Changes in operating conditions for the energy sector, including an adverse business climate marked by a decline in crude oil prices, reduced revenues and reduced operations, or a shift in current period cash flow losses, may make it more difficult to fully recover the carrying value of a long-lived asset.
While many companies already account for the disposal or expected disposal of long-lived assets, current economic conditions for this sector may change these calculations and may also indicate that the carrying amount for the asset has become unrecoverable. In these circumstances, the asset becomes impaired, meaning it is worth less on the market than the value listed on the company's balance sheet. Management should then know when to consider the indicators of potential impairment, how to test for impairment and how to properly account for and disclose impairment if it occurs.
"An impairment loss occurs when the asset's carrying amount is not recoverable and exceeds its fair value."
How to assess impairment
An impairment loss occurs when the asset's carrying amount is not recoverable and exceeds its fair value. While entities are not required to routinely assess all of their long-lived assets for impairment, they should do so whenever conditions within the organization change that may make the carrying cost more onerous. Indicators of impairment include:
- A significant decrease in the market price of the asset
- Higher than expected operating costs from using the asset
- A significant adverse change in the physical condition of the asset
- A change in how the company uses the asset
- A change in the business climate or other legal factors that could affect the asset's value
- Incurring costs to acquire or construct an asset that are significantly higher than originally projected
- Current period operating or cash flow losses associated with the asset along with projections of continued losses
- The expectation that the asset will be retired or sold significantly sooner than originally estimated
Of course, these indicators are not inclusive and if other factors arise that raise doubts about the recoverability of an asset, management should have an accountant assess the asset for impairment.
How to calculate an impairment loss
The business will need to estimate both the expected cash flows and the fair value of the long-lived asset to calculate the impairment loss. The impairment loss is calculated based on the excess of the carrying amount of the long-lived asset over the long-lived asset's fair value.
"Impairment loss is calculated using both the expected cash flows and the fair value of the long-lived asset."
Estimated future cash flows from the long-lived asset can be assessed using receipts and disbursements directly associated with, and expected to arise as a direct result of, the use and eventual disposition of the asset. However, this estimate should also incorporate the business' assumptions about its use of the asset and consider all available evidence, including assumptions used when developing budgets and other information used for financial projections.
If the estimated undiscounted cash flows from the asset are at least equal to the asset's carrying amount, no impairment loss has occurred. However, if the carrying amount exceeds the estimated undiscounted cash flows, this must be recognized as an impairment loss through a charge to earnings and a reduction of the asset's carrying amount. When assessing fair market value of the asset, the business should use the quoted market price in an active market. If that information is not available, the business can use its estimate of fair value based on the best information available, including prices for similar assets in recent transactions.
This adjusted carrying amount then becomes the asset's new cost basis and should be depreciated over the estimated remaining useful life of the asset. If the business decides to sell or abandon the asset, the asset can be depreciated based on the carrying amount at the date of abandonment equal to the expected salvaged value, if any.
Further, while companies should test for recoverability using expected future cash flows at the lowest level for which these cash flows can be identified, companies do often group assets, especially if they intend to sell or abandon the group of assets in a single transaction. Groups may include long-lived assets, as well as shorter-term assets and other liabilities. While this is permissible, impairment should still be assessed for each individual asset at the lowest level possible, whenever it is applicable to do so.
How to disclose an impairment
To disclose the impairment of the asset, the business will need to report the impairment loss in income from continuing operations before income taxes in the income statement. Additionally, the business should describe the impaired asset and the facts and circumstances leading to the impairment, including the method used to determine fair value. If not presented separately on the face of the income statement, the company must clearly identify the amount of the impairment loss and the portion of the income statement in which the loss is aggregated.
If the long-lived asset has been sold, the company's financial statements should report any impairment gain or loss due to the write-down of the asset to fair value less selling costs. Long-lived assets held for sale should be recorded separately in the balance sheet, and any other assets and liabilities grouped for sale with assets should be presented separately.
For additional guidance on accounting for the impairment or disposal of long-lived assets, contact the audit and assurance professionals at LaPorte.