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Impairment Charges: The Good, The Bad and The
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by Rick Wayman (Contact Author | Biography)
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Investing Basics Email Article Print Feedback Reprints Like 2 Share during recession. Her shocking
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Dick Morris - Prepare!
FOREX "Impairment charge" is the new term for writing off worthless goodwill. These charges Senator warns of a financial
ETFs started making headlines in 2002 as companies adopted new accounting rules and 'meltdown'. Dick Morris reveals
disclosed huge goodwill write-offs (for example, AOL - $54 billion, SBC - $1.8 billion, and how to prepare for coming
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McDonald's - $99 million). While impairment charges have since then gone relatively 'aftershock'. Learn more
Bonds unnoticed, they will get more attention as the weak economy and faltering stock market
Economics force more goodwill charge-offs and increase concerns about corporate balance sheets.
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This article will define the impairment charge and look at its good, bad and ugly effects.
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Impairment Defined
amazing joint relief... Learn
Fundamental Analysis As with most generally accepted accounting
principles, the definition of "impairment" is in more
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the eye of the beholder. The regulations are
Options & Futures complex, but the fundamentals are relatively Buy a link here
Personal Finance easy to understand. Under the new rules, all
goodwill is to be assigned to the company's
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reporting units that are expected to benefit
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tested (at least annually) to determine if the
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Retirement recorded value of the goodwill is greater than
answer)
the fair value. If the fair value is less than the
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carrying value, the goodwill is deemed
Young Investors "impaired" and must be charged off. This How do you lose money in the Forex market?
charge reduces the value of goodwill to the (view answer)
FAQs
fair market value and represents a "mark-
Exam Prep to-market" charge. What are the "browser wars"? (view answer)

Exam Quizzer The Good What's the difference between weighted

If done correctly, this will provide investors with more valuable information. Balance sheets average accounting and FIFO/LILO accounting
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are bloated with goodwill that resulted from acquisitions during the bubble years, when
Ask Us companies overpaid for assets by using overpriced stock. Over-inflated financial statements
distort not only the analysis of a company but also what investors should pay for that stock. What effect did the Bankruptcy Abuse
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The impairment charge also provides investors with a way to evaluate corporate What was Robert Citron's role in Orange
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of dollars due to impairment have not made good investment decisions. Managements that
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bite the bullet and take an honest all-encompassing charge should be viewed more What is the difference between LIBOR, LIBID
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recurring impairment charges, thereby manipulating reality.
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The Bad
Free Newsletters 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.
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It's doubtful that very many corporate managements will face reality and take their
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medicine. Compensation packages will incite managers to delay the inevitable as they hope
for a stock market rebound that will boost fair value. 5 Tips For Acing A Phone Interview
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A delay, however, could backfire and adversely impact EPS in 2003. According to the rules,
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impairment charges that occur within the first year of adopting the new accounting rules
(calendar 2002 for most corporations) are accounted for as a charge to equity. After the 5 Specialty Vacations And What They Cost
first year, impairment charges hit the income statement. Consequently, postponing may help
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The other bad thing is that investors will have a hard time evaluating how management is • Free Report: 5 Chart Patterns to Know
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Impairment Charges: The Good, The Bad and The Ugly http://www.investopedia.com/articles/analyst/110502.asp

process will be hidden from investors, which will provide ample opportunity for manipulation. • Huge Returns in Forex - FREE Report
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 Ads by
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The Ugly earn great money from home
Things could get ugly if increased impairment charges reduce equity to levels that trigger during recession. Her shocking
technical loan defaults. Most lenders require companies who have borrowed money to story... Learn more
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 Dick Morris - Prepare!
have a detrimental effect on the company's ability to refinance its debt, especially if it has a
Senator warns of a financial
large amount of debt and in need of more financing.
'meltdown'. Dick Morris reveals
how to prepare for coming
An Example
'aftershock'. Learn more
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 debt of $3.17 billion). Shocking Joint Discovery
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Let's also assume that NetcoDOA took out a bank loan in late 2000 that will mature in 2005. Cambridge Researchers for
The loan requires that NetcoDOA maintain a capitalization ratio no greater than 70%. A amazing joint relief... Learn
typical capitalization ratio is defined as debt represented as a percent of capital (debt plus more
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). Buy a link here
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 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 holds all the cards and can require a
higher interest rate or ask NetcoDOA to find another lender. In the current economic
climate, this is not 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.)

Conclusion
New accounting regulations that require companies to mark their goodwill to market will be
a painful way to resolve the misallocation of assets that occurred during the dotcom bubble
(1995-2000). 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. If the economy and stock markets remain weak, many companies could face
loan defaults.

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. Company made large acquisitions in the late 1990s (notably the telco and AOL).
2. Company has high (greater than 70%) leverage ratios and negative operating cash flows.
3. Company's stock price has declined significantly since 2000.
Unfortunately, the above can be said about most companies.

by Rick Wayman (Contact Author | Biography)

Filed Under: Stocks

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