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As we approach year-end, its time to think about your company’s annual financial statements. If your company prepares its financial statements using generally accepted accounting principles, or GAAP, then at least annually you should evaluate your company’s assets for indications of impairment. For more information on GAAP requirements, consult the Accounting Standards Codification of the Financial Accounting Standards Board, or FASB.
Remember, this article is general in nature, and is not intended to give specific advice to you or your company. You company’s financial statement disclosures will be dictated by your specific facts and circumstances. Always consult with your accountant.
What is asset impairment?
A fundamental accounting principal is that the carrying value of an asset, should be less than or equal to its fair value. If an asset’s carrying value is greater than its fair value, then it is impaired.
Sounds simple enough, right? Unfortunately, in practice it can be difficult and even expensive to determine an asset’s fair value. Since frequently there is no active market for a particular asset, the fair value has to be estimated using valuation techniques. Valuation is a topic that is beyond the scope of this article, but as a general rule fair values are strongly related to expected future cash flows. I’ll talk about valuation in more detail in the future. For the purposes of this discussion, let’s assume that you will retain a valuation expert to assist.
During 2020 we have seen major disruptions to economic activity. Lockdowns and changes in buying habits have in some cases significantly changed the prospects of entire sectors of the economy for the foreseeable future. It would be misleading to issue financial statements that don’t reflect that reality.
If your company has outstanding debt, and is bound by financial covenants, be mindful that recording the impairment of assets could affect compliance with some of those covenants. It is a good idea to perform impairment testing early in the process of preparing financial statements in case you need to discuss the result with your lender(s).
Some definitions
Before we go further, let’s define a few terms:
- An asset’s carrying value is the value at which the asset is reported on the company’s balance sheet. Carrying value is often, but not always, the original cost of the asset. For assets that are depreciated or amortized, like equipment, the carying value would be net of accumulated depreciation.
- An asset’s fair value is the amount at which an asset could be bought or sold between willing unrelated parties in an orderly transaction. An orderly transaction is one that is not a forced or liquidation sale. Think of it as the current market price.
- Goodwill is an asset representing the future economic benefits arising from other assets acquired in a business combination that are not individually identified and separately recognized.
Assets to consider
For this discussion, we will focus on three categories of assets:
Indefinite-lived intangible assets. These are intangible assets that have an indefinite life. Often, intangible assets will arise from an acquisition. Some examples would be:
- an acquired broadcast license which is renewable
- an acquired airline route
- an acquired trademark deemed to have an indefinite useful life.
These types of assets should be evaluated at least annually, or more frequently if impairment indicators exist. Using the example of the acquired airline route, the disruptions to air travel caused by the pandemic would be an example of an impairment indicator. This category of assets is always evaluated first.
Long-lived assets to be held and used. Assets such as property and equipment, or intellectual property with a finite useful life would fall into this category. These types of assets would not be evaluated on any schedule, but when impairment indicators exist. This category of assets would be evaluated after the indefinite-lived intangible assets.
Goodwill. Goodwill should be evaluated annually, or more frequently if impairment indicators exist. It is evaluated last in the process.
An alternative is available for private companies. If a company adopts the alternative accounting for goodwill, it should be disclosed as an accounting policy in the footnotes to the financial statements. A private company which adopted the goodwill alternative accounting would amortize goodwill over 10 years. Goodwill is only evaluated for impairment upon a triggering event. There is a potential pitfall, however. If a company has elected to use the private company alternative accounting method and subsequently decides to go public, it would be required to test goodwill for impairment for each of the historical balance sheets presented in its initial public filings.
A Case Study
The best way to explain the impairment evaluation process would be to look at an example.
Case background
Heartburn, Inc. is a company that operates restaurants and food-service businesses under a number of brands throughout the U.S. In early 2019, Heartburn acquired the assets of Greasy-Spoon Dining, a chain of casual restaurants for a purchase price of $20 million plus inventory. The purchased assets included trademarks and equipment. Heartburn retained a team of valuation experts, and the purchase price was allocated to the assets based on their fair values as summarized in figure 1 below. The total fair value of purchased assets that could be separately identified was $17.5 million. Goodwill of $2.5 million was recorded by Heartburn.
2019 was a banner year for Heartburn, with strong sales and solidly-profitable operations. In 2020, however, many of its locations were forced to close, or operate at greatly-reduced capacity. Heartburn operated at a loss in 2020, and it projects continuing losses through 2021 with a return to profitability in 2022.
Considerations at year-end 2020:
Fortunately, Heartburn has sufficient cash resources and borrowing capacity to fund its operations, and has concluded that it should be able to continue as a going concern. As it prepares its financial statements, Heartburn needs to evaluate its long-lived assets for possible impairment.
The first consideration: are there indications of impairment? Clearly there are:
- Many of the restaurant locations are closed or operating at reduced capacity
- There has been a substantial decline in cash flows from operations
- Heartburn’s forecasts project continued losses for at least a year, with recovery beginning in 2022.
These are all indications of impairment. Remember, the fair value of long-lived assets is strongly associated with the expectation of future cash flows. Under these circumstances, it is likely that the fair values of Greasy-Spoon’s assets have declined.
Recording impairment losses
Heartburn retained a valuation expert to assess the fair value of its assets associated with Greasy-Spoon. The expert looked at Heartburn’s forecasts, current operating trends and other market measures and estimated an overall fair value of Greasy-Spoon of $15 million:
- The fair value of the trademarks was estimated to be $4 million.
- Greasy-Spoon has strong name-recognition in its market and the trademark still has substantial value.
- Heartburn would record a loss of $1 million on the decline in fair value of its trademark assets.
- The fair value of the restaurant equipment was estimated to be $9.5 million.
- The pandemic has had a substantial adverse impact on the entire restaurant industry, resulting in many closures. There is a glut of used restaurant equipment available resulting in reduced prices for used equipment.
- Heartburn would report a loss of $1.25 million due to the decline in fair value of its equipment. See figure 2, below.
- After taking into consideration the changes in estimated fair values for the trademarks and the restaurant equipment, the carrying value of Greasy-Spoon’s assets other than goodwill would be $13.5 million. Since the fair value of the entire operation is $15 million, $1.5 million of goodwill would remain while $1 million of goodwill would be considered impaired. See Figure 3, below.
Conclusion
Companies who issue financial statements under generally accepted accounting principles are required to evaluate long-lived or indefinite lived intangible assets for impairment at least annually, and long-lived tangible assets such as equipment whenever indications of impairment occur. In “normal” years, unless there has been a material disruption to either the company or its industry, this has been a fairly straightforward process. 2020, however, has been anything but “normal” and many companies and industries see clear indicators of possible impairment.
It is a good idea to begin this evaluation as soon as possible, particularly if compliance with financial covenants is an issue. Start by visiting with your accountant. If necessary, retain a competent valuation expert to assist.
This article is part of the Accounting in Plain English project. The Accounting in Plain English project is dedicated to trying to make the complex simple and understandable. That is, translate the language of accounting back into plain English. This is not an education site for accountants, it is intended for company management along with users and readers of financial statements. The intent is not to turn you into an accountant, but to help you avoid being confused by one.
Finally, if you have any questions or suggestions please let me know. If I can be of assistance in this or any other financial reporting matter, please contact me. I’m always happy to help.