company also needs to use judgment in determining the expected future cash flows and the appropriate discount rate. A third party can help assess the fair value of an asset or group of assets, but that does not remove the entity’s responsibility to ensure reasonable assumptions are being used in the calculations.
One difference that exists between the impairment guidance under FASB and IFRS regards the reversal of impairments. Under FASB, once an impairment is recorded, it is permanent. Ultimately, this means there is no mechanism by which it can be reversed. However, under IFRS, impairments are able to be reversed or partially reduced, if certain criteria are met.
Regardless of whether or not a company anticipates an impairment of its assets, a preliminary review of economic indicators to evaluate any potential impairment and analysis of recoverability is something companies should consider performing in the first half of 2020. With the new accounting standards resulting in the recognition of ROU assets on the balance sheet for nearly all leases, it’s important for companies to remember to include the lease assets within the analysis.
Businesses should document their considerations to support internal control procedures, and this analysis should be provided to the auditor. Performing this analysis on your own before an auditor requests it will often result in a streamlined quarterly review and could avoid additional charges from the auditor associated with supplemental procedures they may need to perform as a result of COVID-19.