Assessing Your Dealership's Asset Impairment RiskBy Scott Stafford
Article Date: 04-01-2010
Copyright(C) 2010 Associated Equipment Distributors. All Rights Reserved.
A two-step process to determine whether there’s a shortfall between rental assets’ fair value on your books vs. the carrying amount on your tax statements.
There you are, diligently working away against an unprecedented downturn in the equipment market. You are pouring over your balance sheet and asking yourself, “How can I shore this up?” You are pouring over market data and wondering, “Can there really still be this level of price pressure out there?” You are working diligently to maintain good relationships with your financing sources since, after all, someone has to provide the financing that you and your customers need to close a sales opportunity. At times it almost feels like too much. Then someone from your accounting department, or your bank auditor, or your financial statement auditor walks into your office and brings up yet another concern for you to address: asset impairment.
So you respond to this new problem by asking them a great question: “What are you talking about?” Put into plain English, asset impairment is a situation where the fair value of an asset you have recorded in your financial statements is lower than the carrying amount (cost less accumulated depreciation) you present for that asset, and that shortfall is deemed to be permanent. Without a doubt, asset impairment is one of the biggest potential accounting implications to your dealership’s financial statements of today’s uniquely difficult operating environment.
So what does this mean to you? How can you figure out whether you have an asset impairment issue in your dealership, or how can you evaluate whether someone who may be telling you there is impairment has a reasonable position or not?
The first step to answering these questions is to take a look at your balance sheet and ask yourself, “What are the assets of my dealership that are susceptible to impairment?” Typically, the assets of a dealership that are most susceptible to impairment during a market downturn are those in the rental fleet. When rental rate pressures arise and rental utilization rates fall, that makes for a perfect storm against the value of rental fleet assets. That is not to say those are the only assets where impairment could arise, but they certainly lead the list of prime suspects. Therefore, this discussion is focused on understanding the impairment analysis process related to rental fleet assets.
The next step is to gain an understanding of the basic concepts of the accounting guidance for this area, which can be found in the Financial Accounting Standards Board, Accounting Standards Codification section 360-10-40, Impairment or Disposal of Long-lived Assets (ASC 360-10-40). Under that guidance, you are only required to perform an asset impairment analysis when indicators arise that impairment may exist. Related to rental fleet assets, a couple of common indicators of a potential impairment include, but are not limited to: (1.) negative cash flows from rental operations, and (2.) the time and dollar rental utilization rates decrease significantly from historical trends.
The first common impairment indicator is straightforward – if your rental fleet is generating negative cash flows (i.e., your rental revenue stream is not breaking even with your rental operation costs) you may have an impairment in your rental fleet assets. The second common impairment indicator, equipment utilization rates, is more subjective. When evaluating the trends in your utilization rates and trying to determine if an impairment indicator exists, it is key to evaluate the percentage change in the rates period over period, rather than just the gross change in the rates period over period. Here is an example to help illustrate this point:
In this example, the gross year-over-year change of 11% may not be enough to raise a concern; however, when you evaluate the percentage year-over-year change of 29% and realize that the equipment utilization dropped nearly 30%, the change is alarming. While there are no “bright-line” measurements for the level of utilization rate decrease that give rise to the need for an impairment analysis defined in the accounting guidance, a percentage year-over-year change in excess of 20% would generally be accepted as very strong evidence that an impairment analysis is needed.
Let us assume that an indicator of impairment is present; what are the next steps in performing an impairment analysis? ASC 360-10-40 lays out what is essentially a two-step process for evaluating asset impairments as follows:
Step 1– Prepare an undiscounted cash flow analysis related to the assets in question. This analysis then compares the value of that undiscounted cash flow projection to the carrying amount of the assets. If the undiscounted cash flows are less than the carrying amount, this means that a potential impairment exists and it is time to move to Step 2.
Step 2– Determine the fair value of the assets in question and compare that fair value to the carrying amount of the assets. If the fair value is less than the carrying amounts, the assets are deemed impaired by the amount of the shortfall between those amounts. The impairment is recognized in the income statement as an impairment loss and as a reduction of the assets carrying amount in the balance sheet.
In order to perform Step 1 you must determine the anticipated undiscounted cash flows related to the rental assets being evaluated. An effective approach to do this is to look at projected rental revenues, considering such factors as (1.) the age of the rental asset, (2.) the expected remaining life of the asset in the fleet (a good benchmark is the normal depreciable life of the asset less its current time in the fleet), (3) your expected rental utilization rates for the asset during its remaining life in the fleet, and (4.) the expected rental rates for the asset during its remaining life in the fleet. The projected rental revenues would be offset by anticipated cash outflows for operating costs, such as repairs and maintenance expense in order to calculate the total estimated undiscounted cash flows. In order to illustrate how this calculation may look, let us assume you calculate time utilization based on days on rent during a 28-day month, as follows on page 20.
The next step would be to compare the undiscounted cash flows we calculated above to the carrying amount (again, the cost basis less accumulated depreciation) of the dozer equipment we are analyzing. If the carrying amount of the dozer assets is below $81,720, then you pass Step 1 of the impairment analysis, and you do not have an impairment related to this aspect of your rental fleet. However, if the carrying amount of the dozer assets is above $81,720, further analysis is needed, and it is time to move to Step 2 of the process.
Fair Value Determination
Similar to the evaluation of utilization rates, Step 2 of the process can involve quite a bit of subjectivity. Determination of the fair value of the equipment can be achieved using a number of differing methods. Typical techniques include:
1.)Use of a valuation company to perform an appraisal
2.)A compilation of market comparative data for the assets in question
3.)A discounted cash flow model
However, if your equipment is subject to periodic appraisals by a lender, those appraisal reports can serve as a quick source of the needed fair value data. Additionally, taking the undiscounted cash flows determined in Step 1 and discounting those using a weighted cost of capital for your dealership could also be a quick method for determining the fair value. Regardless of the method used to determine the fair value, you want to ensure that the method is reasonable and supportable. Once your valuation method achieves those goals, you are in a good position to move forward in the process.
Once you establish the fair value the next step is a simple comparison of that value to the carrying amount of the rental assets being evaluated. If the fair value is below the carrying amount, the asset is impaired by that shortfall, and the impairment loss accounting previously described must be followed. If the fair value is above the carrying amount, the rental assets are not impaired, there is no accounting impact, and you can rest your mind that you have put yet another issue to bed (at least until your next financial statement reporting period).
I know what you are thinking. All that sounds great and looks simple enough, but from where I stand things are a bit more complicated than that. My rental fleet has multiple lines of equipment in it, so how do I figure out the level within my fleet to which I need to be performing this analysis – do I pool the equipment lines together or do I leave them separated; do I need to dig deeper into my fleet than the equipment line level? Not to mention that it is going to take a lot of time and resources to evaluate every aspect of my rental fleet in this manner – is all that really necessary? How do I efficiently go about an impairment analysis given all these factors?
The generally accepted approach for determining the level within a group of assets (such as your rental fleet) for which you need to perform an impairment analysis is to determine the level at which the cash flows of the assets distinguish themselves from other assets within the pool. Put another way, at what level do your assets become interchangeable with one another? For example, if your earthmoving fleet cash flows are easily distinguished from your lift truck cash flows and one piece of your earthmoving fleet can be substituted for another one, then you can pool your earthmoving fleet equipment together and perform the analysis at that level for that aspect of your fleet.
An effective way to limit the amount of time and resources devoted to this issue is to think in terms of risk. What rental assets do I have that are at the highest level of risk for impairment? If you perform the analysis on those high-risk assets and pass either Step 1 or 2, then you can have confidence that the lower-risk assets are not impaired as well. So knowing what you now know about the impairment analysis process, you know that the shorter the amount of time the equipment has remaining in the fleet and the lower the rental utilization rates are for the equipment, the greater the risk that the undiscounted cash flows related to that equipment will not exceed its carrying amount. Therefore, focus your evaluation on the aged and idle equipment within your fleet.
Once you determine the levels within your fleet at which the analysis should be performed (using the aforementioned guidance as a framework), evaluate those asset groups to determine which group is the oldest, and therefore has the shortest remaining time in the fleet, and has the lowest expected levels of utilization. Then perform Step 1 of the analysis on that group of assets – if you pass Step 1, you can be confident that you do not have an impairment issue in your fleet. If you fail Step 1, then forge ahead to Step 2 of the analysis. If that group fails Step 2, then move on to the next highest risk level asset group and start the analysis process over. Keep working this process until the asset group being evaluated passes Step 1. When you reach that point, you can have confidence that no other impairment exists. This systematic approach is the most efficient way to fully address the rental equipment impairment risk to your dealership.
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