Real estate owners and developers that issue financial statements will be affected by the Financial Accounting Standards Board's (FASB) Statement No. 121, Accounting for the Impairment of Long-Lived Assets. The Statement addresses the accounting for the impairment of long-lived assets, including land, buildings, equipment, and identifiable intangibles, including patents, trademarks, and goodwill. The new rules specify when assets should be reviewed for impairment, how to determine if an asset is impaired, how to measure an impairment loss, and what disclosures are necessary in the financial statements. The Statement also prescribes the accounting for long-lived assets and identifiable intangibles that a company plans to dispose of.
The Statement requires a three-step approach for recognizing and measuring the impairment of assets to be held and used:
* Determining whether indicators of impairment are present;
* Determining if the sum of the estimated undiscounted future cash flows attributable to the assets is less than their carrying amounts:
* Recognizing an impairment loss based on the excess of the carrying amount of the assets over their fair values.
The Statement requires that long-lived assets and identifiable intangibles that are used in operations be reviewed for impairment only when events or changes in circumstances indicate that the carrying amount of the assets may not be recoverable. The following lists some of the situations that might indicate to management that an impairment exists:
* A significant decrease in the market value of an asset;
* A significant change in the extent or manner in which an asset is used or a significant physical change in an asset;
* A significant adverse change in legal factors or in the business climate that affects the value of an asset, or an adverse action or assessment by a regulator:
* An accumulation of costs significantly in excess of the amount originally expected to acquire or construct an asset;
* A history of operating or cash flow losses or a projection or forecast that demonstrates continuing losses associated with an income-producing asset. For real estate companies, the expiration of material leases would be such an indicator.
Assuming an indicator has been identified, assets would be measured at the lowest level for which there are identifiable cash flows that are largely independent of the cash flows of other groups of assets. If the estimated undiscounted cash flows, before any interest charges, expected to the generated from operations and disposal, are less than the carrying amount of the assets, an impairment exists and an impairment loss must be calculated and recognized.
Statement 121 does not provide guidance for estimating cash flows. Accordingly, estimating future undiscounted cash flows will require a great deal of judgment and will be very subjective. Companies must make their best estimate based upon reasonable and supportable assumptions and projections, including the estimated holding period which is impacted by the asset's economic life and managements intent and ability to hold the asset.
An impairment loss pertaining to assets that are being used in operations is to be recognized based on the excess of the carrying amount of the assets over the fair value of the assets. The Board concluded that the best measure of fair value is the quoted market price for the assets in an active market. However, the Board acknowledged that active markets for many long-lived assets often do not exist. Therefore, if a quoted market price is not available, management's best estimate of the fair value of the assets. based on the best information available under the circumstances, should be used in valuing the assets. Accordingly, in most circumstances, companies will have to rely on appraisals or estimates of discounted future cash flows to determine fair values for these assets.
Once an asset is determined to be impaired and the asset is written down to fair value, the reduced carrying amount represents the new cost basis of the asset. In this regard, subsequent depreciation of the asset is based on the revised carrying amount and companies are prohibited from reversing the impairment loss should facts and circumstances change in the future.
Reporting and Disclosure
An impairment loss pertaining to assets that are being used in operations is to be reported as a component of income from continuing operations before taxes. The amount may be reported as a separate line item in the income statement, parenthetically as part of an aggregate amount on the income statement, or in an appropriate aggregation on the income statement supplemented by disclosure in the notes to the financial statements of the amount of impairment loss and the income statement caption in which the loss is included.
In addition, a company that reports an impairment loss is required to disclose the following information in the notes to the financial statements:
* A description of the assets impaired and the facts and circumstances leading to the impairment;
* The amount of the impairment loss and how fair value was determined;
* For public companies, the business segment(s) affected.
Assets to be Disposed Of
Statement 121 requires that assets held for disposal be valued at the lower of cost or fair value less cost to sell, except for assets included as part of a discontinued operation as defined by APB Opinion No. 30.
This change from net realizable value to fair value less cost to sell will have the greatest impact on the valuation of assets that are to be disposed of over a period that exceeds one year because the Statement requires that subsequent revisions in the estimate of fair value less the cost to sell be reported as an adjustment to the carrying amount of the assets to be disposed of. In this regard, impairment losses may be recovered if the fair value of the assets increase over time; however, the increased carrying amount cannot exceed the carrying amount of the asset before the decision was made to dispose of the asset. Gains and losses from initial and subsequent adjustments, if any, should be presented in the income statement in a manner consistent with the reporting of impairment losses from assets to be held and used. Depreciation should not be recorded during the period the asset is being held for disposal.
Disclosure requirements for assets to be disposed of include:
For each balance sheet presented:
* A description of the assets to be disposed of, the facts and circumstances leading to the expected disposal, the expected disposal date, and the carrying amount of those assets; and
* For public companies, the business segment(s) in which assets to be disposed of are held.
For each period for which a statement of income is presented:
* The impairment loss resulting from the initial measurement when the decision is made to dispose of the asset;
* The gain or loss, if any, resulting from subsequent changes in the carrying amounts of the assets; and
* The results of operations for these assets to the extent that those results are included in the entity's results of operations for the period and can be identified.
Real Estate Developers
Statement 121 amends the impairment provisions of FASB Statement No. 67, Accounting for Costs and Initial Rental Operations of Real Estate Projects. Statement 67 required that the carrying amount of a real estate project held for development and sale not exceed its net realizable value. Statement 121 eliminates this provision and provides two separate criteria for evaluating the impairment of real estate projects depending upon whether they are held for development or in the process of development or whether they are completed and ready for sale.
First, the Statement requires that real estate projects held for development and sale be evaluated for impairment in accordance with the recognition and measurement provisions governing assets to be held and used. Therefore, property held for development and property currently under development but not yet completed would only be evaluated for impairment if impairment indicators were present and would be written down to fair value only if the estimated undiscounted cash flows from the project did not exceed the recorded cost of the project.
Second, the Statement requires that real estate projects that are completed and ready for their intended use be accounted for in accordance with the provisions governing assets to be disposed of. Therefore, once a project is completed and ready for rental or sale it must be reported at the lower of cost or fair value less cost to sell.
Effective Date and Transition
The Statement is effective for financial statements issued for fiscal years beginning after December 15, 1995, with earlier application encouraged. Restatement of previously issued financial statements is not permitted. The Statement requires that impairment losses recorded on assets to be held and used resulting from the initial application of the Statement be reported prospectively in the period in which the recognition criteria are first met. However, impairment losses recorded on assets to be disposed of resulting from initial application of the Statement are to be reported as the cumulative effect of a change in accounting principle in accordance with APB Opinion No. 20, Accounting Changes. Stanley R. Perla is a member of the E& Y Kenneth Leventhal Real Estate Group, New York, NY (212) 773-5528.