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Impairment Charges: The Good, the Bad, and the Ugly

Impairment Charges: The Good, The Bad And The Ugly

Impairment charge is the term for writing off worthless goodwill. It first made headlines in 2002 when companies adopted new accounting rules and disclosed huge goodwill write-offs. It gets attention whenever weak economies and faltering stock markets prompt more goodwill charge-offs and concerns over corporate balance sheets.If a corporation’s goodwill’s fair value is less than its carrying value, it’s deemed impaired, and must be charged off. It’s reduced to fair market value and represents a “mark-to-market” charge.If it’s done correctly, the impairment charge forces companies to revalue bad investments they made during the bubble years, when they overpaid for assets using overpriced stocks.The impairment charge also lets investors evaluate corporate management. If a company has to write off billions of dollars due to impairment, it has made poor decisions.Things get ugly when increased impairment charges reduce equity to levels that trigger technical loan defaults. Most companies who borrow money are required to maintain certain operating ratios. If they fail to meet those ratios, it can be deemed a default of the loan agreement. That’s bad for companies who want to refinance debt, especially large amounts.The bottom line is impairment risk is difficult to evaluate, but investors should watch for three red flags:Companies that made large acquisitions in the late 1990sCompanies with leverage ratios above 70% and negative operating cash flowsAnd companies whose stock price declined significantly since 2000

Reviewed by Natalya YashinaFact checked by Michael Rosenston

What Is an Impairment Charge?

An impairment charge is a process used by businesses to write off worthless goodwill or report a reduction in the value of goodwill. Investors, creditors, and others can find these charges on corporate income statements under the operating expense section.

These figures can be used to determine the financial health of a company. Creditors and investors often review impairment charges to make important decisions about whether to lend or invest in a particular company.

These charges began making headlines in 2002 as companies adopted new accounting rules and disclosed huge goodwill write-offs to resolve the misallocation of assets that occurred during the dotcom bubble. Some of the world’s largest companies reported major losses related to goodwill, including:

  • AOL Time Warner: $45.5 billion in 2002
  • McDonald’s: $99 million in 2004

Impairment charges came into the spotlight again during the Great Recession. Weakness in the economy and the faltering stock market forced more goodwill charge-offs and increased concerns about corporate balance sheets. This article will define the impairment charge and look at its good, bad, and ugly effects.

Key Takeaways

  • An impairment charge is an accounting term used to describe a reduction or total loss of the recoverable value of an asset.
  • Impairment can occur because of a change in legal circumstances, economic conditions, technology, a brand’s reputation, the business’s situation in the market, or as the result of a casualty loss from unforeseen hazards.
  • Impairment charges may be booked as goodwill for the acquiring company in an acquisition.
  • Goodwill is an intangible asset that a company assumes after acquiring another company.
  • The Financial Accounting Services Board’s rules for impairment charges of goodwill outline that companies must determine the fair market value of assets on a regular basis.

Understanding Impairment Charges

As with most generally accepted accounting principles (GAAP), the definition of impairment lies in the eyes of the beholder. The regulations are complex, but the fundamentals are relatively easy to understand. Under the new rules, all goodwill is to be assigned to the company’s reporting units that are expected to benefit from that goodwill.

Then the goodwill must be tested (at least annually) to determine if the recorded value of the goodwill is greater than the fair value. If the fair value is less than the carrying value, the goodwill is deemed impaired and must be charged off. It reduces the value of goodwill to the fair market value (FMV) and represents a mark-to-market (MTM) charge.

Individuals need to be aware of these risks and factor them into their investment decision-making process. There are no easy ways to evaluate impairment risk, but there are a few generalizations that often serve as red flags indicating which companies are at risk:

  1. The company made large acquisitions in the past.
  2. The company has high leverage ratios and negative operating cash flows.
  3. The company’s stock price has declined significantly in the past decade.
  4. Changes in technology or regulations
  5. Changes in the companies operating environment, or changes to the supply and demand situation of its products

Note

Prior to the adoption of the new GAAP accounting rules by the FASB in 2001, companies were allowed to amortize goodwill over a finite time period, sometimes as long as 40 years.

The Good

If done correctly, impairment charges provide investors with really valuable information. Balance sheets are bloated with goodwill that result from acquisitions made during eras of financial bubbles when companies overpaid for assets by buying overpriced stock.

Over-inflated financial statements distort not only the analysis of a company but also what investors should pay for its shares. The new rules force companies to revalue these bad investments, much like what the stock market did to individual stocks.

The impairment charge also provides investors with a way to evaluate corporate management and its decision-making track record. Companies that have to write off billions of dollars due to the impairment have not made good investment decisions. Management teams that bite the bullet and take an honest all-encompassing charge should be viewed more favorably than those who slowly bleed a company to death by deciding to take a series of recurring impairment charges, thereby manipulating reality.

Note

Impairment can be affected by internal factors (damage to assets, holding onto assets for restructuring, and others) or through external factors (changes in market prices and economic factors, as well as others).

The Bad

The Financial Accounting Standards Board (FASB) has rules in place for private and public companies, including those surrounding goodwill. For instance, Accounting Standards Codification (ASC) Topic 350 and Topic 805 allow companies to exercise discretion when allocating goodwill and determining its value.

Determining fair value is just as much an art as it is a science. Different experts can arrive at different valuations. It is also possible for the allocation process to be manipulated to avoid flunking the impairment test. As management teams attempt to avoid these charge-offs, more accounting shenanigans will undoubtedly result.

To help combat this, companies must disclose the fair value measurement, the methods used, reasons for the measurement, and other relevant information.

Important

The goodwill impairment test involves comparing the asset to its fair market value to see if the fair market value has declined below the reported value. If so, impairment must be done.

The Ugly

Things could get ugly if increased impairment charges reduce equity to levels that trigger technical loan defaults. Most lenders require debtor companies to promise to maintain certain operating ratios.

If a company does not meet these obligations, which are also called loan covenants, it can be deemed in default of the loan agreement. This could have a detrimental effect on the company’s ability to refinance its debt, especially if it has a large amount of debt and is in need of more financing. However, this is not common from impairment alone. Usually, other factors would play into a default.

Example of Impairment Charges

Here’s a hypothetical example using a fictitious company to show how impairment charges work. Assume that NetcoDOA has:

  • Equity of $3.45 billion
  • Total debt of $3.96 billion
  • Intangibles of $3.17 billion

To calculate the company’s tangible net worth, we need to use the following formula:

Tangible Net Worth = Total Assets − Liabilities − Intangible Assets

As such, NetcoDOA has a deficit net worth or negative tangible net worth of $3.68 billion ($3.45 billion – $3.96 billion – $3.17 billion). This means the company’s net liabilities are higher than its net tangible assets. Although it may be a cause for concern, companies like NetcoDOA may find themselves in a situation like this for several reasons, including times when changes in future projections impair any present value calculations for assets.

How Do Impairment Charges Work?

Impairment charges became commonplace after the dotcom bubble and gained traction again following the Great Recession. They involve writing off assets that lose value or whose values drop drastically, rendering them worthless. Goodwill refers to any intangible assets a company assumes as a result of an acquisition.

What Is Goodwill?

Goodwill is an intangible asset a company has that is related to the acquisition of one company by another. It represents the part of the purchase price that is higher than the combined total fair value of any assets purchased and liabilities assumed. This can be proprietary technology, employee relations, and brand names.

What Accounted for Cisco’s Impairment Charge in 2001?

Cisco reported an impairment charge of $289 million in 2001. This was the result of an all-stock deal worth $500 million when it acquired a startup company from Texas called Monterey Networks. The loss stemmed from the discontinuation of products Cisco assumed from Monterey following the acquisition.

The Bottom Line

Accounting regulations that require companies to mark their goodwill to market were a painful way to resolve the misallocation of assets that occurred during the dotcom bubble or during the subprime meltdown. In several ways, this metric helps investors by providing more relevant financial information, but it also gives companies a way to manipulate reality and postpone the inevitable.

Read the original article on Investopedia.

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