The accounting for impairment and loss recognition of property depends on the type of property (e.g., property held for development or completed real estate project) and the intent of the owner with respect to its use, once a project is completed. Paragraph 24 of FASB Statement No. 67, Accounting for Costs and Initial Rental Operations of Real Estate Projects, provides, in part:
The provisions in Statement 144 for long – lived assets to be disposed of by sale shall apply to a real estate project, or parts thereof, that is substantially completed and that is to be sold. The provisions in that Statement for long lived assets to be held and used shall apply to real estate held for development, including property to be developed in the future as well as that currently under development, and to a real estate project, or parts thereof, that is substantially completed and that is to be held and used (for example, for rental).
Impairment of a property is subject to the impairment provisions in “FASB Statement No. 144 (Accounting for the Impairment or Disposal of Long – Lived Assets)“. A long – lived asset is considered impaired when the carrying amount of the asset exceeds its fair value.
For purposes of recognition and measurement of an impairment loss, a long – lived asset needs to be grouped with other assets and liabilities at the lowest level for which identifiable cash flows are largely independent of the cash flows of other assets and liabilities.
EXAMPLE: In the case of an office building that a company has acquired to hold for rental, the asset group acquired may include intangible assets, such as in – place leases. In the case of the company’s headquarters facility, the asset group may include all assets and liabilities of the company, because a corporate headquarters building does not have identifiable cash flows that are largely independent of the cash flows of other assets and liabilities.
The guidance for the recognition of impairment losses is fundamentally different for “properties—to be—held—and—used” than for “properties—to be—disposed of—by sale”.
Impairment Of Properties To Be Held And Used
“Long–lived asset to be held and used” encompass all properties of a company that are not to be disposed of by sale (held for sale). Properties to be held and used may include properties a company holds for rental, as well as properties a company uses in its own operations, such as a factory or its corporate headquarters facility. The provisions of FASB Statement No. 144 for long – lived assets to be held and used also apply to real estate under development and to real estate to be developed in the future.
Two Step—Impairment Analysis under FASB Statement No. 144
FASB Statement No. 144 prescribes the following two steps impairment test to evaluate for impairment property to be held and used and to determine the amount of any impairment loss to be recognized:
Step-1: Determine whether the carrying amount of the “long—lived asset“ is recoverable through the sum of the undiscounted cash flows expected to result from the use and eventual disposition of the asset. These undiscounted cash flows exclude payments made by the owner for interest that is recognized as expense when incurred:
- If the carrying amount of the property is recoverable through undiscounted cash flows, no impairment loss needs to be recognized, even if the carrying amount of the asset exceeds its fair value.
- If the carrying amount is not recoverable through undiscounted cash flows, an impairment loss needs to be recognized, the amount of which is determined as described in Step 2 of the analysis.
Step-2: Determine the amount of impairment loss to be recognized by comparing the carrying amount of the asset to its fair value. The excess of the carrying amount of an asset over its fair value is the amount of impairment loss to be recognized in the financial statements.
Properties that are “to be held and used” need to be evaluated for impairment whenever events or changes in circumstances indicate that their carrying amounts may not be recoverable. The following are examples of impairment indicators:
- A significant decrease in the market price of real estate properties
- A significant adverse change in the extent or manner in which the real estate properties are being used or in their physical condition.
- A significant adverse change in legal factors or in the business climate that could affect the value of the real estate properties
- An accumulation of costs significantly in excess of the amount originally expected for the acquisition or construction of the real estate properties
- 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 the real estate properties
- A current expectation that, more likely than not, real estate properties will be sold or otherwise disposed of significantly before the end of their previously estimated useful lives
- Insufficient demand for a rental project currently under development may also indicate that the property is impaired.
When an impairment loss is recognized, the adjusted carrying amount of the real estate property becomes its new basis; restoration of a previously recognized impairment loss is inappropriate.
Impairment Of Properties To Be Disposed Of By Sale
If a company decides to sell a long—lived asset (properties), such as its corporate headquarters facility or a rental property, the property may meet the criteria for being classified as “to be disposed of by sale” (held for sale). A property classified as held for sale is measured at the lower of its carrying amount or fair value less cost to sell.
While classified as held for sale, the property is not depreciated. The provisions in Statement for long—lived assets to be disposed of by sale also apply to a real estate project that is substantially completed and that is to be sold.
One Step—Impairment Analysis under FASB Statement No.144
FASB Statement No. 144 requires a comparison of the carrying amount of the property held for sale with its fair value less cost to sell. If the carrying amount exceeds fair value less cost to sell, an impairment loss needs to be recognized. Any subsequent recoveries in fair value are recognized up to the amount of impairment losses (for a write-down to fair value less cost to sell) previously recognized. The reclassification of property to be held and used as property held for sale may result in the recognition of an impairment loss, as it is no longer appropriate to perform the two step—impairment analysis for properties held and used, described above.
“Loss on Sale of Properties” as a result of the requirement to recognize impairment losses for both:
“Properties to be held and used” and “properties to be disposed of by sale“, loss recognition in the period in which the sale is recorded is expected to occur only in limited circumstances.
In a situation in which, as a result of a decline in fair values, a company becomes aware during contract negotiations that the fair value of the property (less cost to sell) is less than its carrying amount, the company would generally recognize an impairment loss at that time rather than deferring the recognition of a loss on sale until the time of closing.
The impact of recording an “impairment loss” vs. a “loss on the sale of a property” is especially significant for real estate companies that use “Funds From Operations” as a performance measure; when adjusting net income to arrive at funds from operation, impairment losses are not added back. However, losses on the sale of properties are added back. Thus, a classification of “losses” as losses on sale rather than impairment losses leads to higher performance numbers.