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

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.

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

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.

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.

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.

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.