Are Operating Leases Impaired?

Lessors Should Take Necessary Steps to Evaluate

The recent instability and uncertainty in the economy has caused disruption in both our personal and professional lives. While much of this due to the effect of the Coronavirus pandemic over the past year, there are other challenges that lessors are confronted with continuously. Accounting departments appropriately lead the way in evaluating the impact and meaning of such developments on financial reporting. 

Asset performance has changed; some assets are being used more, some are being used less and some are being idled. How long these conditions will last is difficult to know. Accordingly, an area of increasing focus for lessors is that of asset impairment evaluation. FASB Accounting Standards Codification (ASC) Topic 360, “Property, Plant, and Equipment,” provides guidance for the impairment of long-lived assets that are classified as held and used. In particular, the relevant guidance is included in the “Impairment or Disposal of Long-Lived Asset” subsections of ASC 360-10. The following discussion hopes to raise awareness for operating lessors of asset impairment of property, plant and equipment given the dynamic marketplace and provide background and a reference to enhance understanding.

Asset Impairment Defined

Asset impairment describes a permanent reduction in the value of a company’s assets to below the net book value amount that is recognized in the financial statements. There are several accounting models for asset impairment. In the case of “hard” assets such as property, plant and equipment, generally accepted accounting principles or GAAP requires impairment to be considered when the net book value (NBV) of an asset is greater than the net undiscounted cash flows excluding interest expense and taxes. ASC 842 requires that lessors evaluate assets for impairment on an annual basis and when indicators of potential impairment materialize. For operating lease lessors this includes both the underlying assets and the operating lease receivables.

Steps for Evaluating Asset Impairment

There are basically four overall steps to be followed by the lessor when evaluating asset impairment:
1. Determine if there are indicators of impairment.
2. Determine the unit of account to test.
3. Test for recoverability of the asset.
4. Measure for any impairment.

Step 1. Determine if there are indicators of impairment.

Lessors need to be attuned to potential changes in the market value of their assets. Some examples of indicators or triggering events are as follows:
• Physical damage - There is a significant adverse change in the asset’s manner of use, or in its physical condition.
• Market conditions change - Objective evidence indicates there is a significant decrease in the asset’s market price.
• Early asset disposal - The asset is more than 50% likely to be sold or otherwise disposed of significantly before the end of its previously estimated useful life.
• Legal implications - There is a significant adverse change in legal factors or the business climate that could affect the asset’s value.
• Cash flow changes - There are past, current or expected cash flow losses associated with the asset or asset group.

In this environment, the market conditions trigger is often applicable.

Step 2. Determine the unit of account to test.

Lessors need to assess the proper asset or asset group to be tested.
For purposes of recognition and measurement of an impairment loss, a long-lived asset or assets shall be grouped with other assets and liabilities at the lowest level at which there are identifiable cash flows. This means largely independent of the cash flows of other asset or asset groups and liabilities. There is considerable judgement in applying this test. Some companies test long-lived assets under the assumption that each asset is an asset group, while others test entire reporting units (or the entire company as a whole) as an asset group. Both of the above positions appear to be supported by language within the standard as long as the facts and circumstances can support the position.

Step 3. Test for recoverability of the asset.

The recoverability test is performed by the lessor to determine whether an impairment loss should be measured.
The undiscounted net cash flows, excluding finance costs and taxes, expected to be generated by the underlying asset over its useful life, including estimated residual proceeds, are calculated based on the unit of account that was determined. The result is then compared with the asset’s current net book value. If the cash flows are greater than the net book value, then the analysis does not generally need to go further. This is a very forgiving test since discounting is omitted. However, if cash flows are less, then an impairment exists. The next step would be to measure the amount of any impairment, and that measurement is essentially dropping off a cliff.

In this environment, projecting cash flow may be difficult as today’s conditions are unusual. Some of the questions that need to be addressed include:
• How long will the current conditions last?
• What will cash flows be during the interim period to recovery?
• What will the “new normal” look like?

Step 4. Measure for any impairment.

The fair value of the asset or asset group is determined with the impairment being the amount by which the carrying value (NBV) exceeds the asset or asset group’s fair value. In accordance with GAAP guidelines, the determination and the character of cash flows in step 3 above are intended to be specific to the individual company. The cash flow financial projections in step 4 are recreated using market participant assumptions and fair value concepts. An appraisal would potentially be utilized to indicate and support the fair value. If the overall conclusion is that impairment exists, then it must be recognized in the financial statements.

Financial Statement Recognition

Impairment adjustments are recorded as a charge (loss) on the income statement, offset with a reduction to the asset account. If material, impairment charges are reflected as a separate line item. In addition to recording the actual impairment losses, disclosures are required about how the impairment charge was determined, including the indicators or triggering events, and the methods used to calculate the impairment. If an impairment loss is recognized, the adjusted carrying amount would become its new cost basis. Further, if the long-lived asset is depreciable, the new cost basis should be depreciated over the remaining useful life of that asset. Restoration of a previously recognized impairment loss is not permitted.

Allocating Impairment Losses to an Asset Group

In a scenario where an impairment loss is calculated, only the carrying amounts of a long-lived asset or assets of the group are decreased by that impairment loss. The loss should be allocated to the long-lived assets of the group on a pro-rata basis using the relative carrying amounts of those assets. However, the loss allocated to an individual long-lived asset of the group should not reduce the carrying amount of that asset below its fair value.

In Summary

Many lessors are still navigating through challenges in response to the Coronavirus and other factors. As the markets evolve and begin to re-emerge, companies should seek guidance from their professional service partners on impairment factors as discussed above and other elements beyond the scope of this article such as assets held for sale, loss allocations, impairments of receivables, lessee ROU impairment and others. This will ensure that impairment considerations are in compliance with GAAP and it will be meaningful for the stakeholders and users of its financial reporting information.