Our previous coverage of SFAS No. 121 appeared in our October 1995 issue in the article "Accounting for the Impairment of Long-Lived Assets," by Anthony Cocco and Tommy Moores. That article provided an overview of the entire statement. The present article is intended to provide practical guidance on the implementation of the statement to real estate and does not cover all aspects of the statement Readers may find it helpful to refer to the previous article for a general discussion of the statement.
FAS No. 121, Accounting for the Impairment of Long-Lived Assets and for Long-Lived Assets to Be Disposed of is the most significant accounting principles pronouncement for owners and operators of real estate since 1982. SFAS No. 67, Accounting for Costs and Initial Rental Operations of Real Estate Projects, required adjustments for impairments of real estate held for sale or rental real estate under construction, using the property's net realizable value as the basis for the adjustment. However, there was no requirement for recognizing impairment of real property that was substantially complete and available for rental other than some very broadly worded requirement in SFAS No. 5, Accounting for Contingencies, that was inconsistently applied. This statement is designed to correct this omission and standardize accounting and reporting by requiring all impaired real estate to be written down to its fair value. The related impairment loss is to be recognized as a loss from continuing operations.
The statement differentiates between assets to be held for use and assets to be disposed of for purposes of determining when an impairment exists. Let's review these concepts in greater detail and see how they specifically apply to real estate.
Assets to Be Held and Used
Indications of Impairment An entity is required to review its real estate whenever there are changes in circumstances that indicate the recoverability of the carrying amount of the asset is in doubt. There can be numerous indications that real estate may be impaired. Some of the more obvious ones are as follows:
Environmental contamination of the property or its surrounding area.
A current period operating cash flow loss combined with a history of operating cash flow losses that were not projected when the property was acquired.
The expiration of material leases or insufficient rental demand.
Uncertainty regarding an entity's ability to refinance debt encumbering the subject property.
Significant cost overruns in the construction of a building.
Impairment Test and Measurement.
If there are indications the carrying amount of real estate held for use may not be recoverable, it should be tested for impairment. The impairment test consists of comparing the carrying amount of the real property to the future undiscounted net cash flows (before reduction for any interest charges) expected to be produced by the subject asset including its eventual sale. The use of undiscounted cash flows before interest charges was used as a practical approach by the FASB to avoid writing down an asset before it was probable that it was more than temporarily impaired.
If the total future net cash flows thus determined are less than the carrying amount of the real estate, an impairment exists. If an impairment exists and the carrying amount of the real estate exceeds its fair value, an impairment loss is recognized equal to the amount of the excess carrying amount.
The undiscounted cash flows are determined at the lowest level for which there are identifiable cash flows; cash flow streams from different operating properties cannot be combined. If a property does not produce revenue because it is used exclusively by the entity that owns it, the asset is combined with the entity's other long lived assets and compared to the entity's future undiscounted cash flows.
Once real estate held for use is written down to its fair value, it cannot be subsequently written up if the fair value of the asset should increase. …