Understanding Financial Statements What They Dont Tell You

<p>In February, this column featured an article titled, "Stop the Bleeding: Financial Reporting Considerations
of Liquidating a Business," which appropriately addressed financial statements prepared on the liquidation
basis of accounting for entities that are liquidating. Such entities are required to account for assets generally
at net realizable value. However, most entities do not express the intent or need to liquidate until it's too
late to even make a difference to the users of its financial statements. Accordingly, understanding the two
basic tenets of the present financial reporting model under U.S. generally accepted accounting principles
and some of the rules for asset valuation is critical to a user of financial statements.

</p><p>Our U.S. reporting model under the Generally Accepted Accounting Principles (GAAP) relies on a
basic going-concern assumption for all entities, unless the contrary is an expressed intent of or undeniable
reality to an entity. Thus, liquidation-basis financial statements would generally not apply; rather, historic
cost-based financial statements are the required basis of accounting for most entities except for those
liquidating and certain special instances, such as regulated entities and entities requiring financial and other
assets to be marked to market. The going-concern assumption and the historic cost-based accounting for
assets in our reporting model severely limit the usefulness of financial statements. The balance-sheet test
spoken of by practitioners in the restructuring community would be hard to measure except by pure chance
from a financial statement prepared in accordance with GAAP. Financial statements don't tell you all you
want or need to know.

</p><p>It's interesting that when accounting theoreticians and academics debate the reporting model, they focus
on forward-looking models and replacement-cost-based models with an emphasis on addressing the
limitations of the current model in its prohibition of asset write-ups. It's true that financial statements do
not capture the values implied by the market capitalization of a firm, whether higher or lower than an
entity's capitalization based on GAAP. However, given current market values (and let's not forget the
litigation environment), I'm not sure anyone is pushing to solve that issue. But GAAP has tried to address
some specific valuation issues such as the impairment of long-lived assets (again, focusing on asset
write-downs and prohibited by the accounting model to address write-ups). The remainder of this article
will discuss these rules which, in my opinion, unsatisfactorily address a critical valuation issue not fully
understood by most users of financial statements.

</p><p>In March 1995, the Financial Accounting Standards Board (FASB) issued Statement No. 121,
Accounting for the Impairment of Long-Lived Assets and for Long-Lived Assets to Be Disposed Of.
Statement 121 establishes the accounting for the impairment of long-lived assets, such as property, plants
and equipment; identifiable intangibles, including patents and trademarks; and goodwill related to those
assets. The rules specify when assets should be reviewed for impairment, how to determine whether an
asset or group of assets is impaired, how to measure an impairment loss and what financial statement
disclosures are necessary. Statement 121 also addresses accounting for similar assets that a company plans
to dispose of except for those assets that are part of a discontinued operation (covered by an entirely
different set of rules).

</p><p>Statement 121 requires the following three-step approach for recognizing and measuring the impairment
of assets to be held and used in an entity's business:

</p><ol>
<li>Consider whether indicators of impairment of long-lived assets exist.
</li><li>If indicators of impairment exist, determine whether the sum of the estimated undiscounted future
cash flows attributable to the assets in question is less than their carrying amounts.
</li><li>If less, recognize an impairment loss based on the excess of the carrying amount of the assets over their fair values.</li></ol>

<p>Thus, the rules only require an impairment review when events or circumstances indicate that an
impairment might exist (<i>i.e.,</i> the carrying amount of the assets might not be recoverable). Statement 121
lists the following examples of events or changes in circumstances that may indicate to management that
an impairment exists:

</p><ul>
<li>a significant decrease in the market value of an asset
</li><li>a significant change in the extent or manner in which an asset is used or a significant physical
change in an asset
</li><li>a significant adverse change in legal factors or in the business climate that affects the value of an asset or an adverse action or assessment by a regulator
</li><li>an accumulation of costs significantly in excess of the amount originally expected to acquire or
construct an asset, and
</li><li>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 an
income-producing asset.</li></ul>

This list is not all-inclusive, and there may be other events or changes in circumstances, including
circumstances that are peculiar to a company's business or industry, indicating that the carrying amount of a group of assets might not be recoverable and thus impaired.

<p>If one or more indicators are present, Statement 121 sets forth the following steps to determine any impairment:

</p><ul>
<li>Identify group assets at the lowest level for which there are identifiable cash flows.
</li><li>Estimate the future undiscounted cash flows expected to be generated from the use of those assets
and their eventual disposal. Interest-carrying costs are excluded from this measurement.
</li><li>Compare the estimated undiscounted cash flows to the carrying amount of the assets:

<ul><li>If the estimated undiscounted cash flows exceed the carrying amount (<i>i.e.,</i> net book value) of the assets, an impairment does not exist and a loss should not be recognized. However,
given the existence of the indicators of impairment, it may be appropriate for the entity to
review its depreciation policies (<i>e.g.,</i> reduce the estimated remaining useful life of the assets).
</li><li>If the estimated undiscounted cash flows are less than the carrying amount of the assets,
an impairment does exist and an impairment loss must be calculated based on the fair value
of the assets and recognized income.</li></ul></li></ul>

<p>Estimating future undiscounted cash flows requires a great deal of judgment. Entities must make their
best estimate based on reasonable and supportable assumptions and projections that are applied on a
consistent basis. Statement 121 indicates that all available evidence should be considered in developing
the cash-flow estimates, and the weight given that evidence should be commensurate with the extent to
which the evidence can be verified objectively.

</p><p>The expected future undiscounted cash flows from the use and eventual disposal of each group of assets
must be compared with the carrying amount of that group of assets. If the sum of the estimated
undiscounted cash flows is less than the carrying amount of the assets, an impairment loss must be
recorded. The impairment loss is measured by comparing the fair value of the assets with their carrying
amount. Any write-downs are treated as permanent reductions in the carrying amount of the assets.

</p><p>Fair value is the amount for which the asset could be bought or sold in a current transaction between
a willing buyer and seller. The use of fair value was considered appropriate because "a decision to continue
to operate rather than sell an impaired asset is economically similar to a decision to invest in that asset,"
and because "the fair value of an impaired asset is the best measure of the cost of continuing to use that
asset because it is consistent with management's decision process." Although the best measure of an asset's
fair value is its quoted market price in an active market, active markets for many long-lived assets often do
not exist. Therefore, if quoted market prices are not available, the estimate of fair value shall be based on
the best information available in the circumstances. The estimate of fair value shall consider prices for
similar assets and the results of valuation techniques to the extent available in the circumstances. Examples
of valuation techniques include the present value of estimated expected future cash flows using a discount
rate commensurate with the risks involved, option-pricing models, matrix pricing, option-adjusted spread
models and fundamental analysis.

</p><p>Statement 121 also requires that long-lived assets and identifiable intangibles that are held for disposal
be reported at the lower of the assets' carrying amount or fair value less costs related to the assets'
disposition. If the fair value of those assets increases or decreases in subsequent periods, the carrying
amount of the assets would be adjusted accordingly. However, any increase cannot cause an asset's
carrying amount to exceed the carrying amount of the asset before the decision to dispose of the asset
has been made.

</p><p>An entity that recognizes an impairment loss shall disclose all of the following in financial statements
that include the period of the impairment write-down:

</p><ul>
<li>a description of the impaired assets and the facts and circumstances leading to the impairment

</li><li>the amount of the impairment loss and how fair value was determined

</li><li>the caption in the income statement or the statement of activities in which the impairment loss is aggregated if that loss has not been presented as a separate caption or reported parenthetically on the face of the statement

</li><li>if applicable, the business segment(s) affected.</li></ul>

<p>However, <i>there is no affirmative requirement to disclose</i> whether any indicators were present, or the results
of applying the tests for impairment were present, <i>unless an impairment loss was recognized.</i>

</p><p>Therefore, notwithstanding the timing or present value of estimated undiscounted cash flows associated
with long-lived assets (other than those held for disposal), so long as the undiscounted amount is greater
than or equal to the carrying amount of the assets, no impairment is recorded. The user of such financial
statements would be unaware of even the consideration of impairment indicators and the results of the
impairment evaluation. That's a critical factor to recognize by users of financial statements. Using an
extreme example, a $1 million asset having future undiscounted cash flows of $1 million all realized 10
years from now is not impaired under this accounting principle.

</p><p>What's the economic reality of such an accounting convention? Not much. But at least you're aware
of the issue and won't be so ready to just accept generally accepted accounting principles and financial
statements prepared in accordance with GAAP on face value. Then again, if you're a restructuring
professional, you probably don't accept anything on face value; this is just another example of why you're
correct in keeping to that principle.

</p>