As a result of the current inflationary economic conditions and lingering effects of the COVID-19 pandemic, many real estate owners have experienced a decline in values and are experiencing other distress relating to their real estate assets. This may result in the inclusion of non-cash impairment charges in the financial statements of current or future periods. Companies that prepare financial statements using accounting principles generally accepted in the United States (GAAP) must evaluate whether there has been an impairment of their real estate and other long-lived assets and, if so, record an impairment charge in earnings.

Defining an impairment test

When triggering events develop, such as the decline in market values that has been prevalent among certain real estate asset classes in the current economic environment, impairment testing should be performed. An impairment test is an accounting test to determine whether the economic benefits that the asset embodies have materially decreased.

When an asset is considered impaired

The regulations are complex, but the fundamentals are relatively easy to understand. The general threshold for impairment, as described under GAAP, is a lack of recoverability of the net carrying amount. Financial Accounting Standards Board (FASB) Accounting Standards Codification (ASC) 360-10-35-17 states that an impairment loss should be recognized only if the carrying amount is not recoverable and exceeds fair value. The carrying amount of the asset is considered not recoverable if it does not exceed the undiscounted net cash flows to be generated from the use and eventual disposition of the asset. If the fair value is less than the carrying value, the asset is deemed impaired and must be charged off or written down. This charge reduces the value of the asset to the fair market value and represents a mark-to-market charge.

Identifying asset groups subject to impairment

To determine whether there are triggering events or other key indicators, an entity first needs to identify asset groups that could be subject to impairment. An asset group is the grouping of assets and liabilities that represents the lowest level of identifiable cash flows that are largely independent of the cash flows of other groups of assets and liabilities (ASC 360-10-35-23). This is judgmental and will depend on the specific facts and circumstances of the entity. In the case of a rental real estate entity, this would generally include land, building, and improvements.

In certain limited situations, a long-lived asset, such as a corporate headquarters, may not have identifiable cash flows that are largely independent of the cash flows of any other asset groups. In this case, the asset group for that long-lived asset would include all assets and liabilities of the entity (ASC 360-10-35-24).

Importantly, the cash flows of one asset group may not be used to offset shortfalls in another asset group when applying the recoverability test discussed below.

Indicators and trigger events that help determine impairment

After the asset group is identified, the entity should determine whether events or changes in circumstances indicate that the asset group’s carrying amount may not be recoverable. Examples of these impairment indicators include, but are not limited to:

• A significant decrease in the market price of a long-lived asset (asset group)
• A significant adverse change in the extent or manner in which a long-lived asset (asset group) is being used or its physical condition
• A significant adverse change in legal factors or in the business climate that could affect the value of a long-lived asset (asset group), including:
  • An adverse action or assessment by a regulator;
  • An accumulation of costs significantly in excess of the amount originally expected for the acquisition or construction of a long-lived asset (asset group); or
  • A current-period operating or cash flow loss combined with a history of operating or cash flow losses or a projection or forecast that demonstrates continuing losses associated with the use of a long-lived asset (asset group)
• A current expectation that, more likely than not, a long-lived asset will be sold or otherwise disposed of significantly before the end of its previously estimated useful life, where the term “more likely than not” refers to a level of likelihood that is more than 50%

Impairment indicators that may exist in the current environment include the lingering effects of the COVID-19 pandemic, which have impacted asset valuations, effects of geographic concentration, governmental and political factors, declines in operating activity, downturn or volatility in markets, and reduced or idle production levels, in addition to inflation and rising interest rates, which have impacted capital markets, limiting the availability of affordable financing.

How to perform a recoverability test

If it is determined that impairment indicators are present, companies should perform a recoverability test. Such a test is performed by comparing the sum of the estimated undiscounted future cash flows attributable to the asset group from its operations and disposal to its carrying amount. The undiscounted cash flows used should include future cash flows directly associated with, and that are expected to arise as a direct result of, the use of the asset group and its eventual disposition. It generally should be determined on a pretax basis and exclude cash outflows for interest expense. Cash flow estimates should be generated based on the entity’s intended use of the asset group and its existing service potential or capacity. This should be exclusive of additional capital expenditures to increase capacity, although, capital expenditures to maintain existing service potential or capacity should be included. Existing cash flow projections should be fully reassessed to see if the entity’s operations have been impacted due to economic conditions or otherwise. If the carrying amount of the asset group is not recoverable, an impairment loss should be measured based on the excess of the carrying amount of the asset group over its fair value.

The appropriate order for impairment testing

It is also important to note that impairment testing should be performed in the appropriate order. Consistent with FASB ASC 360-10-35-27, impairment testing, which applies to other asset categories under applicable GAAP, as well as long-lived assets, should be performed as follows:

1. Adjust the carrying amounts of any assets, such as accounts receivable and inventory, as well as liabilities, such as accounts payable, long-term debt, and asset retirement obligations, that are not covered by FASB ASC 360-10 and are included in an asset group in accordance with other applicable GAAP.
2. Test for impairment and adjust carrying amounts of indefinite-lived intangible assets that are included in an asset group under FASB ASC 350-30.
3. Test long-lived assets (asset group), such as real estate and amortizable intangible assets, under FASB ASC 360-10.
4. Test goodwill of a reporting unit, or for private companies, an entity, that includes the aforementioned assets under FASB ASC 350-20.

How to recognize an impairment loss

If an asset is deemed to be impaired, the impairment loss is reported as part of operating income while reducing the carrying amount of the asset. Impairment loss should reduce only the carrying amounts of the long-lived assets of the asset group, excluding goodwill and indefinite-lived intangibles. 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 and should not reduce the carrying amount of those assets below their fair value. The carrying amount of the long-lived asset, after allocating impairment loss, is depreciated over the remaining useful life of that asset. Once the asset’s net carrying amount is adjusted for impairment loss, the entity is not permitted to write up the value of the long-lived assets in the future, even if circumstances change.

Considerations when performing impairment testing

As impairment testing is a requirement under GAAP, it could create some future issues for companies that require the write-down of impaired assets. When performing impairment testing, management should carefully consider interpreting the impairment test results and analyzing the underlying business model to determine if a company has impaired assets. Budgeting and modeling that are not performed correctly could result in inaccurate results. Certain components of impairment testing are subjective, so assets that are potentially performing well and generating sufficient cash flows may be deemed impaired if these considerations are not taken into account.

Potential impacts to consider when recording an impairment loss include debt covenant ratio violations, the impact on future operations, the inability to write up the asset when conditions improve, and additional potential financial statement disclosures, including those relating to going concern.

Citrin Cooperman’s Real Estate Industry Practice is skilled at helping clients navigate these complexities. If you have questions relating to impairment testing and your particular business, contact your Citrin Cooperman advisor or Jon Scalzitti at jscalzitti@citrincooperman.com.