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

RMA Journal, The, April, 2003 by Alan Reinstein, Mohamed E. Bayou

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.