Businesses in every sector of the economy are dealing with the ramifications of the COVID-19 pandemic. Fixed assets are a critical component as companies seek to reassess asset values. In light of COVID-19 it is vital for businesses and accounting professionals to understand how the shockwaves of the pandemic flow down to the assets on the balance sheet. Accounting Standards Codifications (“ASC”) 350 (Intangibles – Goodwill and Other) and 360 (Long-lived Assets, Property, Plant, and Equipment) provide the framework for companies to test for impairment at both the reporting unit and asset group levels.
Is COVID-19 A Triggering Event For My Business?
For many businesses, COVID-19 represents the first potential triggering event in over a decade. Starting in late 2009, the United States economy began its recovery from the fallout of the Great Recession. While the generally accepted accounting guidance does not define what constitutes a triggering event, it is widely accepted as an external macroeconomic or industry-specific condition or consideration that significantly impacts the equity value of a business.
Clearly, COVID-19 has caused massive upheaval in the domestic and global economy. Governments have rushed to provide liquidity and payroll assistance to businesses of all sizes. Industries such as travel, leisure, retail, energy, and hospitality have seen unprecedented market deterioration. Ultimately, the decision as to whether the COVID-19 pandemic constitutes a triggering event will be determined by management in collaboration with its audit firm.
Fixed Assets Do Not Exist in a Vacuum
A common misconception of fixed assets is that they are isolated from the other assets on the balance sheet and/or the external economic environment In truth, fixed assets are interwoven with the business enterprise similar to intangible assets such as trade name, patented technology, and customer relationships. Companies should be actively evaluating all macroeconomic indicators to accurately capture fixed asset values. A discussion with valuation experts can be a starting point to understanding how COVID-19 could be affecting equity values. The fair value of the fixed assets is directly tied to the cash flows of the overall business. If the values of the fixed assets do not support the cash flows, a theoretical market participant would likely discount their purchase consideration of the assets in order to achieve their full economic benefit. In this scenario, a deeper dive into the presence of either functional or economic obsolescence would likely be required.
Functional and Economic Obsolescence
The COVID-19 pandemic has created the need for businesses to reassess the common methodologies associated with fixed asset depreciation. Market dynamics, business interruption, and a deteriorating secondary market for certain asset classes are just a few of the factors driving values down.
Technological advancements and changing attitudes towards machinery and equipment that require physical contact is also negatively impacting fixed asset values.
The carrying book value of fixed assets is often a linear calculation based on the original capitalized cost, acquisition date, and age of the asset. Based on the classification of the asset an economic life is then assigned. As an example, an asset with a capitalized original cost of $10,000 that was acquired in 2015 and assigned an economic life of ten years would have a carrying book value of $5,000.
While this approach is sufficient to satisfy a company’s internal accounting and depreciation procedures, there are additional steps required in the valuation process to arrive at fair value.
- Functional Obsolescence – The concept of functional obsolescence is relatively straightforward. Advancements in technology, processes, procedures, hardware and software design, and engineering affect the value of an asset. Machines that were built 20 years ago reflect the specifications of that era. Theoretically, assets designed and built with current specifications would be able to produce the same or greater utility than a comparable 20-year vintage asset. The older asset could be subject to a reduction in fair value due to the relatively outdated internal characteristics when analyzed against a comparable modern replacement.
- Economic Obsolescence – Fixed assets operate in concert with the business enterprise. Industries such as energy, manufacturing, and chemical processing require significant fixed asset investment to generate the revenues to support the business. Often the companies operating in these industries have profit margins correlated with a commodity such as oil. Declines in either production or demand of the commodity can have a direct impact on the profitability of these businesses. An oilfield services company that provides maintenance and repairs for drilling rigs is an example of a business reliant upon certain economic indicators (i.e. oil prices at levels to support drilling). If drilling activity decreases, the profitability of the business could decline. The decline in profitability should be reflected in the carrying value of the company’s assets, including fixed assets.
Conclusion
The COVID-19 pandemic has introduced a high degree of uncertainty into the financial markets. Proper reporting of financial conditions can give the users of a company’s financial statements comfort that the financial information being provided is reliable. Since many users of financial statements are concerned about potential impairment of assets in this environment, it is imperative that businesses operate in collaboration with their external auditors, valuation professionals, and other advisors to determine the accounting ramifications of COVID-19 as a triggering event for the balance sheet. The BVA team has extensive experience valuing fixed assets for impairment purposes consistent with ASC 360. The scope of our work routinely includes site inspections as well as discussions with management personnel to address some of the issues discussed in this article.
