Virtually every company out there has some type of long lived asset and they all have to be considered for impairment. Watch PwC’s Jonathan Franklin describe the held and used accounting model, when it is used and common triggering events.
Hi, I’m Jon Franklin.
Virtually every company out there has some type of long lived asset and they all have to be considered for impairment. The held and used accounting model is commonly applied in impairment analyses and is used when the asset doesn’t meet the criteria for held for sale. In this video, I’ll share some common triggering events and explain the two step held and used impairment model.
Long lived asset are not tested annually for impairment rather impairment is a trigger based assessment. There are many indicators of a triggering event. These include:
While those are some of the potential indicators, it’s not an all inclusive list. Really, you’re looking for triggers that indicate the carrying value may no longer be recoverable.
Now let’s move to the model itself. In Step 1, you compare the undiscounted cash flows of the asset or asset group to the related carrying value. This acts as a filter or first screen to indicate that the asset value may not be recoverable. In my experience, many of the key judgements you need to make are in step one. If step one is tripped, then you move to Step 2, which calculates the amount of potential impairment. If the carrying amount exceeds fair value, then an impairment is recorded for that amount. This is the key distinction, undiscounted cash flows are used in step one, while fair value is used in step two. Like many things, it sounds easy in theory, but can be a little trickier in practice and usually requires a significant amount of judgement. Three of the more significant areas in the Step 1 analysis are asset grouping, cash flow projections and probability weighting different scenarios.
Let’s start with asset grouping. The asset or asset group to be tested for impairment should represent the lowest level for which identifiable cash flows are largely independent of the cash flows of other assets and liabilities. A number of company-specific operating characteristics should be assessed, including the interdependency of revenues between asset groups and shared cost structures. For example, a manufacturing company that has multiple plants may consider each plant to be its own asset group because the cash flows of each are separately identifiable. However, if there are significant shared costs for things such as research and development, engineering and design, purchasing or other costs, the asset group may be at a higher level, such as at a regional level. Company specific facts and circumstances are extremely important when determining asset groups. It’s important to put thought into this upfront so you don’t do multiple assessments unnecessarily, or worse, find out late in the game that you need to move down a level. Once the asset group has been determined, you need to estimate undiscounted cash flows for the remaining useful life of the primary asset, which is generally viewed as the most important asset of the group.
Cash flow projections are made based on an entity specific assumption, rather than a market participant assumption. As such, estimating cash flows for purposes of the recoverability test is subjective and requires judgment. Cash flows used should generally be consistent with other information used by the entity, such as internal budgets and projections, accruals related to incentive compensation plans or information communicated to others, including the investor community. The cash flows used should include all cash inflows for the remaining useful life, any cash outflows necessary over that period, including maintenance costs for the asset group, and cash flows from the eventual disposition of the asset or group. However, any cash flows that would extend the life of the asset or increase its service potential, such as a planned expansion of a manufacturing facility, would not be included in the cash flow projections for the recoverability test.
Lastly, is the impact of probability weighted assessments. Often, multiple courses of action for the asset or asset group are being considered. The held-and-used model allows for a range of possible future cash flows to be utilized on a probability weighted basis. For example, say a company has a facility that was built on the outskirts of town many years ago. Fast forward to today, and the facility isn’t as profitable as it once was but the town has grown and now the property is in a prime growth area. So the company is considering continuing to operate it, or simply shut it down and sell the property. When performing step 1 of the impairment test, the company estimates a 40 percent probability that the facility will be sold for a price of $300. They also estimate a 60 percent probability that the facility will continue to operate which will generate cash flows over the remaining useful life of $400. The company would use total undiscounted cash flows of $360 and compare that amount to the carrying value to determine recoverability and whether the company would need to proceed to step 2 of the test.
As you can see, understanding the held and used model is important, not just because of its pervasiveness, but because impairment testing usually occurs at a challenging time in a company’s economic environment. In those cases there is usually a lot happening at once, so it’s best to be prepared and think about these things before the test is necessary.
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