Among the countless lessons companies learned from 2020, expect the unexpected should be toward the top of the list. Things happen, surprises fall out of the sky, and the marketplace throws massive, roll-off-the-table sinkers that leave organizations swinging at air.
In other words, things change, and it’s critical that accounting and finance leaders know how to address such changes, both big and small. And as you might guess, asset impairment is one of the best examples of plans going sideways, putting your accounting for long-lived asset impairment under a bright spotlight.
But that’s where Embark enters the fray. With a few insights and best practices leading the way, we promise that long-lived asset impairment is nothing more than a manageable bump in the accounting road – scout’s honor. So let’s dig right in.
What are Impaired Long-lived Assets?
A long-lived asset includes things like buildings, equipment, ROU assets, and intangible assets. These assets are considered “impaired” when their fair value is less than its carrying value. From a more practical sense, when the future cash flows that an asset [or asset group – more on that later] produces have decreased significantly or completely dried up, there’s a very good chance that the carrying value on the books exceeds the actual fair value of an asset.
This can occur for many reasons, from shoddy physical condition or changes in the marketplace or use of the asset to running through an asset’s useful lifespan faster than you thought you would. That’s why long-term assets are especially at risk of impairment – there’s more time for things to go astray. Asset impairment isn’t exclusive to only long-lived assets, though, also rearing its inopportune head for indefinite-lived intangible assets and goodwill.
While we’ll zero-in on the long-lived assets side of impairment in a bit, we encourage you to read our past thoughts on goodwill impairment for a deeper dive on that critical topic, especially in light of COVID-19 and the financial repercussions it’s exacted on companies. Also, for those considering impairments specific to any indefinite-lived intangible asset, ASC 350-30 provides the relevant guidance on its impairment model.
Asset Depreciation vs. Asset Impairment
We know what you’re thinking – our brief description of asset impairment has you wondering what the point of impairing a long-lived asset when you’re already depreciating or amortizing it. And you’re certainly not incorrect for thinking that because, at least from a distance, they do appear quite similar. However, impairment and depreciation have different purposes under US GAAP.
The most obvious distinction between the two is the predetermined nature of depreciation. Anyone that’s spent some time with a good ol’ fashioned straight-line or ACRS/MACRS schedule knows that the purpose of depreciation is to distribute the cost of long-lived assets over its estimated lifespan in a systematic or rational manner. This allows companies to distribute the cost from use of the asset equitably over the period in which it benefits from the use of that asset.
But impairment doesn’t roll like that – it likes to keep you on your toes and pop up unexpectedly, much like a flat tire on your car or a hemorrhaging pipe underneath your kitchen sink. Put another way, depreciation – a form of cost allocation – addresses normal wear and tear on a fixed asset while impairment – a valuation premise – accounts for sudden, unforeseen dips in an asset’s value.
Accounting for Impaired Assets
Now that we have the basics out of the way, let’s take a closer look at the actual accounting process for impaired assets, starting with identifying whether or not you have an impaired asset on your hands. Or, more accurately, on your books.
1. When to Test for Impairment
As we said above, US GAAP only considers a long-lived asset impaired when it’s not recoverable and the carrying value exceeds its fair value. However, an important first step is recognizing if impairment exists in the first place.
For long-lived assets, GAAP indicates the impairment model and related testing is event-driven. Thus, a lot of judgment is needed to assess when a “triggering” event occurs. When it’s time to dig in and see if you have a triggering event on your hands, companies should look at things like:
- Your cash flow from the asset: Have you incurred either operating losses or cash flow losses because of the asset, or are you forecasting continued losses?
- Costs associated with the asset: Have you incurred excessive costs to acquire, build, or maintain the asset?
- Disposal value and timeline: Is there a better-than-average chance you’ll sell or dispose of the asset before its estimated useful life is up?
- Legalities: Are there legal factors that might negatively impact the value of the asset?
- The asset’s market-going price: Have you seen a significant drop in the asset’s market value?
- The asset’s useability: Have things changed in the way you can use the asset or even where it’s located?
According to GAAP, you must perform impairment tests for long-lived assets at the lowest level that independent cash flows exist or, generally speaking, according to asset groups. Therefore, before setting sail on the impairment seas, management must first assess the company’s asset groups to know where they must assess for triggering events and test for impairment.
This process will vary from company to company, so, for instance, your asset groups won’t necessarily be similar to a competitor’s. Also, asset groupings are not fixed so a company may from time to time revise its asset groupings based on internal reorganizations or acquisition and disposal activities. However, once you determine that you do, in fact, have an event-based trigger for your long-lived asset group, it’s time to perform the two-step impairment model under GAAP.
Before we move on, though, we need to reiterate the point that not all assets are equal. In fact, there’s an order to your impairment testing and write-offs in GAAP. Start with other assets, things like accounts receivable [AR] and inventory, following the relevant guidance for each. Next, you test indefinite-lived intangible assets if you have any. From here, you move on to your long-lived assets before finally capping the impairment testing off with goodwill.
2. Assessing Recoverability & Measuring Impairment
At this point, you know that you have a business asset – or asset group – that may not be recoverable due to any number of factors and circumstances. Now, to gauge whether you need to record any actual amount of impairment, you perform two different tests – [Step 1] recoverability and [Step 2] measurement.
- Recoverability: Determine if the asset’s [or asset group’s] undiscounted cash flows are less than its carrying value on your books. If so, then you have failed the recoverability test and must then measure the impairment loss.
- Measuring impairment loss: Determine the impairment loss, if any, which you determine by calculating the difference between the asset’s [or asset group’s] carrying value and its fair value.
It is important to keep in mind a couple key differences between any cash flows used in Step 1 for testing recoverability and Step 2 for measuring any impairment loss:
- Cash flows used in Step 1 are based on company-specific assumptions, whereas cash flows in Step 2 are from a market-participant perspective.
- Cash flows used in Step 1 are undiscounted, whereas cash flows used in Step 2 [under an income approach] are discounted.
3. Accounting for Your Impairment Loss
Now that you’ve measured your loss on impairment, it’s time to record the loss. In many cases, an impairment loss will pertain to many assets included in an asset group. Under ASC 360, you need to allocate any impairment loss on a pro-rata basis to all assets in the asset group in the scope of the standard.
In other words, if there are other assets included in the asset group that are not long-lived assets [e.g. working capital], you do not allocate impairment to those particular assets. Also, keep in mind that when allocating any impairment loss to in-scope long-lived assets, you cannot write down any asset below its fair value. Because of this constraint on the loss allocation, some assets in the asset group may be written down to their fair value and some may be recorded at a new carrying value that is still in excess of the asset’s fair value.
The write-down of any long-lived asset following impairment also creates a new cost-basis for the asset [i.e. any accumulated amortization or depreciation is written off with the allocated impairment loss to arrive at the new basis]. You then depreciate or amortize this new cost-basis over the remaining useful life of the asset.
4. Reevaluating Assets for Impairment Loss
As we said, US GAAP states that once an asset’s value is impaired, that impairment charge cannot be reversed in future periods to subsequently increase the asset’s carrying value. Note that we specifically said increase, not decrease. To that point, an impairment charge is not a one-and-done concept. A company must continually monitor its long-lived assets and, in some cases, record additional impairment losses in future periods, especially in an environment with continual market declines or other triggering event indicators.
Asset Impairment Example in the Real World
Discussing the accounting basics to impairment losses is important to understanding the concept, the process involved, and what it might mean for your accounting and finance teams. But there’s something to be said for using a real-world example to drive it all home.
Given the countless examples that 2020 unfortunately provided us, we thought it would be best to pull a relevant impairment charge from an industry hit especially hard throughout the coronavirus pandemic – oil and gas.
Back in Q2 2020, Shell’s management reviewed how the pandemic was impacting the commodity price environment, causing the company to revise its crude forecast from $60 a barrel down to $35. Of course, this would significantly impact projected cash flows and, thus, likely generate impairment losses stemming from the drastic downturn in oil prices.
Ultimately, the company took a $16.8 billion post-tax impairment charge, primarily across its integrated gas units but also in its upstream assets and refining portfolio. Granted, those are staggering figures but, considering what was going on in the world at the time, there are a couple of key takeaways that we want to point out:
- Shell’s management correctly understood that, thanks to an extremely volatile commodities market driven by the coronavirus pandemic, they needed to reassess their asset values in light of plummeting crude prices – in other words, multiple triggering events
- Just as we said above, a significant change to estimated cash flows across the company’s assets necessitated the impairment losses as they failed their recoverability test and then measured their impairment losses.
Yes, this is an extreme example that doesn’t exactly occur every day. As a matter of fact, 2020 was the worst year on record for oil industry write-downs, totaling nearly $150 billion in the first three quarters alone. However, this example also typifies the unexpected nature of impairments, cash flow forecasting during uncertainty, and the need to keep your head on a swivel, no matter what industry you’re in.
Other Impairment Insights and Best Practices
Finally, we wouldn’t be doing you much justice if we left everything so high-level without adding some of the tips we’ve picked up in the accounting trenches. So on that note, let’s look at some practical insights you can use to make the impairment loss process a bit more efficient.
Be Aware of the Relevant Guidance
Keep in mind there is a slightly different approach to impairments for long-lived assets that are classified as held-for-sale. The two-step impairment model we detailed above is for the more common impairment framework – assets you’re holding and using – but it’s not the only game in town.
An asset group held-for-sale is recorded at its fair value less cost to sell in the period a company determines it met the held-for-sale criteria. Any impairment loss on this group is simply the difference between its carrying amount and its fair value, less cost to sell. Naturally, it’s important to be aware of the relevant guidance and follow the framework that fits your circumstances.
Future Cash Flows
While it’d be nice if your cash flow projections were always spot-on, that’s just not realistic. Thus, there’s a significant amount of judgment involved when using cash flow projections to assess and measure impairment.
Of course, this means that auditors will pay especially close attention to the judgment you use in calculating impairment loss. For that reason, you want to be consistent with the assumptions you use in your impairment analysis and avoid using contradicting cash flow models for different needs [e.g. forecasts for realizability of deferred taxes]. Your story should remain the same or, at the very least, the information you use should make sense and be supportable.
Read the Room and Act Accordingly
Once again, GAAP states you must reassess for impairment loss when events or conditions occur that suggest the carrying value of an asset [asset group] may not be recoverable. In “ordinary” times, if those even exist anymore, you probably won’t have to conduct those detailed impairment assessments too often, at least with long-lived assets.
However, in a year like 2020, when everything seemed upside down and right-side up, circumstances might change more often than usual – just look at our Shell example as proof of that notion. That’s why it’s so important to stay aware of the environment, the many variables out there, and reassess for possible impairment whenever necessary.
US GAAP vs. IFRS
We’ve concentrated on US GAAP accounting standards thus far, but it’s a big world out there. Companies with international operations that account for things under IFRS don’t adhere to FASB's two-step impairment model as spelled out in ASC 360. Instead, they use the one-step model described in IAS 36. We won’t go much further than that right now, but it goes without saying that if the IFRS standards apply to you, then it’s an excellent idea to familiarize yourself with the relevant guidance as there can be numerous differences in how to apply accounting concepts.
Embark’s Final Word
No, we didn’t take a very nuanced look at accounting for asset impairments, but that’s for a very good reason – a thorough discussion could very well consume half of the internet. Obviously, when it comes to addressing your own impairment accounting and the subsequent financial reporting, you’ll need to understand the relevant guidance, your cash flows and operations, and, most importantly, have the in-house expertise to handle the countless ins and outs involved.
Sounds like a lot, right? Well, that’s because it is. However, don’t think for a moment that you’re on your own, a boat with an uncertain rudder. Embark’s team of specialists are ready to steer you to shore, no matter how adrift you might feel. It’s what we do.