In the world of finance, impairment is defined as “reduction in the estimated or nominal value of an asset.” No one wants their asset values to decrease, which is why regular assessments and inspections of assets are important. This is also known as “impairment testing.”
Commercial real estate assets, in particular, play a significant role in the financial statements of many organizations. As these assets are subject to potential impairment, it becomes crucial for businesses to conduct impairment testing to ensure accurate reporting of their financial positions. The Financial Accounting Standards Board (FASB) provides guidelines for impairment testing, outlining the requirements and procedures that organizations should follow.
Let’s explore the FASB guidelines for impairment testing in commercial real estate and discuss best practices to help businesses navigate this complex process effectively.
Understanding Impairment Testing
First, some basics. If you’re unaware, impairment testing is a critical step in assessing the value of commercial real estate assets. It involves determining whether the carrying amount of the asset exceeds its recoverable amount. The recoverable amount is the higher of the asset’s fair value less costs to sell or its value in use. If the carrying amount exceeds the recoverable amount, an impairment loss must be recognized in the financial statements.
FASB Guidelines for Impairment Testing
The FASB provides guidance on impairment testing in Accounting Standards Codification (ASC) Topic 360, Property, Plant, and Equipment. Here are key aspects to consider when conducting impairment testing in commercial real estate, inspired by the FASB’s guidance:
- Identifying Indicators of Impairment: Organizations should regularly assess whether there are any indicators of potential impairment. These indicators may include a significant decline in market value, adverse changes in the property’s physical condition, changes in legal or regulatory factors, or economic factors affecting the property’s income-generating ability.
- Measurement of Impairment: The FASB allows two approaches to measure impairment. The first is the fair value approach, where the fair value of the asset is compared to its carrying amount. The second is the value in use approach, where the present value of estimated future cash flows generated by the asset is compared to its carrying amount.
- Fair Value Considerations: If the fair value approach is chosen, organizations should carefully consider the fair value measurement techniques specified in ASC Topic 820, Fair Value Measurement. This includes considering market participant assumptions, utilizing appropriate valuation methods, and incorporating relevant market data.
- Estimating Future Cash Flows: When using the value in use approach, organizations need to make reasonable and supportable estimates of future cash flows. This involves considering factors such as expected rental income, occupancy rates, operating expenses, capital expenditures and discount rates.
Best Practices for Impairment Testing
While adhering to FASB guidelines, organizations can also follow these best practices to enhance the effectiveness and efficiency of impairment testing in commercial real estate:
- Regular Monitoring: Stay vigilant and monitor the commercial real estate market, economic conditions, and property-specific factors on an ongoing basis. Regular monitoring helps identify potential impairment indicators promptly.
- Engage Expertise: Involve professionals with expertise in commercial real estate valuation and impairment testing. Their knowledge and experience can ensure accurate and reliable assessments. (Quarem provides similar resources you can access, FYI.)
- Documentation and Transparency: Maintain detailed documentation of impairment testing procedures, assumptions, and rationale behind estimates. Transparent documentation is essential for auditors, regulators and stakeholders to understand the impairment assessment process.
- Sensitivity Analysis: Perform sensitivity analyses to assess the impact of changes in key assumptions on impairment calculations. This analysis helps organizations understand potential variability in impairment outcomes and make informed decisions.
- Regular Review of Discount Rates: The discount rate used in impairment testing significantly impacts the measurement of impairment. Organizations should regularly review and update their discount rates to reflect changes in market conditions and risks.
- Internal Controls: Establish robust internal controls to ensure the accuracy and consistency of impairment testing. This includes segregation of duties, review processes, and quality assurance mechanisms.
Impairment testing is a critical process for organizations with commercial real estate assets. To see how Quarem helps ensure compliance with accounting standards like FASB, request a demo of our tool today.