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Impairment toolkit: Inventory and other current assets · PwC's accounting podcast

• 0:00
  SPEAKER_00: Thought Leadership from PWC.
• 0:09
  SPEAKER_01: Welcome to PWC's Accounting Podcast.
• 0:12
  SPEAKER_01: I'm Heather Horn.
• 0:14
  SPEAKER_01: Thanks for tuning in for our brand new Toolkit series where we're taking a deep dive each month into a single topic, recapping the basics, but also focusing in on frequently asked questions and judgmental areas.
• 0:27
  SPEAKER_01: This month we're all about impairment.
• 0:30
  SPEAKER_02: Timely consideration of the triggering events is critical.
• 0:34
  SPEAKER_01: That was Pat Durbin, a partner in PWC's national office and frequent guest to the podcast.
• 0:40
  SPEAKER_01: Pat's here today to provide us with an overview of the impairment models, including talking about the hierarchy of impairment as well as triggering events.
• 0:49
  SPEAKER_01: We'll then hit the specific impairment models for a few types of assets, including inventory and other current assets.
• 0:56
  SPEAKER_01: Pat has a wealth of experience and a lot to share.
• 1:00
  SPEAKER_01: So let's get started.
• 1:05
  SPEAKER_01: Pat, welcome back to the podcast.
• 1:07
  SPEAKER_01: It's been a few months, so very nice to have you back.
• 1:10
  SPEAKER_01: And you're kicking off our month of September dedicated to discussing impairment matters.
• 1:16
  SPEAKER_01: And we thought this was a great topic just given sort of the broader macroeconomic environment as well as a lot that's going on from a geopolitical perspective.
• 1:25
  SPEAKER_01: So before we jump into things and get into the specifics on some impairment issues, I thought it'd be helpful to back up and take a look at what's going on more broadly.
• 1:36
  SPEAKER_02: Yeah, sure, Heather.
• 1:36
  SPEAKER_02: And uh thanks.
• 1:37
  SPEAKER_02: Uh good to be here.
• 1:38
  SPEAKER_02: Um, always a pleasure to uh join you on the podcast.
• 1:41
  SPEAKER_02: Um, yeah, and I think the setup, you said impairment, and you might say, well, what's that mean?
• 1:46
  SPEAKER_02: And it's really um kind of our accounting term for when bad things start to happen.
• 1:52
  SPEAKER_02: And um, as we've been seeing over the last uh six months in particular, I would say there's been certainly a lot of market volatility.
• 2:00
  SPEAKER_02: We've certainly seen a lot of decreases in broader share prices.
• 2:04
  SPEAKER_02: We've seen some of the geopolitical issues driving some rising costs of oil prices, energy prices, we've got supply chain challenges, rising costs, inflation in general.
• 2:15
  SPEAKER_02: A lot of those things sometimes lead to eventually economic challenges, which means companies have to respond to those.
• 2:23
  SPEAKER_02: All of those things can start to put pressure on the values of assets we have on the balance sheet.
• 2:27
  SPEAKER_02: So I think that's kind of the why we're here today.
• 2:30
  SPEAKER_02: And, you know, if we just kind of step back and start with, you know, we sort of had COVID and lockdowns, and then we came out of that with some supply chain disruptions just from that sort of unprecedented disruption in life, generally, um, a couple of areas in particular, uh chip shortages, you know, that obviously created a lot of pressure on getting products to market coming out of the pandemic when we had sort of a post-COVID spike in demand.
• 2:58
  SPEAKER_02: Then you have, as I mentioned earlier, the geopolitical issues that drove significant increases in oil prices.
• 3:06
  SPEAKER_02: All of those factors sort of conspired to create a lot of uh inflation very recently, you know, pushing uh near double digits almost at one point here in the U.S.
• 3:16
  SPEAKER_02: So then you see central banks try to respond to that with their normal response, which is let's raise interest rates, just try to slow down the economy, slow down demand.
• 3:27
  SPEAKER_02: I think one of the interesting aspects of this this time around is maybe it's it's as much a supply challenge as it is a demand surplus, you know, almost not enough supply rather than too much demand.
• 3:39
  SPEAKER_02: But in any case, all of those things pretends potential for slowing economic growth, um, some potential fears even of a recession, and and all of that uncertainty certainly leads to a lot of volatility in the markets, um, particularly around equity prices, um, just the rising interest rates in and of themselves, depress asset value.
• 4:02
  SPEAKER_02: So, you know, if you break all that down, there's a lot of assets on the balance sheet that could be affected ultimately by those economic challenges.
• 4:14
  SPEAKER_01: All right.
• 4:15
  SPEAKER_01: Well, definitely lots to think about.
• 4:17
  SPEAKER_01: One thing you said though, Pat, really struck me, and I want us to clarify here, because I think it's such a good point.
• 4:23
  SPEAKER_01: You said it it's not that there's too much demand, it's that there's not enough supply.
• 4:28
  SPEAKER_01: Now, obviously those two things go together.
• 4:31
  SPEAKER_01: And so you kind of say, well, wait, what do you mean by that?
• 4:33
  SPEAKER_01: And I think what you mean is that it's not like demand has spiked, it's that supply has dropped.
• 4:39
  SPEAKER_01: But do you just want to clarify what you were getting at?
• 4:42
  SPEAKER_02: Yeah, and I mean, I'm certainly not an economist, and there's plenty of commentary out there on this.
• 4:47
  SPEAKER_02: I just think it's it's a little bit of an interesting phenomenon because um, you know, oftentimes I think the money supply is used as a tool to either speed up or slow down the economy.
• 4:59
  SPEAKER_02: And in this case, I think there's a real challenge in just getting products to market regardless of the price.
• 5:07
  SPEAKER_02: And so it, you know, it just continues to drive prices higher.
• 5:09
  SPEAKER_02: So it'll just be interesting, I guess, to see how successful that is and whether it really leads to you know the slowdown.
• 5:15
  SPEAKER_02: But I think that's certainly the set of circumstances collectively is sort of why we're having the conversation today about how to think about some of what could happen, uh, because some of the what could happen is the thing that we need to really deal with in today's accounting, even if it may not have happened yet.
• 5:34
  SPEAKER_01: Uh so Pat, that's a great point.
• 5:36
  SPEAKER_01: And I really think a perfect lead-in sort of to our overall topic here, which is there is sort of this convergence of factors that we haven't seen in some time.
• 5:47
  SPEAKER_01: Like we've seen some of these factors, like supply chain, what we were just talking about, I think is something we've been talking about since 2020.
• 5:54
  SPEAKER_01: But then the combination of these factors is relatively new.
• 5:58
  SPEAKER_01: And to the extent maybe it doesn't directly impact your balance sheet today, it could impact the value of assets that you have on your balance sheet.
• 6:06
  SPEAKER_01: So, with sort of that background, then how do you think about impairment?
• 6:12
  SPEAKER_01: Well, what so one thing I think is interesting, there's lots of different impairment, you know, sort of ordering and things.
• 6:18
  SPEAKER_01: So, how if you are talking to someone about impairment, where do you start?
• 6:23
  SPEAKER_02: Well, I think that is really the critical first step is really understanding that, okay, from a very broad perspective, you might say there's pressure on asset values, but we have lots of different measurement approaches we use in accounting, and we also have a lot of different impairment models depending on the class of the asset.
• 6:42
  SPEAKER_02: So it's really important to recognize that not everything is going to be measured or impaired potentially the same way.
• 6:50
  SPEAKER_02: And it is also important which order you test some of the assets for impairment, because some assets you look at individually and you look at an individual value for the asset.
• 7:01
  SPEAKER_02: Others you look at in sort of a collective unit or grouping of assets.
• 7:06
  SPEAKER_02: And so if you've got a different measure for one of the assets in that group, it could lead you to a different conclusion for the overall group if it's an asset that gets impaired in the context of the group as opposed to the individual asset.
• 7:19
  SPEAKER_02: So it's probably a uh like many things, an accounting, something only an accountant could love.
• 7:24
  SPEAKER_02: But there's a lot of reasons why we have that.
• 7:26
  SPEAKER_02: We won't get into all the history of the different models, but we thought it was important maybe just a level set on the different impairment models that we have.
• 7:33
  SPEAKER_02: And that starts with this question of okay, what order do I do it in?
• 7:38
  SPEAKER_02: So if we want to just start there, um, you know, I kind of think of this as like an order of liquidity exercise, meaning you sort of start with the most liquid, most readily tradable, marketable assets, and sort of work your way down the balance sheet with the what we would call probably the most illiquid asset, goodwill as sort of being the last in line in terms of when you're doing your impairment analyses.
• 8:04
  SPEAKER_02: And I think um we've got this set up to sort of go through kind of a series over the course of the month of working through some of these different models, but maybe just at a very high level to kind of tee up the framework for people.
• 8:16
  SPEAKER_02: If you start with your financial assets, um, you know, debt and equity securities, things that are traded, marketable.
• 8:25
  SPEAKER_02: Most of the accounting models for those are already some version of a fair value on the balance sheet at any point in time.
• 8:32
  SPEAKER_02: So there's really not usually much to deal with in terms of incremental impairment.
• 8:37
  SPEAKER_02: A certain class of debt securities available for sale debt securities, which we typically would measure at market, but you wouldn't recognize an impairment necessarily through the PL unless that's considered to be other than temporary.
• 8:52
  SPEAKER_02: Um, we have for receivables, we have sort of our normal credit loss model, or what we refer to today as Cecil.
• 8:59
  SPEAKER_02: So that sort of takes care of those.
• 9:02
  SPEAKER_02: If you keep moving your way down the balance sheet, we do have a class of equity securities which we say doesn't have a readily determinable fair value.
• 9:11
  SPEAKER_02: Those have a special impairment consideration.
• 9:15
  SPEAKER_02: I would say importantly, on anything that's sort of an investment in another entity or an investment in a debt security of some sort, there's usually no forgiveness on the time period in which you need to recognize the impairment if it if it's appropriate.
• 9:30
  SPEAKER_02: You still need to be thinking about those sort of at every balance sheet.
• 9:35
  SPEAKER_02: If we work our way then to sort of the non-financial asset space, um inventory, probably the most classic one, that's got a I'll say a fairly old-fashioned, more of a cost recovery type impairment model.
• 9:50
  SPEAKER_02: And then we have some other current assets, which we don't really have a comprehensive impairment framework for, but a lot of it gets to essentially this cost recovery concept, meaning, can I realize at least what I have on the balance sheet in some form of future economic benefit, kind of almost the definition of an asset.
• 10:10
  SPEAKER_02: And then we get into our long-lived assets, and there's really three pretty distinct types of those.
• 10:18
  SPEAKER_02: We have our indefinite lived intangibles other than goodwill, so think of brands, trademarks, those sorts of things, which we don't amortize, but we test them for impairment annually just based on an estimate of their fair value.
• 10:33
  SPEAKER_02: We have PPE or other um amortizable, intangible assets, so everything that we either depreciate or amortize, those get tested at an asset group level, and that test is um really technically only trigger-based, you know, and we'll talk a little bit more about triggers, but only trigger-based, and you really look at whether the cash flows from the group that those assets operate within, so we call it an asset group.
• 11:03
  SPEAKER_02: Um, you know, think of like a plant that might have lots of pieces of equipment or a part of a business that might depend on a particular technology that you acquired and it's on the balance sheet is an intangible, but you're amortizing it.
• 11:17
  SPEAKER_02: You look at that as sort of a collective group and say, can the cash flows from that group of assets support the cost I have it on the balance sheet for on an undiscounted basis?
• 11:28
  SPEAKER_02: That's sort of the threshold for whether I even need to think about an impairment.
• 11:33
  SPEAKER_02: And then last but certainly not least, we get the goodwill, which we also test in sort of this this group concept.
• 11:40
  SPEAKER_02: It's a different group, it's called a reporting unit, but that's really based more on an enterprise value concept of that group, and we have to go through sort of a discounted cash flow analysis, which is distinguished from the PPE and uh finite lived intangibles, which you do on an undiscounted basis.
• 12:00
  SPEAKER_01: Thank you for that ordering, but in particular, thank you for the comment you made at the beginning about the order of liquidity, because I don't know how many times we've talked about this topic on the podcast, not to mention the number of times I've had to do this in practice.
• 12:13
  SPEAKER_01: I think you are the first person that's ever made that observation to me.
• 12:17
  SPEAKER_01: So maybe a gap in my knowledge, but I do think it's a good rule of thumb for people if they're trying to remember wait, how do I do this?
• 12:26
  SPEAKER_01: Um, it's a great way to kind of think about it and for people to be minded.
• 12:30
  SPEAKER_01: So thank you for that.
• 12:31
  SPEAKER_01: And to the point Pat made as well before he started, we are going to do some separate episodes on some of these.
• 12:38
  SPEAKER_01: So, including dealing with the financial assets, we'll have a whole separate discussion and then goodwill as well.
• 12:46
  SPEAKER_01: But Pat, kind of sticking with this broad theme, you mentioned you started talking about triggers, and you mentioned, you know, financial assets were typically each period.
• 12:57
  SPEAKER_01: But let's talk again, stick broad here and talk about the triggers we'd have for these non-financial assets.
• 13:04
  SPEAKER_02: Yeah, and I think that's probably the the first key distinction is it really only comes into play if you're in a model where the accounting framework is not already a periodic remeasurement of that asset.
• 13:17
  SPEAKER_02: So you can sort of think about most of your financial assets as being already kind of dealt with, so there's no real incremental trigger.
• 13:25
  SPEAKER_02: I think there's again some in the debt security space, and I don't want to try to get into that realm.
• 13:30
  SPEAKER_02: But if you're outside of that space, um I guess we could talk quickly about inventory.
• 13:36
  SPEAKER_02: It's not really a trigger concept because there is an expectation you do it periodically.
• 13:40
  SPEAKER_02: Although in the ordinary course, if you're selling your product, you're earning a normal margin, you probably don't have to think very hard about it.
• 13:49
  SPEAKER_02: Um, but there's not an explicit sort of deferral of any impairment just till you have a trigger.
• 13:54
  SPEAKER_02: Where they become more important is um the amortizable or depreciable long-lab assets, um, and that would include, by the way, um right of use assets under leases now, because those get um included in their respective asset group.
• 14:13
  SPEAKER_02: In that case, um the trigger is the only trigger for doing an impairment.
• 14:19
  SPEAKER_02: There's not even an obligation necessarily to do it on an annual basis.
• 14:23
  SPEAKER_02: Now I would say it's part of your normal process, you're evaluating your business, you're going to be looking to make sure depreciable lives are still appropriate.
• 14:31
  SPEAKER_02: So you're probably implicitly looking at it, but there's really only an expectation to do the full impairment analysis if there's been some negative event.
• 14:40
  SPEAKER_02: Having said that, the way the triggers are described in GAP, they're fairly broad.
• 14:45
  SPEAKER_02: And when you think about a sort of broad-based negative economic downturn, I don't think it's going to be difficult for a lot of people to conclude they have an impairment trigger at some point, likely in 2022.
• 14:59
  SPEAKER_02: And the key here is you need to really identify when that trigger occurs.
• 15:04
  SPEAKER_02: Because once the trigger occurs, you don't get to wait until it's convenient.
• 15:08
  SPEAKER_02: You don't get to wait until the next annual closing period.
• 15:12
  SPEAKER_02: You need to do that analysis currently.
• 15:15
  SPEAKER_02: Goodwill, as I mentioned, we do annually no matter what.
• 15:18
  SPEAKER_02: We could be required to do it on an interim basis if there's a trigger.
• 15:22
  SPEAKER_02: And so that's why it's really important to be thinking about what are these triggers.
• 15:26
  SPEAKER_02: And again, they are fairly broad based and general in nature, but you need to be looking at the triggering events on a on a current basis at least to identify whether you've had them or not.
• 15:39
  SPEAKER_02: It's still it's going to be subject to any particular company circumstances, but you do need to have a process in place.
• 15:46
  SPEAKER_01: Well, and Pat, I think from having again talked to you about actually some specific impairments in the past, I believe you've said previously that if you are wondering if you've had a trigger, you probably have had a trigger.
• 15:58
  SPEAKER_01: Like as soon as you start asking yourself that question, it's it's probably a good sign.
• 16:02
  SPEAKER_01: I I do think um I want to get into some examples, and then maybe if you can think about this as we're talking, I do think there's a it's sometimes an issue here, which to your point, sort of when was the trigger?
• 16:18
  SPEAKER_01: You know, sort of things, if things are gradually getting worse, then was that this quarter?
• 16:22
  SPEAKER_01: Was it last quarter?
• 16:23
  SPEAKER_01: So maybe if we can give some examples for these different categories and then perhaps touch briefly on, okay, well, how do you think more broadly if things are are declining?
• 16:34
  SPEAKER_01: So just plant that seed and we can come back to it.
• 16:37
  SPEAKER_02: Yeah, so maybe just to talk some uh practical examples.
• 16:41
  SPEAKER_02: I mentioned inventory, where again, technically it's not really a trigger model, it should be a periodic assessment.
• 16:47
  SPEAKER_02: But if you think about things that are happening that might really uh precipitate the need to really think more about an impairment of inventory, um, certainly in any sort of consumer space, changes in consumer preferences or trends.
• 17:01
  SPEAKER_02: So, for example, we're seeing obviously a much greater demand for electric vehicles as opposed to traditional gasoline or fossil fuel-powered vehicles.
• 17:10
  SPEAKER_02: So all that stuff that's in your supply chain, are you going to be able to sell all that now?
• 17:16
  SPEAKER_02: Maybe right now, demand for any kind of car seems pretty high, so maybe it's not an issue.
• 17:20
  SPEAKER_02: But that's just an example of the type of shift in demand that might trigger the need to think about your inventory.
• 17:28
  SPEAKER_02: Any sort of technological change, so evolution of use of different types of materials.
• 17:32
  SPEAKER_02: So assume you're some sort of more of a business-to-business supplier and and and you make, for example, steel, maybe not a great example because it's sort of a commodity-driven pricing, but shifting to lighter weight materials, again, fueling more fuel-efficient vehicles, you might think about um that having an impact on your demand side.
• 17:54
  SPEAKER_02: Certainly, cost can have a big part in this equation.
• 17:58
  SPEAKER_02: So with the dramatic change in some of the input costs, particularly commodities, that all now drives the cost of your inventory up.
• 18:06
  SPEAKER_02: And assuming you're in a market where there's a lot of competition and you can't pass that on necessarily to your customer base, that's gonna drive the potential need for an impairment.
• 18:17
  SPEAKER_02: And then I think we've seen with all these supply chain disruptions, maybe that creating some different bubbles in the supply chain, particularly for retailers, as they try to say, well, we got to have the stuff when we need it.
• 18:31
  SPEAKER_02: So we're gonna maybe have more than we need, and then all of a sudden the season changes, or we get into a period where we have now too much inventory, you start discounting, so now you're making decisions to try to move the inventory, but you may not be able to realize the cost of the inventory.
• 18:47
  SPEAKER_02: So that could all drive you to think differently about inventory.
• 18:53
  SPEAKER_02: If we think about the long-lived assets, um, again, I mentioned the the nature of the test is sort of this undiscounted cash flow recovery test.
• 19:02
  SPEAKER_02: And the fact that it's undiscounted, a lot of times you might think provides some inherent, I'll call it headroom, because you know, assets you buy in theory are sort of at a current value, the cash flows you're going to generate over time in gross undiscounted terms, usually might be well in excess of that value.
• 19:20
  SPEAKER_02: But if you have a lot of negative factors conspiring against your business, rising costs, um maybe supply chain challenges, difficulty getting product through your system, all of those things have negative cash flow implications.
• 19:36
  SPEAKER_02: And because you're usually looking at a pretty long horizon, maybe even a relatively nominal decrement in those cash flow projections could cause you to end up on the wrong side of that undiscounted cash flow.
• 19:49
  SPEAKER_02: So you think about the geopolitical disruption, maybe even the um you know lockdown phenomena in different places.
• 19:57
  SPEAKER_02: You could end up with, you know, maybe facilities you've decided you need to temporarily idle.
• 20:02
  SPEAKER_02: That's going to have a cash flow implication.
• 20:05
  SPEAKER_02: Um maybe there's just the broader changes in the business climate, uh, some of the technology changes, some of the regulatory changes we've talked about, um, particularly in the um energy space, you know, those could all be factors that uh could contribute there.
• 20:22
  SPEAKER_02: And you can sort of combine all of that, if you will, and then think about goodwill, which is a you know, sort of an enterprise value concept.
• 20:31
  SPEAKER_02: So it depends on all of those different types of inputs.
• 20:34
  SPEAKER_02: But when you look at um the other big driver in the goodwill space would be essentially what's happening to market value.
• 20:43
  SPEAKER_02: So again, all other things being equal, as growth expectations come down, as interest rates go up, you know, all the valuation multiples come down.
• 20:53
  SPEAKER_02: So even if really nothing happened to your cash flows, you might say your value has declined, and that in and of itself might be a trigger, even if there wasn't any inherent bad news.
• 21:06
  SPEAKER_02: So looking at market prices for even the company as a whole, but that has to sort of reconcile to the value of the uh the different reporting units within a company, that can be a trigger in and of itself.
• 21:19
  SPEAKER_01: So definitely a lot of moving parts.
• 21:21
  SPEAKER_01: And then, Pat, if I sort of overlay this idea of like, well, okay, now we're at third quarter, what's different from second quarter, what's different from first quarter?
• 21:30
  SPEAKER_01: It almost seems like in this type of environment, you'd almost be best practice to just each quarter be jotting down for your areas where you could have impairment.
• 21:41
  SPEAKER_01: We don't, you know, we don't think there was a trigger, here's why, or we think there was, and we you did your test because that way at least you're not trying to remember wait, what were we thinking back in March?
• 21:50
  SPEAKER_01: And why didn't we kind of start thinking about some of this?
• 21:54
  SPEAKER_02: Yeah, you're absolutely right, Heather.
• 21:55
  SPEAKER_02: It's a great point.
• 21:56
  SPEAKER_02: And um, I think the reality is if you don't Do that, you're going to have a hard time when you realize you have a trigger.
• 22:04
  SPEAKER_02: Uh, well, wait a minute, maybe it was in an earlier period, right?
• 22:09
  SPEAKER_02: So certainly if you have a material amount of any of these assets that have this kind of trigger-based framework, you should have some process in your normal closing cycle.
• 22:20
  SPEAKER_02: And again, it it might vary depending on the circumstances in terms of the depth and the rigor that you need to apply to it, but you should have some discipline of assessing, hey, did we have a triggering event or not?
• 22:31
  SPEAKER_02: And then, if even possibly, you know, perhaps some more diligence in that case.
• 22:37
  SPEAKER_01: All right, very helpful.
• 22:38
  SPEAKER_01: So then, Pat, you mentioned um some of this as we went along, but the other question I would have is that this is really a case where we start to see differences among sectors, and we often don't focus too much on that, but I think it's helpful to kind of talk about some of the challenges you're seeing.
• 22:54
  SPEAKER_01: Because I know you're getting questions from lots of different sectors.
• 22:57
  SPEAKER_01: So, any sort of broad thoughts sector-wise?
• 23:01
  SPEAKER_02: Yeah, when you think about the broader trends, so one of the big, you might call it root cause type items is this whole supply chain challenge.
• 23:10
  SPEAKER_02: So anybody who's trying to get products from perhaps multiple suppliers to market in a competitive end market, uh, particularly maybe consumer-driven end market with some of the other broader uncertainty.
• 23:25
  SPEAKER_02: So think retail, you know, think automotive, those are places where you might start to see some of those challenges a little earlier.
• 23:33
  SPEAKER_02: Industrial manufacturing, just because a lot of times it's exposed to maybe more of the commodity pricing and um you know supply chains can be very complex.
• 23:43
  SPEAKER_02: So I would say those are those are some places, particularly when we look at, you know, I'll say inventory, some of the um, you know, goodwill, long-lived assets, they tend to be asset intensive in some respects.
• 23:56
  SPEAKER_02: So, you know, all those things create a bit more more risk.
• 24:00
  SPEAKER_02: Um, I don't want to speak too much out of my area of expertise in the in the financial sectors, right?
• 24:05
  SPEAKER_02: But certainly there's just a lot of disruption in the financial market, so there's going to be some exposure there.
• 24:11
  SPEAKER_02: But again, we're in a in a place where a lot more of that tends to be recognized currently anyway, so maybe more of a business challenge than an incoming challenge.
• 24:21
  SPEAKER_02: Um one that's a little bit more unique and uh maybe a little bit um less obvious is some of the healthcare providers, particularly where they um received perhaps a lot of additional funding via some of the COVID-related stimulus or just um funding to provide health services that maybe hid some other challenges they might have been dealing with in that environment coming out of that.
• 24:50
  SPEAKER_02: The labor challenges or labor shortages are certainly um particularly um challenging in that space.
• 24:58
  SPEAKER_02: And so um that's an area where you might have challenges in the, you know, more in the business outlook, which kind of drive those long-lived asset impairment models.
• 25:09
  SPEAKER_01: All right, so definitely a lot to think about.
• 25:11
  SPEAKER_01: And I know those are just a few examples.
• 25:13
  SPEAKER_01: So, Pat, you touched on this as we went along, but I do think digging a little deeper into the models for non-financial assets would be helpful.
• 25:22
  SPEAKER_01: We'll leave financial assets to uh that team when I have them on.
• 25:27
  SPEAKER_01: But perhaps we can start with inventory and then kind of work our way down the balance sheet.
• 25:32
  SPEAKER_02: Just to really get into it on inventory, as I mentioned, it's kind of an old-fashioned cost recovery model.
• 25:39
  SPEAKER_02: Um, we did refresh it here just um it's probably maybe six or seven years ago now.
• 25:45
  SPEAKER_02: Um, some might know it as the old lower of cost or market or LCM model.
• 25:50
  SPEAKER_02: Technically, now for most inventories, it's the lower of cost and net realizable value or NRV.
• 25:57
  SPEAKER_02: Um that's a concept that was part of the lower of cost or market construct, but a little bit simpler to apply, uh, maybe a bit more intuitive for people.
• 26:07
  SPEAKER_02: And again, it sort of gets back to can I basically recover the inventory for what I have it on the balance sheet at?
• 26:14
  SPEAKER_02: So essentially you're looking at your cost, and that might not be the cost of the finished good, it might be some materials or some work in process.
• 26:21
  SPEAKER_02: So you have to take the cost on the balance sheet, add the cost you would need to complete the inventory, and any incremental cost to sell, so think just direct distribution, uh selling costs incremental to that sale.
• 26:36
  SPEAKER_02: But if I add those all up and I can't sell it for something equal to or greater than that amount of cost, I have an impairment of that inventory, and so I need to write it down to that net realizable value amount.
• 26:51
  SPEAKER_02: The one exception uh I alluded to um is the lower cost of market, which is still the model for inventories that are measured using LIFO, or perhaps even more um obscure concept, the retail inventory method, um, which is used obviously in the retail space.
• 27:12
  SPEAKER_02: But in those two circumstances, you would compare your cost of inventory determined either under LIFO or under this retail method, and probably importantly under LIFO, most of the time because you're using old costs on the balance sheet, because you're putting the last costs through the PL, you have the old costs on the balance sheet.
• 27:31
  SPEAKER_02: The the actual measured amount of inventory on the balance sheet tends to be somewhat depressed relative to current costs anyway.
• 27:40
  SPEAKER_02: So a lot of times there's a little bit of inherent cushion.
• 27:43
  SPEAKER_02: But if you get into these very volatile um economic cycles, and a lot of people who use LIFO probably have exposure to commodities, you can get some pretty strange movements between inventory costs and where where the market is.
• 27:57
  SPEAKER_02: So it's not like a complete give out a jail free card.
• 28:01
  SPEAKER_02: But if you're using LIFO, then you need to apply this lower of cost or market technique.
• 28:07
  SPEAKER_02: And market is generally defined as replacement cost.
• 28:11
  SPEAKER_02: So what could I go buy that inventory for?
• 28:13
  SPEAKER_02: And if what I have it on the balance sheet for is more than that replacement cost or market, in theory I'd have an impairment.
• 28:20
  SPEAKER_02: Now there's replacement cost, though, in this context is sort of constrained between a ceiling and a floor.
• 28:28
  SPEAKER_02: The ceiling is the same as this NRV concept that I just described for the base inventory model, and the floor is that NRV amount less a normal profit margin.
• 28:40
  SPEAKER_02: So it tries to put your um, if you believe markets sort of your true measurement of what the value of that inventory is, if we're going to write it down, you don't write it down to an amount that's below your net realizable value unless a reasonable profit margin.
• 28:58
  SPEAKER_02: Nor would you, if you couldn't get net realizable value for it, you wouldn't have a replacement cost that exceeded that net realizable value.
• 29:07
  SPEAKER_02: So you it's just a more complicated way to get to something actually pretty close to probably the NRV model.
• 29:13
  SPEAKER_02: Um so there's not a great conceptual rationale for why we have these two different models, it was just a little bit of incremental change that that led us to that place.
• 29:23
  SPEAKER_02: Maybe just one one more point here, because we do get this question sometimes, is if I have a commitment to buy materials that will be used in my inventory and it's a firm, non-cancelable commitment, and I haven't otherwise hedged that for some other reason.
• 29:42
  SPEAKER_02: If I'm gonna buy stuff and once I turn it into products that I'm gonna sell, I'm gonna end up with this NRV problem on the inventory.
• 29:51
  SPEAKER_02: I essentially peek ahead looking at that commitment of what I'm gonna buy and run those materials through this NRV screen ultimately.
• 30:00
  SPEAKER_02: And if I conclude I'm going to have that NRV issue once I buy the inventory, I would go ahead and accrue that in advance of purchasing, actually completing the purchase at the inventory.
• 30:11
  SPEAKER_02: I point that out because it's an exception to what most people understand is a prohibition from accruing losses on just general executory contracts.
• 30:23
  SPEAKER_02: I mean, if we're in derivative space and those kind of places, we might have a liability.
• 30:27
  SPEAKER_02: But normally, we're not accruing those types of losses.
• 30:30
  SPEAKER_02: So this is a little bit of an exception.
• 30:33
  SPEAKER_01: Well, and Pat, I guess similarly, then if we're thinking about net realizable value, if I have inventory and a firm sales commitment, which is maybe higher than let's say current prices, then my net realizable value for that inventory would take that contract into account, or I could think about that.
• 30:53
  SPEAKER_02: Yeah, and that's a great uh follow-up, Heather, because I failed to mention that when we were talking about the NRV concept.
• 30:59
  SPEAKER_02: You look at the part of the NRV concept is the estimated selling price in the ordinary course of business.
• 31:05
  SPEAKER_02: So that could come through a firm sales commitment that you have, or just as you assess the market, it's I'd say not all that common, but there could be circumstances where you say, look, there's some sort of temporary disruption, but I don't intend to sell this inventory for another six months.
• 31:21
  SPEAKER_02: I expect the market to recover.
• 31:23
  SPEAKER_02: That is acceptable or potentially appropriate in the inventory context.
• 31:28
  SPEAKER_02: Not a lot of other places where you're doing asset valuations, would you be able to sort of anticipate that?
• 31:33
  SPEAKER_02: And I would definitely say proceed with caution, but the concept of being able to look at the prospective market for what you expect to be able to sell it for.
• 31:42
  SPEAKER_02: So it's not kind of a fire sale concept, it's not a I have to unload this all right today for whatever reason.
• 31:48
  SPEAKER_02: It is really looking at the ordinary course of business and what I expect to sell it for.
• 31:53
  SPEAKER_01: All right, that's helpful.
• 31:54
  SPEAKER_01: And I I actually have more inventory questions, and I know it's something you're interested in, but maybe another, we'll have to have another podcast because I know we have some other models to talk about here.
• 32:04
  SPEAKER_01: So this one we mentioned in passing, and then we we haven't touched on it again, but there is this sort of other current assets, you know, that don't fall into one of the other categories.
• 32:15
  SPEAKER_01: So, how do you typically think about those types of assets?
• 32:20
  SPEAKER_02: So I guess um there are some, there's maybe a little bit more guidance on things that um surround maybe a particular customer arrangement or customer contract.
• 32:31
  SPEAKER_02: Um, and this is they're not really part of the revenue model per se.
• 32:36
  SPEAKER_02: You know, if we had a contract asset that arose from our revenue accounting, that would be dealt with more like a receivable under the CISO model.
• 32:45
  SPEAKER_02: But if we, for example, had um a uh cost to obtain a contract that we had capitalized those costs and that's on the balance sheet, or if we had um the cost to fulfill a revenue contract, which is sort of akin to what I think of as like work in process inventory, you could think of it in that um connection.
• 33:08
  SPEAKER_02: Or there's even cases where maybe you make an upfront payment to a customer.
• 33:13
  SPEAKER_02: Um, those usually end up being a reduction of revenue, but there are times when it's appropriate to put those on the balance sheet as an asset.
• 33:20
  SPEAKER_02: We typically look at those and say, hey, should we recognize or how how should we measure impairment of those types of assets?
• 33:28
  SPEAKER_02: And as long as we think we're essentially going to be able to sell product under that arrangement for a positive margin, we'd say, okay, well, that's a that's a good asset.
• 33:40
  SPEAKER_02: You know, there's essentially enough revenue there to recover the cost of that asset.
• 33:46
  SPEAKER_02: So that's the sort of general model for some of those customer-related assets.
• 33:53
  SPEAKER_02: You get into a whole host of other things that might be on the balance sheet that probably are more out of convention, maybe it's like some sort of other prepayment.
• 34:01
  SPEAKER_02: Um, those we tend to just look at on an item-by-item basis and say, is there some reason why I don't think I'm gonna get the value out of this?
• 34:09
  SPEAKER_02: You know, maybe the counterparty um has failed, you know, so I prepaid for some service that they're not gonna be able to deliver.
• 34:16
  SPEAKER_02: Well, that's probably not any good to me.
• 34:19
  SPEAKER_02: And maybe I have a claim against them in bankruptcy, but you know, that's about the best of it.
• 34:24
  SPEAKER_02: And I probably wouldn't be able to maintain I'm gonna get my full value out of that.
• 34:28
  SPEAKER_02: But it's gonna be more of a, I'll just say a case by case and sort of what seems sensible.
• 34:33
  SPEAKER_02: I mean, those tend not to be um huge numbers, but you still have to think about them.
• 34:39
  SPEAKER_01: Yeah, I think that's a great reminder because I do think sometimes, especially if they're sort of longer in nature, you know, a few-year contract that it's easy to sort of overlook.
• 34:48
  SPEAKER_01: And, you know, it's again a good reminder that you should be checking, looking at these each uh reporting period.
• 34:54
  SPEAKER_01: So, Pat, so we've hit in this episode sort of the framework, and we also talked about inventory and now these other assets.
• 35:02
  SPEAKER_01: And then just a quick reminder for listeners look for our separate episodes on the financial assets, and then we will also have two episodes, one on PPE and the like, and then one on goodwill and intangible.
• 35:15
  SPEAKER_01: So more to come.
• 35:16
  SPEAKER_01: But Pat, I know one other area, and it kind of overlaps with some of your areas of focus, is that there can be other types of contracts that maybe aren't on the balance sheet, but that we should be also considering when we're doing our kind of holistic impairment look.
• 35:33
  SPEAKER_01: So I thought we could kind of hit those in this episode as well.
• 35:37
  SPEAKER_01: Uh, so what comes to mind?
• 35:39
  SPEAKER_01: So, sort of what's top of mind uh for you, and maybe I'll give a hint.
• 35:43
  SPEAKER_01: I was hoping you could start with revenue.
• 35:45
  SPEAKER_02: Yeah, so I think it's really just maybe it's the types of contracts that probably gave rise to some of those other assets we were talking about.
• 35:52
  SPEAKER_02: So um if you have a revenue contract in process, maybe you might not necessarily have a significant amount of inventory on the balance sheet, but in particular, um two areas I would say to focus on.
• 36:06
  SPEAKER_02: If you've got any sort of variable consideration, and a lot of times these might be longer-term arrangements where you have estimates of how much of something someone's going to buy that could have tiered pricing, various discount structures.
• 36:21
  SPEAKER_02: Now that we've got all these things happening in the economy, I really need to take a look and say, do all those estimates I had in place still make sense?
• 36:30
  SPEAKER_02: Do I still think my customers are going to buy as much as they were?
• 36:34
  SPEAKER_02: Um, I might have supply contracts on the other side.
• 36:37
  SPEAKER_02: Do I still think I'm going to buy as much as I was going to buy?
• 36:40
  SPEAKER_02: Sometimes when longer-term arrangements are negotiated and there's a big economic disruption, one of the parties is not going to be in a great spot in that arrangement.
• 36:51
  SPEAKER_02: So there might be renegotiations, and then you get into contract modifications.
• 36:56
  SPEAKER_02: And we have a specific contract modification framework in the revenue space, we don't really have that if we're on the buyer's side, supply side.
• 37:06
  SPEAKER_02: You could think about some of those concepts, but there's not really the same, I'll say, algorithm for working your way through what those or how you should handle those modifications.
• 37:16
  SPEAKER_02: I would say the one principle we tend to lean on is if you were in business and procuring goods and services from a counterparty and you expect to still be in business with them going forward, you probably need to look at those goods and services, if they're similar, as sort of all part of one longer-term arrangement.
• 37:37
  SPEAKER_02: Even if there's some shift in the economics, maybe you need to think about adjusting the pricing, not just of what you're going to buy in the future, but perhaps what you already procured.
• 37:47
  SPEAKER_02: Now, again, it's judgmental.
• 37:49
  SPEAKER_02: We work through them typically facts and circumstances, but I'd say that's sort of our going-in perspective.
• 37:55
  SPEAKER_02: And then just maybe one final point, if you're in any sort of a longer-term contract, I talked earlier about sort of we don't normally recognize losses on executory contracts.
• 38:04
  SPEAKER_02: If you are in a long-term, traditionally construction type project where you're estimating your total costs and you've got a fixed price, think of somebody building something now and all of a sudden the cost of their materials went way up.
• 38:19
  SPEAKER_02: If they don't have an ability to recover that through pricing, they could very well be in a situation where they are going to lose money completing that contract.
• 38:27
  SPEAKER_02: That's something that does need to be recognized currently.
• 38:30
  SPEAKER_02: So again, you don't necessarily have an asset on the balance sheet, but now you've got a situation where you're going to incur more costs than your revenue, and you might need to recognize that loss under the applicable gap framework.
• 38:43
  SPEAKER_01: All right, definitely a good reminder there, and I think a lot to think about.
• 38:48
  SPEAKER_01: So, Pat, clearly, you know, impairment is a big area, kind of spans the entire range of assets as well, as you just pointed out, as we think about our long-term contracts.
• 39:02
  SPEAKER_01: I know this is also an area where you tend to get a lot of questions.
• 39:06
  SPEAKER_01: So just taking a step back from your perspective, not necessarily focus on an individual model, but what is some of your sort of key reminders as you talk to people about thinking through triggering events, impairments, or otherwise?
• 39:22
  SPEAKER_02: Well, certainly, I think we chatted about it a little bit before, but timely consideration of the triggering events is critical, right?
• 39:28
  SPEAKER_02: Making sure you don't miss those.
• 39:31
  SPEAKER_02: And importantly, a lot of the triggers, even though that implies something's already happened, they have a little bit of a forward-looking feel to them.
• 39:40
  SPEAKER_02: So it's not enough to just wait until you've actually had a loss or you've actually had negative cash flows.
• 39:47
  SPEAKER_02: You really need to be thinking about what today is the current expectation.
• 39:52
  SPEAKER_02: You know, that could drive a trigger.
• 39:54
  SPEAKER_02: We talked about the ordering in which you do these impairment tests.
• 39:58
  SPEAKER_02: That's not discretionary.
• 40:00
  SPEAKER_02: That's a requirement in GAP in terms of the order you need to work through those impairment analyses.
• 40:05
  SPEAKER_02: So just make sure you pay attention because there are some places where you could get a different answer depending on the order you do them in.
• 40:12
  SPEAKER_02: That's why it's important to do it in the right order.
• 40:16
  SPEAKER_02: A lot of these factors, the macroeconomic conditions, they're likely going to affect multiple asset classes, but because we have these different impairment models, those effects could all be a little bit different.
• 40:28
  SPEAKER_02: And that can be frustrating, especially in a situation where you'd really say, okay, this is when things really went south.
• 40:35
  SPEAKER_02: I'd just like to get all the bad news behind me.
• 40:38
  SPEAKER_02: You really have to work your way through the models, and sometimes you just don't get to take all of the impairment that maybe you feel like you really think is coming if the model doesn't produce that result.
• 40:49
  SPEAKER_02: So um it's just important to sort of stay true to the to the gap framework.
• 40:55
  SPEAKER_01: All right.
• 40:55
  SPEAKER_01: Well, definitely some good reminders there.
• 40:57
  SPEAKER_01: Pat, thank you so much.
• 40:59
  SPEAKER_01: And then I have now our favorite time, which although having you on scares me because I think uh you've stumped me in the past.
• 41:07
  SPEAKER_01: But that said, I do have two stump the guest questions.
• 41:11
  SPEAKER_01: And uh, at least the first one, I will offer multiple choice if you don't want to guess.
• 41:16
  SPEAKER_01: So uh I think the the team was looking at, since we're kind of bumping up potentially against recession or it keeps in the news, they're looking back to the great recession of 2007 to 2009.
• 41:29
  SPEAKER_01: And as a result of the recession stock market plunge, how much net worth did Americans lose?
• 41:38
  SPEAKER_01: And like I said, happy to give a multiple choice here.
• 41:41
  SPEAKER_02: I I did say at the beginning I wasn't an economist, so I uh something probably with a trillion after it, but I think all right.
• 41:49
  SPEAKER_01: So then you already kind of guessed that the uh choice is I was going to give, because I was gonna give you billion and trillion.
• 41:56
  SPEAKER_01: So it was 19 trillion of net worth, according to the US Department of Treasury.
• 42:02
  SPEAKER_01: So it's a big number.
• 42:04
  SPEAKER_01: And then the second one related to this, you may be able to guess.
• 42:08
  SPEAKER_01: So in response to this financial crisis, what act was passed in 2010 with the goal of increasing government regulation over financial institutions?
• 42:18
  SPEAKER_02: Is that the Dodd-Frank Act?
• 42:20
  SPEAKER_01: Yes, good guess, Pat.
• 42:21
  SPEAKER_01: I'm not sure I could have pulled that one out.
• 42:23
  SPEAKER_01: So the Dodd-Frank Act was passed in 2010, and it included a number of provisions intended to prevent a similar financial crisis, including establishing the Consumer Financial Protection Bureau and improving the whistleblower program established by SOCS in 2002.
• 42:41
  SPEAKER_01: So excellent guessing there, or excellent knowledge, I should say, not guessing.
• 42:46
  SPEAKER_01: Um but Pat, it's always such a pleasure to have you on.
• 42:49
  SPEAKER_01: Thanks for joining me.
• 42:50
  SPEAKER_01: Thank you, Heather.
• 42:51
  SPEAKER_02: Good to be here.
• 42:53
  SPEAKER_01: That's our show for today.
• 42:55
  SPEAKER_01: Tune in later this week for more ESG content, and we'll be back next Tuesday to continue our series on impairment, where we'll be diving into the accounting considerations related to financial instruments.
• 43:06
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• 43:14
  SPEAKER_01: And to stay up to date on all our latest accounting and reporting news, sign up for our newsletter at viewpoint.pwc.com.
• 43:22
  SPEAKER_01: From Thought Leadership at PWC, I'm Heather Horn.
• 43:26
  SPEAKER_01: Thanks for tuning in.
• 43:31
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