Question

Electroboy Enterprises, Inc. operates several stores throughout the western United States. As part of an operational and financial reporting review in a response to a downturn in its markets, the company’s management has decided to perform an impairment test on five stores (combined). The five stores’ sales have declined due to aging facilities and competition from a rival that opened new stores in the same markets. Management has developed the following information concerning the five stores as of the end of fiscal 2016.

Original cost \(36million Accumulated depreciation \)10 million Estimated remaining useful life 4 years Estimated expected future annual cash flows (not discounted) \(4.0 million per year Appropriate discount rate 5 percent

Accounting

1. Determine the amount of impairment loss, if any, that Electroboy should report for fiscal 2016 and the book value at which Electroboy should report the five stores on its fiscal year-end 2016 balance sheet. Assume that the cash flows occur at the end of each year.
2. Repeat part (a), but instead assume that (1) the estimated remaining useful life is 10 years, (2) the estimated annual cash flows are \)2,720,000 per year, and (3) the appropriate discount rate is 6 percent.

Analysis

Assume that you are a financial analyst and you participate in a conference call with Electroboy management in early 2017 (before Electroboy closes the books on fiscal 2016). During the conference call, you learn that management is considering selling the five stores, but the sale won’t likely be completed until the second quarter of fiscal 2017. Briefly discuss what implications this would have for Electroboy’s 2016 financial statements. Assume the same facts as in part (b) above.

Principles

Electroboy management would like to know the accounting for the impaired asset in periods subsequent to the impairment. Can the assets be written back up? Briefly discuss the conceptual arguments for this accounting.

Short answer

Answer

No, an impairment charge is necessary as the undiscounted value is less than the book value when the estimated cash flow is $2,720,000. Electroboy will need to write the stores down to $20,019,445 from $26 million. If the assets are held-for-sale, the assets can be written back up.

Step-by-step solution

Step-by-Step SolutionStep 1: Meaning of depreciation

In financial accounting, depreciation could be a strategy for spreading out the cost of tangible resources over their functional lives. Essentially, it is the disintegration of the value of an asset, which happens over time due to continuous use and abrasion of the asset.

(a) Explaining the “accounting” part

Calculating the undiscounted future cash flows

$\begin{array}{c}\text{Undiscounted\hspace{0.17em}future\hspace{0.17em}cash\hspace{0.17em}value}=\text{Expected\hspace{0.17em}future\hspace{0.17em}annual\hspace{0.17em}cash\hspace{0.17em}flow}\times \text{Estimated\hspace{0.17em}remaining\hspace{0.17em}life}\\ =\$4\text{\hspace{0.17em}million}\times 4\text{\hspace{0.17em}year}\\ =\$16\text{\hspace{0.17em}million}\end{array}$

Calculating the book value

$\begin{array}{c}\text{Book\hspace{0.17em}value}=\text{Original\hspace{0.17em}cost}-\text{Accumulated\hspace{0.17em}depreciation}\\ =\$36\text{\hspace{0.17em}million}-\$10\text{\hspace{0.17em}million}\\ =\$26\text{\hspace{0.17em}million}\end{array}$

The impairment test suggests that an impairment charge is necessary as the undiscounted value is less than the book value.

Calculating the estimated fair value

$\begin{array}{c}\text{Estimated\hspace{0.17em}fair\hspace{0.17em}value}=\text{Estimated\hspace{0.17em}expected\hspace{0.17em}future\hspace{0.17em}annual\hspace{0.17em}cash\hspace{0.17em}flow}\times {\text{PVF-OA}}_{4,5}\%\\ =\$4\text{\hspace{0.17em}million}\times 3.54595\\ =\$14,183,800\end{array}$

Calculating the impairment charge

$\begin{array}{c}\text{Impairment\hspace{0.17em}charge}=\text{Book\hspace{0.17em}value}-\text{Estimated\hspace{0.17em}fair\hspace{0.17em}value}\\ =\$26,000,000-\$14,183,800\\ =\$11,816,200\end{array}$

Post-impairment book value = $14,183,800

(b) Explaining the “accounting” part

Calculating the undiscounted future cash flows

$\begin{array}{c}\text{Undiscounted\hspace{0.17em}future\hspace{0.17em}cash\hspace{0.17em}value}=\text{Expected\hspace{0.17em}future\hspace{0.17em}annual\hspace{0.17em}cash\hspace{0.17em}flow}\times \text{Estimated\hspace{0.17em}remaining\hspace{0.17em}life}\\ =\$2.72\text{\hspace{0.17em}million}\times 10\text{\hspace{0.17em}year}\\ =\$27.2\text{\hspace{0.17em}million}\end{array}$

Calculating the book value

$\begin{array}{c}\text{Book\hspace{0.17em}value}=\text{Original\hspace{0.17em}cost}-\text{Accumulated\hspace{0.17em}depreciation}\\ =\$36\text{\hspace{0.17em}million}-\$10\text{\hspace{0.17em}million}\\ =\$26\text{\hspace{0.17em}million}\end{array}$

It is found that the undiscounted future cash flow is greater than the book value; the impairment test suggests that no impairment charge is necessary.

Book value at fiscal year-end = $26 million.

Explaining the “analysis” part

If the stores are being sold, they will very certainly be classified as “held-for-sale” for financial reporting purposes. The impairment test is based on discounted cash flows rather than undiscounted cash flows if they are held-for-sale. It's essentially a lower-of-cost-or-market strategy.

Calculating the estimated fair value

$\begin{array}{c}\text{Estimated\hspace{0.17em}fair\hspace{0.17em}value}=\text{Estimated\hspace{0.17em}expected\hspace{0.17em}future\hspace{0.17em}annual\hspace{0.17em}cash\hspace{0.17em}flow}\times {\text{PVF-OA}}_{4,5}\%\\ =\$2.72\text{\hspace{0.17em}million}\times 7.36009\\ =\$20,019,445\end{array}$

As a result, Electroboy will have to write down the stores from $26 million to $20,019,445. When management wants to sell the assets, fixed asset write-downs are more likely.

Explaining the “principles” part

Once an asset has been written down to an impairment value, it cannot be written up again under GAAP. This provision is based on a combination of caution and concerns about the accuracy of measures for upward revaluations of the respective impairment.