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Weekly UpdatesThe Governmental Accounting Standards Board just released a new standard on when and how governments should recognize that the service potential of a capital asset has been impaired. The new pronouncement also offers guidance on the appropriate accounting treatment for insurance recoveries, including those not associated with the impairment of capital assets. The provisions of GASB Statement No. 42 will first be mandatory for the fiscal year ended December 31, 2005. Earlier implementation, however, is encouraged.
BACKGROUND
Occasionally, the service potential of a capital asset will be either substantially reduced or eliminated altogether by an intervening event (e.g., natural disaster, accident, obsolescence). Accountants have always recognized immediately in the financial statements the loss that occurs when a capital asset loses all of its remaining service potential. They have not always done so, however, in cases involving only the partial impairment of a capital asset's service potential. GASB Statement No. 42, Accounting and Financial Reporting for Impairment of Capital Assets and for Insurance Recoveries, will henceforth require the recognition of such impairments.
SCOPE
It is not practical to attempt to reflect in the financial statements every situation in which the service potential of a capital asset has been impaired. Innumerable impairments represent no more than the inevitable result of age and use. Also, the financial effect of a given impairment is often insignificant. To avoid unduly burdening financial statement preparers, the GASB has chosen to limit its requirement to recognize capital asset impairments to just those situations that meet both of the following criteria:
* The event or change that gives rise to the impairment is outside the normal life cycle of the asset (thus eliminating the normal effects of aging and use)
* The magnitude of the decline in service value is significant
INDICATORS OF IMPAIRMENT
GASB Statement No. 42 identifies five specific situations that may indicate that a capital asset impairment meeting the criteria just described might have occurred:
1. Evidence of physical damage. Examples include an office building damaged in a windstorm or a school building requiring mold remediation.
2. Changes in legal or environmental factors. An underground storage tank that is no longer usable as the result of changes in environmental standards is one example of this criterion.
3. Technological changes or obsolescence. For example, consider medical equipment that can still be used, but for which demand is expected to significantly decrease with the advent of additional, more attractive treatment options.
4. Changes in manner or duration of use. Sometimes a capital asset is put to a significantly less valuable use than the one for which it was originally intended. One example of this is a superfluous school building being used instead as a warehouse.
5. Construction stoppage. A construction project may need to be abandoned for legal or practical reasons. Examples include highway construction that threatens the habitat of an endangered species or runway construction for the benefit of an airline that subsequently goes bankrupt.
Note that reduced demand, of itself, does not constitute an impairment. Assume, for example, that a government built a new water treatment plant in anticipation of growth rates that never materialized. The resultant underutilization of capacity would not qualify as an impairment. In other words, the simple fact that demand proves to be less than projected does not create an impairment. Conversely, a reduction in demand resulting from one of the five indicators cited earlier would constitute an impairment.
TEMPORARY VERSUS PERMANENT IMPAIRMENTS
The duration of an impairment is an important factor in its accounting treatment. A merely temporary impairment should not be recognized in the financial statements. A permanent impairment, on the other hand, needs to be recognized in the period in which it occurs. GASB Statement No. 42 directs financial statement preparers to presume that an asset impairment is permanent. In other words, the burden of proof rests on a financial statement preparer wishing to classify a capital asset impairment as temporary.
Furthermore, for permanently impaired capital assets, the appropriate accounting and financial reporting depends on whether the asset is expected to remain in service. For capital assets expected to remain in service, the impairment loss must be recognized using one of four different methods set forth in GASB Statement No. 42. If not, the capital asset should be reported at the lower of its carrying value or fair value.
CALCULATING IMPAIRMENT LOSSES
GASB Statement No. 42 describes four different methods for calculating impairment losses for capital assets that will remain in service:
* The restoration cost approach. This method generally is used for impairments associated with evidence of physical damage.
* The service units approach. This method is used for impairments resulting from changes in legal or environmental factors or from technological changes or obsolescence. It also may be used to calculate impairments associated with changes in the manner or duration of use of a capital asset.
* The deflated depreciated replacement cost approach. This method is used to calculate impairments associated with changes in the manner or duration of use of a capital asset.
* The lower of carrying value or fair value approach. This method is used for capital assets that will no longer be used following an impairment, as in the case of those associated with the stoppage of construction.
The relationship between specific impairment indicators and impairment calculation methods is illustrated in flowchart form in Exhibit 1 (which is taken directly from GASB Statement No. 42).
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It should be noted that these methods of calculating capital asset impairments are quite different from the approach employed in the private sector. The private sector approach is based on projected cash inflows associated with a given capital asset, a concept that would clearly not apply to most of the capital assets associated with governmental activities (because they are not revenue-generating). Furthermore, the GASB declined to authorize use of the private sector approach for business-type activities and enterprise funds to avoid needless complexity.
NOTE DISCLOSURE
GASB Statement No. 42 calls for two specific disclosures in connection with capital asset impairments. First, the amount and classification of any impairment losses need to be disclosed in the notes if they are not already visible on the face of the financial statements. Second, any capital assets that are idle, either permanently or temporarily, need to be disclosed.
INSURANCE RECOVERIES
If an insurance recovery occurs in the same year as the related loss, GASB Statement No. 42 directs that the two items be netted. In governmental funds, with their unique measurement focus and basis of accounting, insurance recoveries should be classified as an other financing source.
STEPHEN GAUTHIER is director of GFOA's Technical Service Center in Chicago, Illinois.
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