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

Reviewed by Natalya Yashina

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 drastic reduction or loss in the recoverable value of an asset.
• Impairment can occur because of a change in legal or economic circumstances, 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 (greater than 70%) leverage ratios and negative operating cash flows.
3. The company’s stock price has declined significantly in the past decade.

Note

Prior to the adoption of the new FASB accounting rules, companies were allowed to amortize the goodwill from any acquisitions they made every quarter.

The Good

If done correctly, impairment charges provide investors with really valuable information. Balance sheets are bloated with goodwill that result from acquisitions during the bubble years 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.

The process of allocating goodwill to business units and the valuation process is often hidden from investors. This can provide ample opportunity for manipulation. And companies are not required to disclose what is determined to be the fair value of goodwill, even though this information would help investors make a more informed investment decision.

Important

The goodwill impairment test goes through three phases, including a preliminary qualitative assessment (determining whether the goodwill will exceed its fair market value), the first stage of a quantitative assessment (calculating the fair value and comparing it to the amount of goodwill carried), and the second stage of a quantitative assessment (reviewing the value of individual assets and liabilities to determine the fair value).

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.

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 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 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. Eventually, many companies could face loan defaults.

Read the original article on Investopedia.