Goodwill impairment testing - Merry Christmas

Its closing bell for 2008, (whew finally...) and this year in addition to the usual laundry list of closing activities for USGAAP related accounts, there is bound to be an extensive list of activities to be added to the closing checklist on the CFO's calendar.... "Impairment Testing"

Companies are under FAS 142 required to look for factors that may lead to goodwill or other intangible asset impairments at quarter ends but are mandatorily required to examine and assess whether a firms goodwill and intangible assets have been impaired at the year end. This is to be performed regardless of there being a triggering event.

A goodwill write-down is required when the impairment is deemed permanent — or not "recoverable within a reasonable amount of time". In accounting terms, if the stock price stays below carrying value for 60 days it generally means a triggering event. We are in that kind of situation now, in which many companies are experiencing depressed pricing for longer than 60 days, and not seeing much volatility on the upside,

Where there is smoke there is fire, well if plummeting stock and real estate prices weren't enough, significant cash flows have begun to dry up. These will make it a thorny and a rather intriguing time on the excel sheets for financial analysts drawing up their round of cash flows over the next 5 years for impairment analysis testing.

The testing process itself is onerous and can be thorny, as it includes running several valuation models, examining and reworking internal forecasts, gathering and digesting analysts' price targets, reviewing historical pricing, and crunching industry data. Whats more once all this is through on the excel sheets, the same needs to be convinced to the board, thanks to  SOX & as well as to the audit firms. Companies may need to plan additional time devoted to this activity.

Assuming after all the testing, there is a permanent impairment and a Company is required to book impairment losses, "USGAAP rules prevent impairment losses to be reversed in the future.

This means that if the year 2008 were to be the worst year for a decade, we will be stuck with these impairment losses sitting in the reserves in the years to come. This can however be overcome, once you either sell the business unit in which the goodwill loss has been booked or the easier way out convert your accounts to IFRS as IASB allows reversal......... 

Well converting to IFRS maybe an easier solution as you can offset your losses by booking DTA (deferred tax assets) on the impairment losses with the hope that these will reverse once you convert to IFRS.......but thats only when you can pass the going concern test in the first place.......blip..zzzbliiipppzzz

Merry Christmas to Goodwill testing (i have time until March 31 as my books close then..)

PS - i now beleive in the theory that fair value accounting will lead to naked short selling (read our earlier article)... with the losses to be posted in Jan 09...better we shy away from the markets..click here

Leases - Asset Retirement obligations and MLP's

Should asset retirement obligations or costs incurred by an entity at the time of retirement of a fixed asset in a lease be included in calculating the minimum lease payments...

Asset retirement obligations or ARO's are defined as legal obligations imposed on an entity to reimburse costs to a third party upon retirement of tangible long lived assets. The term retirement is defined as the other-than-temporary removal of long lived assets from service and includes sale, disposal of assets etc.

To illustrate this in simple terms

Assume a Chemical Company takes on lease a factory for a period of 10 years from the Govt, the Company has been obligated by the Govt to decommissions all hazardous machinery at factory at the end of the lease term. The costs which will be incurred to dispose of the hazardous machinery are commonly referred to as ARO's.

Accounting for the ARO's are primarily been zeroed in USGAAP's FAS 143, wherein Companies are required to estimate the fair value of the ARO at the time of retirement and account them at their present values.

This issue of Substance over form looks at whether costs in an ARO for a leased property should be included while calculating the minimum lease payments for a lease classification there impacting lease accounting under FAS 13 under US GAAP or AS 19 under IGAAP.

Let us take two cases where there is a ARO involved

Case 1 - Company leases a fully furnished office (with carpets, cubicles, Air conditioning etc) and has been contractually obligated to remove the furnishings at the expiry of the lease

Case 2 - Company leases a raw office and furnishes the office, the Company is obligated to remove all furnishings at the expiry of the lease and hand over the office in the same raw condition back to the lessor

In both the circumstances there is a cost which the Company will incur at the expiry of the lease, the question is whether these costs should be categorized as minimum lease payments of the leased office for determining the classification and accounting of the lease of the office.

GAAP by definition, defines lease as the right to use the asset, therefore only monies which are directly identifiable to that asset should be included in the minimum lease payments.  

Case 1 - As the Company leased a furnished office, and has to incur costs at the end of the lease term to dismantle the asset, the cost of the dismantling or ARO will be construed as a minimum lease payment as the rent for the leased property included the cost of the furnishings and that the assets belonged to the lessor.

On case 2, as the assets were constructed post the leasing of the office, the dismantling costs or the ARO should not be included as the costs are not linked to the lease payments of the office. Rather these should be accounted under FAS 143 under USGAAP, at present there is no such  requirement under Indian GAAP

Let us take an another example to illustrate this further

Company A (lessor) owns a petrol station that it leases to Company B (lessee). The property includes pre-existing underground fuel storage tanks that are required by the local government to be removed in ten years. Even though Company A leases the petrol station to another party, it remains legally obligated for removal of the underground storage tanks and must recognize an ARO pursuant to FAS 143.

If the lease agreement requires Company B to remove the underground storage tanks at the end of the lease term, the cost of removal would be included in the minimum lease payments and accounted for under GAAP for leases 

 As the concept of ARO is still not very understood in the Indian GAAP context, one must always look for such costs embedded in agreements lease as these could be covered under AS 19. 

Its an another example of an embedded lease - GAAP is in more ways than truly substance over form.

Read our earlier article on embedded leases by clicking here.