What bankers should know about impairment and disposal costs SFAS No. 144

Asset impairment condition is an increasingly important consideration for banks and their business customers. It affects not only the short-term profits of a firm but also the value of collateral in lenders' portfolios. SFAS No. 144 details the requirements for recognizing and reporting deterioration or disposal costs for various categories of assets.

Bankers often hold collateral in client portfolios that contain major, long-term assets, whose values could decline from impairment or disposal events. For example, a nuclear plant must consider the costs of disposing its spent nuclear power cells, a tanning factory must dispose of a facility that spews pollutants into a lake, and a retailer must (eventually) dispose of its owned retail space, if only to erect a new building in the same location. For many years, many such firms ignored such costs until they loomed in the near-term future. Now, the Financial Accounting Standards Board (FASB) requires firms to recognize (that is, match) such costs over the assets' productive lives. While reducing many firms' short-term profits, this standard should provide more realistic long-term financial results. Recognizing that declining profits arising from implementing this new Standard are cost-beneficial, bankers should insist that their clients conform to the new provisions--specifically, SPAS No. 144, Accounting for the Impairment or Disposal of Long-Lived Assets--and resolve related implementation and practice problems.

Conforming to SPAS No. 144 means that firms must now:

* Do a better job at matching the costs and benefits associated with recognizing and measuring impairments of long-lived assets.

* Complete a separate report of discontinued and continuing operations.

* Focus on relevant costs by discontinuing the accrual of all future operating losses associated with disposals.

* Use probability-weighted cash flows to measure impairments.

* Recognize impairment losses when the book values of such assets are not expected to be recoverable from expected, undiscounted net cash flows. The provisions of SPAS 144 apply to all firms'

(including not-for-profits) long-lived assets held for use or future disposal, including lessees' capital leases, lessors' assets subject to operating leases, long-term prepaid assets and amortizable intangibles. It does not apply to goodwill, indefinite life intangible assets, financial instruments accounted for under the cost or equity method, deferred policy acquisition costs, and unproved oil reserves and deferred tax assets. Its provisions are especially important to financial institution managers, because a client's assets provide the main data sources for risk assessment and profitability programs.

Overview

SFAS No. 144 classifies long-lived assets into three categories: (1) held and used; (2) disposed of other than by sale; and (3) disposed of by sale. It calls asset groups--whose identifiable cash flows are largely independent of other groups' assets/liabilities-the lowest level. It identifies a disposal group as a set of long-term assets expected to be disposed and focuses on assets and liabilities expected to be "bulked" as one, as when a computer manufacturer expects to dispose of a specific set of old cathode ray tubes as one unit.

Asset impairment conditions arise when a firm's carrying amount of a long-lived asset (or asset group) exceeds its fair value. Firms should test long-lived assets for recoverability when certain impairment indicators arise and recognize asset impairment losses only after assessing that the carrying amount of a long-lived asset is not recoverable and exceeds its fair value.

Firms should also report business components of discontinued operations when they expect to eliminate related operations and cash flows from ongoing operations, and they should have no significant involvement in the operations after the disposal transaction. Firms should test impairment when significant adverse events arise for an asset or asset group, they expect not to recover the asset's carrying amount, and the carrying amount of undiscounted cash flows exceeds its fair value. They should consider an assets carrying amount as unrecoverable if it exceeds the sum of the undiscounted cash flows expected to result from the asset's use and ultimate disposal, regardless of whether the asset is in actual use.

In short, impairment loss equals the excess of the asset's carrying amount over its fair value. Firms need not test long-lived assets for impairment each reporting period, but only test them for recoverability when events indicate that carrying amounts may not be significant. Conditions under which they should be tested include the following:

* Decreases in the market price of a long-lived asset (asset group).

* Changes in the extent or manner that assets are used or physically changed.

* Adverse changes in legal factors or business climates that could affect the assets' values or a regulator's adverse actions or assessments.

* Cost accumulations exceeding amounts originally expected to obtain/construct the assets.

* Current period operating or cash flow losses combined with a history of operating or cash flow losses or a forecast that demonstrates continuing losses associated with an asset.

* Current expectations that it is more likely than not that an asset will be disposed of before the end of its previously estimated remaining useful life, that is, exceeding 50%.

If these or other conditions indicate that impairment could exist, firms should determine if and by how much to recognize an impairment loss. If an impairment exists, firms should:

* Group assets at the lowest level for which there are identifiable cash flows.

* Estimate only the future net undiscounted cash flows from the asset.

* Compare the sum of the expected future cash flows to carrying amounts of the assets.

If the carrying amount of the asset exceeds the sum of the expected future cash flows, the firm should recognize an impairment loss up to the extent that the asset's carrying value exceeds its fair value.

After identifying impairment indicators, firms should review depreciation estimates and methods, and assets' estimated useful lives--for example, measure future cash flows to test for recoverability. They should group a long-lived asset being tested for impairment with other assets and liabilities for which the lowest level of identifiable cash flows are largely independent of other assets and liabilities' cash flows. Impairment losses would reduce only long-lived asset (group's) carrying amounts and these losses would be allocated to individual long-lived assets on a pro rata basis, using their relative carrying amounts.

SFAS 144 considers only expected future cash inflows minus associated cash outflows (except for interest charges) that relate directly to and are expected to occur as a direct result of using and disposing of the asset (group). SFAS 144 provides additional guidance to implement the above basic requirements regarding the estimation approach, the estimation period, and types of asset-related expenditures to consider.

The estimation approach. Firms should use reasonable assumptions and estimates about their own use of assets that are consistent with other information for similar periods--for example, information used in preparing internal budgets and projections. However, when considering alternative plans or estimated ranges of possible outcomes, firms should consider the likelihood of those possible outcomes-for example, using a probability-weighted approach, which best considers the likelihood of reasonable outcomes.

The estimation period. Bankers should pay special attention to the estimated useful lives of their clients' assets, as they can significantly influence periodic income and cash flows. SFAS 144 requires firms to use appropriate estimation periods to estimate their assets' estimated future cash flows and remaining estimated useful lives over the period that they expect to receive service potential from a long-lived asset--that is, the remaining useful life to the entity. However, they may not consider land, goodwill, or an indefinite life intangible asset as primary assets in making such determinations. If a long-lived asset is part of an asset group, the cash flow estimation period is the remaining useful life of the primary asset of the group--that is, the "principal long-lived tangible asset being depreciated or intangible asset being amortized that is the most significant component asset from which the asset group derives its cash-flow-generating capacity." Some factors defining primary assets include wheth er the firm would have acquired other assets of the group without that asset, the level of investment that would be required to replace the asset, and the remaining useful life of the asset relative to other assets of the group.

Capital expenditures. Asset-related expenditures are capital expenditures that depend on whether the assets' development is substantially complete or still under development.

Development substantially completed firms--those firms with substantially complete assets--should estimate future cash flows based on the asset's existing service potential at the dates of impairment. Thus, firms should consider the asset's remaining useful life, its cash-flow-generating capacity, and physical output capacity to determine its service potential, and firms also should consider future cash outflows needed to maintain the asset's existing service potential--for example, repairing an existing building elevator. But, they should not consider future capital expenditures that would increase the long-lived asset's service potential, such as adding a new elevator up the building's side.

For an asset under development--a long-lived asset that is not completed--firms should include cash flows related to all future expenditures to substantially complete the asset to measure its recoverability, that is, capitalizable interest payments under SFAS 34.

If, after estimating future cash flows to test recoverability, the asset's carrying amount exceeds the sum of the estimated future cash flows, a recognized impairment loss arises, which equals the amount by which the carrying amount of the asset exceeds its fair value. An asset's fair value is defined as the amount at which the firm could buy or sell it in a current single transaction between willing parties (that is, other than in a forced or liquidation sale). Fair values can be determined by quoted market prices, present value techniques, or other objective tools. Thus, firms recognizing impairment losses by reducing long-lived assets to fair values will have such fair values become the assets' new cost bases. They should then amortize/depreciate the new cost basis over the assets' estimated remaining useful life; previously recognized impairment loss cannot be restored.

Reporting and Disclosure Requirements

SFAS 144 requires the reporting of impairment losses within "income from continuing operations before income taxes." The notes to the financial statements should describe the:

* Impaired long-lived asset (group) and circumstances leading to the impairment.

* Amount of impairment loss and caption in the statement of income that includes the loss, if not presented separately on the face of the statement.

* Method(s) to determine fair value.

* Segment in which the impaired long-lived asset (asset group) is reported, if applicable.

Firms should continue to classify a long-lived asset as held and used until its disposal date, when they plan the disposition by (a) abandonment, (b) exchange for similar productive long-lived assets, or (c) a distribution to owners in a spin-off. Firms should classify swapped or spun-off long-lived assets as held for use until the transaction occurs. They should then recognize impairments for the excess of the carrying amount over fair value and classify abandoned assets as held for use until they cease to be used. Abandoned or spun-off groups of long-term assets also become part of discontinued operations at the disposition date--the date when they cease to use them. Commitments to abandonment plans should shorten the asset's estimated useful life, except for temporarily idled assets.

A long-lived asset or disposal group cannot be considered held for sale unless it meets specific criteria. This requirement holds even when a binding agreement for future sale is not required. Such criteria include:

* Management, with the authority to approve the action, commits to a plan to sell the asset;

* The asset is available for immediate sale in its present condition, subject only to usual and customary terms for sales of such assets;

* It actively seeks to locate buyers and takes other actions to sell the asset;

* It actively markets the asset for sale at a reasonable price relative to its current fair value;

* The asset's sale is probable, with transfer expected to qualify for recognition as a completed sale within one year, except for circumstances beyond the firm's control; and

* Significant changes to the plan seem unlikely, lest the firm will withdraw that plan.

Firms should meet two conditions to classify newly acquired assets as held for sale: (1) at the acquisition date, it meets the one-year requirement to transfer the asset, and (b) it probably meets other held-for-sale conditions within three months after the acquisition date.

Measurement of asset values. Firms should base a newly acquired asset's carrying amount at fair value minus cost to sell at the acquisition date. They should also measure the asset at the lower of (a) its carrying amount or (b) fair value minus cost to sell; they should then cease depreciation or amortization. Before measuring the fair value minus cost to sell of a disposal group, firms should adjust the carrying amounts of any non-SFAS 144 covered assets, including goodwill, and continue accruing interest and other costs associated with a disposal group's liabilities.

To determine an asset's costs, firms should include such incremental direct selling costs as broker commissions, legal and title transfer fees, and closing costs, but not accrued future operating losses. Firms should recognize losses for initial or subsequent write-downs to fair value minus selling costs and recognize gains for subsequent increases in the asset's fair value minus selling cost to sell, limited to cumulative losses previously reported. Upon actual sale of the asset, firms should recognize all gains and losses not previously recognized.

Incremental costs should not usually include contracted costs for an asset's sale as a purchase condition-for example, expected future losses to continue operations during the holding period. Firms using present value techniques to estimate fair value should not include expected future operating losses that marketplace participants would not consider in estimating the fair value, which would reduce the asset's carrying amount below its current fair value less selling costs.

Financial statement reporting of long-lived assets classified as held for sale. On a balance sheet, firms should present separately long-lived assets classified as held for sale, but not present the net carrying amount of the disposal group as a single line item. They should disclose major classes of assets and liabilities classified as held for sale either on the face of the balance sheet or in the notes to the financial statements. For long-lived assets or a disposal group classified as held for sale or sold during the period, firms should disclose the following in the notes to its financial statements:

* Description of facts and circumstances leading to the expected disposal, the expected manner and timing of that disposal, and, if not presented on the face of the balance sheet, the major classes of assets and liabilities included as part of a disposal group.

* Gains or losses recognized in adjusting carrying amounts to fair values and, if not separately presented on the face of the income statement, the caption in the income statement that includes that gain or loss.

* Amounts of revenue and pretax profit or loss reported in discontinued operations.

* The method for determining fair value.

* The segment in which the long-lived asset (disposal group) is reported under SFAS 131.

They also should disclose the facts and circumstances leading to changing the plan to sell long-lived assets and its effect on the results of operations for all current and prior periods presented. For impairment charges on a long-lived asset held for use, the firm should state the impaired asset (group) and facts and circumstances leading to the impairment, the amount of the impairment loss, and the caption in the income statement where that loss is aggregated.

Firms also should disclose the components that comprise operations and cash flows that clearly can be distinguished, operationally and for financial reporting purposes from the rest of the entity. Such components may be reportable as operating segments, reporting units, or asset groups. Firms changing sales plans or removing individual assets or liabilities from a disposal group should disclose the circumstances leading to these actions and the effect of that decision on the results of operations for the period and any prior periods presented.

The machinery is the asset group's primary asset (that is, the group's major constraint relative to the other assets) and, as the major source of cash flows, it becomes the primary asset. Thus, to test recoverability, future cash flows of the asset group should be projected over 10 years.

Thus, we use the six-year life of Asset D. Also, if expected undiscounted cash flows for six years is $1.55 million, plus $90,000 salvage, we allocate to Assets A - E impairment loss from operations of $2 million less $1.64 million: $360,000.

Now, assume that Asset B's fair value is $270,000, which exceeds the calculation above by $24,000. We must thus increase Asset B's carrying value to $270,000.

New SFAS 144 example. IHT's Manufacturing Co. tests for recoverability as a group. The asset group also includes accounts receivable, inventory (which is reported at the lower of cost or market), and other current assets and liabilities not covered by SFAS 144. The $3 million aggregate carrying amount of the asset group is not recoverable and exceeds its fair value by $800,000. Thus, IHT allocates the $800,000 impairment loss to the long-lived assets of the group as follows:

                                                    Allocation
                                         Pro-rata       of      Adjusted
                              Carrying  Allocation  Impairment  Carrying
Asset Group                    Amount     Factor      (Loss)     Amount

Current Assets                  $ 860       --          --        $ 860
Liabilities                     (410)       --          --        (410)
Long-lived assets:
 Manufacturing bldg.              900      0.35      $ (282)        618
 Loading system                   850      0.33        (267)      1,068
 Handling equipment               500      0.20        (157)        343
 Mounting System                  300      0.12         (94)        206
Subtotal--long-lived assets:  $ 2,550      1.00      $ (800)    $ 2,684
Total                          $3,000      1.00      $ (800)    $ 2,200

* For sold, discontinued components, disclose: components' operating income/loss from start of year until disposal date; and gain/loss on disposal, including tax effects.

* For those held for sale, disclose: components total yearly operating gain/loss; and impairment loss if fair value is greater than carrying value.

Conclusion

SFAS 144 requires firms to match the costs of deteriorating long-lived assets being held by banks as collateral over their productive life. Asset impairment occurs at the point when the costs exceed the value of the asset. The new standard defines asset classes and reporting requirements. As mentioned earlier, the standard does not apply to goodwill, indefinite life intangible assets, financial instruments accounted for under the cost or equity method, deferred policy acquisition costs, and unproved oil reserves and deferred tax assets. While the additional work required by SFAS 144 may seem to be just one more annoyance banks and their customers could do without as well as a cause for reduced short-term profits, the golden lining is a more realistic long-term financial picture. Events of recent years certainly show that the benefits of such accounting could far outweigh the problems.

Acme Production Co. tests the following long-lived asset group for
recoverability purposes:

                       Remaining Estimated  Asset's Net
Long-lived assets      Useful life (years)  Book Value

Building                       12             $1,500
Machinery                      10              1,000
Trucks                          8                600
Leasehold improvement          14                500
Furniture                       3                200

New Example of Asset Carrying Values and Remaining Lives

Long-Lived asset         Carrying Value  Remaining Life

Asset A                      $100,000        5 years
Asset B                       300,000        8 years
Asset C                       500,000        7 years
Asset D (primary asset)       700,000        6 years
Asset E                       400,000       10 years

Total                     $ 2,000,000

Loss Allocation of $750,000--Phase I

                                (rounded)
                    Adjusted     Pro-rata   Allocation of   Adjusted
Long-lived          Carrying    Allocation   Impairment     Carrying
Asset                 Value       Factor        Loss          Value

Asset A              $ 100,000     0.05        $ 18,000       $ 82,000
Asset B                300,000     0.15          54,000        246,000
Asset C                500,000     0.25          90,000        410,000
Asset D (primary)      700,000     0.35         126,000        574,000
Asset E                400,000     0.20          72,000        328,000

Total              $ 2,000,000     1.00       $ 360,000    $ 1,640,000

                      New      (rounded)
                   Adjusted     Prorata    Allocation of   Adjusted
Long-lived         Carrying    Allocation   Impairment     Carrying
Asset                Value       Factor        Loss          Value

Asset A              $ 82,000     0.06       $ (1,412)       $ 80,588
Asset C               410,000     0.29         (7,059)        402,941
Asset D (primary      574,000     0.41         (9,882)        564,118
Asset E               328,000     0.24         (5,647)        322,353
Subtotal          $ 1,394,000     1.00      $ (24,000)    $ 1,370,000
Asset B               246,000       --          24,000        270,000

Total             $ 1,640,000                              $1,640,000

SFAS No. 144 Presentation of Income from Continuing Operations

                                         Income from
                                    continuing Operations

Before income taxes                      $ 5,240,000
Less: Income Taxes (30% rate)              1,572,000
Income from continuing Operations        $ 3,668,000

Discontinued operations (Note T)
  Loss from operations of
  discontinued component Z
  (including $310,000 loss on
  classification as held for sale)         $ 850,000
  Less: Income tax benefit                   255,000
  (of taxable loss)
  Loss on discontinued operations          $ 595,000
  Net Income                             $ 3,073,000

Contact Reinstein at a.reinstein@wayne.edu; contact Bayou at mbayou@umd.umich.edu

Alan Reinstein, CPA, DBA, is the George R. Husband Professor of Accounting, School of Business, Wayne State University, Detroit, Michigan; Mohammed E. Bayou, Ph.D., is Associate Professor of Accounting, School of Management, University of Michigan--Dearborn.

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