[IMGCAP(1)]During the past few years, a host of factors have caused significant reductions in the assets of alternative energy companies on balance sheets. Unfortunately, this trend is likely to continue and is complicated by industry confusion about the impairment rules that are behind the write-downs.
These write-downs flow directly to the income statement as losses. Not good news for investors.
The alternative energy field in particular is littered with impairments. For instance:
• ECD, a solar panel manufacturer, inked a cumulative $622.4 million impairment of property, plant and equipment, goodwill and development loans prior to its bankruptcy due to an “adjustment to its technology roadmap.”
• First Solar wrote down $52.4 million of assets because of a significant reduction in research and development activities that had been focused on an alternative photovoltaic product.
• Canada-based Boralex wrote down (CAD) $6.5 million of assets after closing a thermal power station.
• Advanced Energy Industries wrote off a total of $2.4 million of property and equipment related to restructuring.
• And an Australian solar installer company, CBD Energy Ltd., wrote down impaired assets of (AUS) $12 million against a company market value of $19 million, blaming the removal of subsidies and political uncertainty.
An impairment of an asset on a company’s balance sheet usually happens during times of market volatility. That’s certainly the case given the recent recession, uncertainty about government incentives in renewable energy, and the inability of companies to commercialize their technology assets. We expect more impairments―and their associated losses on income statements―to continue as survivors of the industry’s economic shakeout adjust their strategic models to meet changing market demands.
Accounting Rules Misunderstood
U.S. GAAP guides companies on how they are supposed to account for long-lived assets, such as plant and equipment. However, in our work as auditors and public accountants, we’ve seen these rules misinterpreted or misapplied. Of course, companies want to avoid any potential comment letters from the SEC that might result in eventual restatement of financial results. Therefore, a review of the two-step impairment process might be helpful.
While there are different requirements for intangible assets not subject to amortization, such as goodwill related to a business acquisition, we will focus on long-lived assets such as property, plant and equipment.
Evaluating the Two-Step Impairment Process
Companies must evaluate their long-lived assets for impairments under a two-step process when certain triggering events exist. If any of these conditions, or events, is present, management must initiate the two-step process:
• Have you witnessed a significant decline in the market price for your long-lived assets, or adverse change in their physical condition, or how they are being used?
• Is there an adverse change in legal factors, such as actions by a regulator, which could affect an asset’s value?
• Have costs for an asset risen significantly over original projections?
• Has the company experienced operating losses or negative cash flows related to the use of the asset(s)?
• And finally, do you expect to sell or otherwise dispose of the asset before the end of its previously estimated time of service? The expectation is based on more or less than 50 percent sure.
Step 1: If any one of those questions is answered with a yes, management needs to enter the two-step process. The first step is to compare the undiscounted cash flows to the carrying value. If the projected cash flows are higher than the carrying value, no impairment exists and life can go on. If the cash flow is less than the carrying value, however, management has to proceed to the next step.
Step 2: The next step is to measure the amount of the impairment loss by comparing the carrying value to the fair value of the asset or asset group. Fair value is defined by U.S. GAAP as: “the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date.”
This is where things can get very subjective since fair value is purely an estimate, and there are many different variables that can factor into a price paid between two market participants. The accounting literature related to fair value provides two important concepts in estimating fair value. The first is the orderly transaction language. That means that you don’t value the asset as if it were part of a forced liquidation, a fire sale, if you will.
The other important concept, in our experience with this issue, is that fair value should assume the “highest and best use” of an asset or asset group. For instance, when valuing a manufacturing facility, the highest and best use of the facility may be to operate the plant for its estimated useful life as opposed to selling the individual assets. In that scenario, a discounted cash flow analysis would be more appropriate than the appraised value of each of the individual assets within the manufacturing facility.
Because of the subjectivity inherent in the fair value concept, it may be necessary for management to hire an outside valuation expert. Appraisers use three approaches to measure value. Any one of them or a combination of them can be used. They are (1) the market approach, (2) the income approach or (3) the cost approach. You can infer intuitively what they are: The market approach values an asset on external, comparable market information gleaned from other transactions. The income approach discounts the expected cash flows from the use of the asset. The cost approach estimates the replacement cost of the asset in today’s dollars.
For alternative energy companies in relatively new technologies, a pure market approach presents issues because much of their equipment is custom designed and manufactured for that company; in many cases the equipment is unique. There may not be a secondary market for those assets; therefore the sale of the equipment may not be the “highest and best use” of the assets.
The income approach is highly subjective since a key variable is management’s estimate of future cash flows. Adding to the subjectivity in the alt-energy field is the fact that much of the technology is very young, has proven to be highly volatile, and has been subject to oversupply problems (solar) and legislative impact (wind and geothermal production tax credit annual renewals). Companies are unable to predict what Congress will do with tariffs, tax credits and incentives.
The ultimate selection of the appropriate valuation methodology will be based on the “highest and best use” criterion and the advice of the outside valuation expert if used. Ultimately however, taking the time to evaluate the three approaches against your company’s current situation will provide you with the most reliable outcome for your income statement.
Greg Pfahl, CPA, is an audit partner in the Denver office of Hein & Associates LLP, a full-service public accounting and advisory firm with additional offices in Houston, Dallas and Orange County. He specializes in financial reporting for complex transactions, including initial public offerings, private offerings, and mergers and acquisitions, and serves as a local leader for the firm’s alternative energy practice area. Greg Pfahl can be reached at firstname.lastname@example.org or (303) 298-9600.
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