What happens when the fair value of long-lived assets change?

Answer 1

CHANGES IN THE FAIR VALUE OF LONG-LIVED ASSETS

A firm acquires assets for their future benefits. The world changes, and expected future benefits change, sometimes increasing and sometimes decreasing. U.S. GAAP does not permit firms to increase the balance sheet carrying values of tangible and intangible long-lived assets when the fair values of their assets increase. This prohibition means that firms will recognize the increase in the fair value of the asset only as the firm realizes the value increase through either sale or continuing use.

In contrast, IFRS permits upward asset revaluations, the recognition of unrealized increases in the fair value of long-lived assets under certain conditions. In the case of an intangible asset, firms must base the revaluation on the price in an active market; in addition, the firm must perform the revaluation regularly and at the same time for all assets in a class of assets. These conditions are sufficiently restrictive that revaluations of intangible assets are rare. In the case of tangible long-lived assets, firms need not base fair value on the price in an active market; however, firms must keep the revaluations up to date. For both tangible and intangible assets, firms credit the increase in a revalued asset's balance sheet carrying value to other comprehensive income, not net income. However, firms would credit income if the increase reverses a revaluation decrease that was previously recognized as a loss.

ASSET IMPAIRMENTS

U.S. GAAP and IFRS differ in the recognition of unrealized increases in fair values, but both require firms to recognize decreases in fair values as an impairment loss. U.S. GAAP and IFRS distinguish three categories of long-lived assets for purposes of measuring and recognizing impairment losses:

Category 1 . Long-lived assets except intangible assets not subject to amortization and goodwill.

This category includes property, plant, equipment, patents, franchise rights, and similar assets. These assets provide benefits over predictable, finite periods of time and are therefore subject to depreciation or amortization. This category, however, also includes land, which provides benefits for an indefinite period of time and is not depreciated.

Category 2 . Intangibles, other than goodwill, not subject to amortization.

This category includes brand names, trademarks, and renewable licenses or other legal rights. Firms do not amortize these intangibles if they provide benefits over an indefinite period of time.

Category 3 . Goodwill.

Although both U.S. GAAP and IFRS distinguish the same three categories of long-lived assets for impairment analysis, the procedures for assessing an asset for impairment and measuring the impairment loss differ.

Under U.S. GAAP and IFRS reporting standards, management assesses the firm's assets for impairment at each reporting date by determining if impairment indicators are present. Impairment indicators include, for example, a decline in the market value of an asset significantly beyond what would be expected because of use or the passage of time; significant adverse changes in the entity's technological, market, economic, or legal environment; significant increases in expected return on investment.

U.S. GAAP Treatment of Asset Impairment for Long-Lived Assets Other Than Nonamortized Intangibles and Goodwill (Category 1)

U.S. GAAP provisions require a three-step procedure for measuring and recording impairments for long-lived assets other than nonamortized intangibles and goodwill.

1 . The test for an impairment loss for this category compares the sum of the undiscounted cash flows from the assets with their carrying values. An asset impairment loss arises when the carrying values of the assets exceed the sum of the undiscounted cash flows.

2 . The amount of the impairment loss is the excess of the carrying values of the assets over their fair values.

3 . At the time the firm judges that an impairment loss has occurred, the firm reduces the carrying value of the asset to its current fair value.

In requiring that the firm use undiscounted cash flows to test for an asset impairment in Step 1, the FASB reasoned that a loss has not occurred if the firm can recover in future cash flows an amount at least equal to or larger than the carrying value. The use of undiscounted, instead of discounted, cash flows seems theoretically unsound. The economic value of an asset may decline below its carrying value, but the firm would recognize no impairment loss because the undiscounted future cash flows from the asset exceed its carrying value.

IFRS Treatment of Asset Impairment for Long-Lived Assets Other Than Nonamortized Intangibles and Goodwill (Category 1)

The test for an impairment loss for assets in this category compares the balance sheet carrying value with the asset's recoverable amount, defined as the higher of (1) fair value less cost to sell, and (2) value in use, defined as the present value of future cash flows of the asset in its current use by the firm. The impairment loss is the excess of the carrying value over the assets' recoverable amount. The IASB requirements differ from those of U.S. GAAP in two ways:

1 . Under IFRS, firms need not compare the carrying value to the sum of the undiscounted cash flows to determine if an impairment loss has occurred. An impairment loss occurs whenever the carrying value exceeds the recoverable amount.

2 . Firms measure the impairment loss under IFRS by comparing the carrying value to the higher of the fair value less costs to sell and the value in use.

The recording of an impairment loss is similar under U.S. GAAP and IFRS. The accounting involves first removing the building's acquisition cost and the accumulated depreciation from the accounts and then establishing a new asset cost: fair value under U.S. GAAP and recoverable amount under IFRS.

Under both U.S. GAAP and IFRS, the firm includes the loss in net income, unless the firm had previously revalued the assets upward under IFRS. In that case the loss is a revaluation decrease (a debit to other comprehensive income) up to the amount of the revaluation, with any excess loss recognized in net income.

U.S. GAAP Treatment of Asset Impairment on Nonamortized Intangibles, Other Than Goodwill (Category 2)

Because these assets have an indefinite life, firms cannot feasibly apply the undiscounted cash flow test for asset impairment. That is, the indefinite life precludes estimation of total future cash flows. U.S. GAAP requires firms to recognize an impairment loss on a nonamortized intangible other than goodwill whenever the carrying value of the asset exceeds its fair value.

IFRS Treatment of Asset Impairment on Nonamortized Intangibles, Other Than Goodwill (Category 2)

The treatment for these assets parallels that for amortized or depreciated assets (Category 1) except that firms perform the impairment test annually (regardless of the presence of impairment indicators). The measurement of the loss and the new balance sheet carrying value are the same as for Category 1 assets.

Asset Impairment for Goodwill (Category 3)

Firms do not amortize goodwill under either U.S. GAAP or IFRS. Both standard-setting bodies require firms to test annually for impairment losses on goodwill, as well as whenever there is an indication of impairment due, for example, to changes in the legal or economic climate, adverse regulatory conditions, unanticipated competition, and loss of key personnel.

Goodwill is not a separable asset, so it is evaluated for impairment as part of a reporting unit (U.S. GAAP) or a cash generating unit (IFRS). These units are identifiable groups of assets that generate identifiable cash flows,which firms use to measure fair value (U.S. GAAP) or recoverable amount (IFRS).

U.S. GAAP Treatment of Goodwill Impairment

Before testing for goodwill impairment, firms must first apply the procedures described earlier for measuring and recognizing impairment losses on assets other than goodwill. Firms then follow these two steps:

Step 1 . Test for Impairment of Goodwill.

Ascertain the current fair value of a reporting unit that includes goodwill. Fair value is an exit value, the price a firm would receive if it sold the reporting unit in an orderly transaction at the measurement date. If the fair value of a reporting unit that includes goodwill is less than the carrying value of its assets (including goodwill) less liabilities, then an impairment loss on goodwill may have occurred and the firm proceeds to Step 2 .

Step 2 . Measure the Amount of the Goodwill Impairment Loss. Measuring the amount of the impairment loss of goodwill involves the following:

a . Allocate the fair value from Step 1 to identifiable assets and liabilities of the reporting unit based on their current fair values.

b. Allocate any excess fair value to goodwill.

c. Compare the amount allocated to goodwill in Step 2b with the balance sheet carrying value of goodwill.

d. Recognize an impairment loss on goodwill to reduce the carrying value of goodwill to its fair value computed in Step 2b.

This computation parallels the initial computation of goodwill when the reporting unit first recognized it at the time of a business combination. However, goodwill impairment does not involve a remeasurement on the balance sheet of the identifiable assets and liabilities. The accountant uses the allocations described in Steps 2a and 2b solely for purposes of measuring
the amount of the impairment loss to goodwill.

IFRS Treatment of Goodwill

The impairment test under IFRS is applied at the level of a cash generating unit, defined as the smallest identifiable group of assets that generates cash flows that are largely independent of the cash flows of other assets. If the recoverable amount of the unit is less than the balance sheet carrying value, the firm recognizes an impairment loss. The credit to offset the debit for the impairment loss is allocated first to goodwill and second to the other assets, the latter prorated based on their carrying amounts. In each instance, the asset (whether goodwill or a separately identifiable asset) is written down to its recoverable amount or zero, whichever is larger.

Although the amounts will be different, because both the impairment test and the subsequent balance sheet carrying value will be different. Unlike U.S. GAAP, IFRS requires that firms assess, every reporting period, whether there has been a recovery of a goodwill impairment loss. Firms must recognize a recovery if one has occurred.