An impairment charge is a relatively new term used to describe for writing off worthless goodwill. These charges started making headlines in 2002 as companies adopted new accounting rules and disclosed huge goodwill write-offs (for example, AOL – $54 billion, SBC – $1.8 billion, and McDonald's – $99 million) to resolve the misallocation of assets that occurred during the dot com bubble (1995-2000). They again became prevalent during the Great Recession, as the weak economy and faltering stock market forced more goodwill charge-offs and increase concerns about corporate balance sheets. This article will define the impairment charge and look at its good, bad, and ugly effects.

Key Takeaways

  • In accounting, an impairment charge describes a drastic reduction in the recoverable value of a fixed asset.
  • Impairment can occur due to a change in legal or economic circumstances, or as the result of a casualty loss from unforeseen hazards.
  • When acquiring another company, impairment charges are booked as "goodwill" for the acquirer.
  • Here, we discuss how impairment and goodwill can affect a company's books, for the better and for the worse.

Impairment Charges: The Good, The Bad And The Ugly

Impairment Defined

As with most generally accepted accounting principles (GAAP), the definition of "impairment" is in the eye 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. This charge reduces the value of goodwill to the fair market value and represents a "mark-to-market" charge.

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

1. The company made large acquisitions in the past.
2. Company has high (greater than 70%) leverage ratios and negative operating cash flows.
3. Company's stock price has declined significantly in the past decade.

Impairment charges started making headlines in 2002 as companies adopted new accounting rules and disclosed huge goodwill write-offs.

The Good

If done correctly, this will provide investors with more valuable information. Balance sheets are bloated with goodwill that resulted 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. Managements 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 accounting rules (FAS 141 and FAS 142) allow companies a great deal of discretion in allocating goodwill and determining its value. Determining fair value has always been as much an art as a science and different experts can arrive honestly at different valuations. In addition, it is possible for the allocation process to be manipulated for the purpose of avoiding flunking the impairment test. As managements 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, which provides ample opportunity for manipulation. Companies are also 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.

The Ugly

Things could get ugly if increased impairment charges reduce equity to levels that trigger technical loan defaults. Most lenders require companies who have borrowed money to promise to maintain certain operating ratios. If a company does not meet these obligations (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 in need of more financing.

An Example of Impairment Charges

Assume that NetcoDOA (a pretend company) has equity of $3.45 billion, intangibles of $3.17 billion and total debt of $3.96 billion. This means that NetcoDOA's tangible net worth is $28 million ($3.45 billion of equity less intangibles of $3.17 billion).

Let's also assume that NetcoDOA took out a bank loan in late 2012 that will mature in 2017. The loan requires that NetcoDOA maintain a capitalization ratio no greater than 70%. A typical capitalization ratio is defined as debt represented as a percent of capital (debt plus equity). This means that NetcoDOA's capitalization ratio is 53.4%: debt of $3.96 billion divided by capital of $7.41 billion (equity of $3.45 billion plus debt of $3.96 billion).

Now assume that NetcoDOA is faced with an impairment charge that will wipe out half of its goodwill ($1.725 billion), which will also reduce equity by the same amount. This will cause the capitalization ratio to rise to 70%, which is the limit established by the bank. Also assume that, in the most recent quarter, the company posted an operating loss that further reduced equity and caused the capitalization ratio to exceed the maximum of 70%.

In this situation, NetcoDOA is in technical default of its loan. The bank has the right to either demand it be repaid immediately (by declaring that NetcoDOA is in default) or, more likely, require NetcoDOA to renegotiate the loan. The bank can require a higher interest rate or ask NetcoDOA to find another lender, which may not be an easy thing to do.

(Note: The numbers used above are based upon real data. They represent the average values for the 61 stocks in Baseline's integrated telco industry list.)

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 dot com bubble (1995-2000) or during the subprime meltdown (2007-09). In several ways, it will help 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.