Evaluating the asset group
When companies fail to appropriately define asset groups, the unit of account for these analyses, they may inadvertently exclude assets or operations that would affect whether an impairment is required to be recognized. Determining the asset group can be complex and is driven by accounting guidance. Often, it may take a combination of accounting, operations and management — along with an understanding of existing accounting policies — to determine the asset group.
Although the valuation in Step 3 is based on a market-participant view, the unit of account for impairment is the asset group determined in Step 2. Management and their advisors should clearly document what comprises the asset group, along with any related accounting policy elections, such as the treatment of lease liabilities, income tax effects and the allocation of certain other types of assets or liabilities to the group. They may also need to understand whether the carrying values of other assets included in the asset group already include the effects of impairment assessments under other accounting rules.
Regarding income taxes, ASC 360 is silent on whether an entity should use pre- or post-tax cash flows in performing a recoverability test. Accordingly, an entity should adopt a formal policy of using either pre- or post-tax cash flows when performing a recoverability test. In practice, we have observed that most companies perform the recoverability test on a pre-tax basis. If an entity elects to perform the recoverability test using post-tax cash flows, the deferred taxes related to the asset group are included in the computation of the carrying value. Similarly, if an entity performs the recoverability test on a pre-tax basis, deferred taxes would not be included in the computation of the carrying value. The asset group and related cash flows must be consistent when performing the recoverability test. Regardless of the method applied (i.e., pre- or post-tax), the recoverability test will generally yield a consistent answer as to whether the assets are recoverable.
Identifying any differences in the unit of valuation and the unit of account (the asset group), and the related carrying values of related assets and liabilities in the asset group can be important to the final analysis.
Determining the term of the analysis
Companies are required to use the term of the primary asset in the asset group for evaluating recoverability. Sometimes companies may try to “back into” the analysis, using cash flow periods that are aligned more with an income-based approach to valuation following fair value measurement principles, and may ask valuation professionals to help determine such periods. The recoverability test, however, is also driven by accounting rules, which limit the cash flow period to the remaining life of the primary asset in the asset group. Although they sometimes align, this period can be significantly different than a market participant assumption.
When an ROU asset is the primary asset in the asset group, the remaining lease term, inclusive of reasonably assured renewal options, is the appropriate term for the recoverability test.
Estimating cash flows using company-specific assumptions
Cash flow estimates used for the recoverability test contain several inputs and assumptions. While these should reflect company-specific expectations, many of these may also involve valuation considerations. For example, if management is planning to sublease a ROU asset, management may need valuation insights to support its company-specific estimates, such as sublease rates, likely incentive cash flows, and estimates of the time and cost to find a sublease tenant.
Even if the company plans to continue to use the assets, valuation specialists may be asked to provide input. While the test presumes that the primary asset is not replaced or subject to major maintenance (routine maintenance is considered), other assets in the asset group may need to be replaced over this period, such as furniture, fixtures or other leasehold improvements. This may require estimates of the cash outflows to acquire a replacement asset. Conversely, estimates of terminal cash flows may be needed for assets that may have a longer life than the primary asset. Each of these inputs may require insights from valuation professionals.
We have increasingly seen cash flow analyses that fail to recognize a residual value or terminal cash flows for one or more of the assets in the asset group, which may often be sufficient to cause the asset group to pass the recoverability test. Even when such analyses include a residual (terminal) value, management often struggles to support this value given the difficulty in forecasting future market conditions.
Cascading effects of the recoverability test
Companies may inadvertently take some “shortcuts” or otherwise incorrectly determine asset groups or evaluate certain aspects of the recoverability test using incorrect assumptions, which can lead to cascading errors in the rest of the impairment analysis.
Errors or omissions in Step 2 can lead to incorrect conclusions about whether an asset group is impaired. Even if an impairment is still triggered, errors in determining the asset group (and its related carrying value) can ultimately lead to errors in the measurement and allocation of impairment losses.
As a result, companies should be careful to understand the accounting-related determinations and management-specific assumptions required and recognize that they may be different from market-participant assumptions.