Understanding Impairment Charges: Impacts on Assets and Goodwill

An impairment charge is an accounting entry used by businesses to write off worthless goodwill or to report a reduction in the value of goodwill (as well as other assets).

Investors, creditors, and others can find these charges on corporate balance sheets and income statements under the operating expense section.

Impairment charges can be used to determine the financial health of a company. Creditors and investors often review them to make important decisions about whether to lend to 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 defines “impairment charge” and looks at its good, bad, and ugly effects.

Understanding the Concept of 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.

With regard to goodwill, under the rules, it 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. That 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. There have been changes in technology or regulations.
5. There have been changes in the company’s operating environment, or changes to products’ supply and demand.

Benefits of Impairment Charges

If done correctly, impairment charges provide investors with very 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 rules force companies to revalue these bad investments, much like what the stock market does to individual stocks.

Impairment charges also provide 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 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.

Drawbacks of Impairment Charges

The Financial Accounting Standards Board (FASB) has rules in place for private and public companies, including rules concerning 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.

Challenges With Impairment Charges

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 commonly due to impairment alone. Usually, other factors would play into a default.

Example of How Impairment Charges Work

Here’s a hypothetical example using fictitious companies to show how impairment charges work.

Netco purchased a company it had been watching—Zazz—because it felt it would strengthen its competitive edge and market share. The price Netco paid for Zazz, $23.5 million, was higher than its fair market value of $20 million by $3.5 million.

Netco acknowledged that it was paying extra for Zazz’s high-value brand. It recorded the $3.5 million amount as goodwill.

Over time, it became clear that Zazz was failing to live up to the expectations that Netco had for it. Zazz’s value declined by $1.5 million. This decreased Netco’s value, in turn.

The difference between what Netco paid for Zazz and its current value of $18.5 million increased the original difference between purchase price and fair market value. That indicated a loss in the value of goodwill. Consequently, Netco recorded an impairment charge of $1.5 million.

The Bottom Line

Accounting regulations that require companies to mark their goodwill to market can resolve the misallocation and incorrect pricing of assets. This can result in impairment charges.

Impairment charges are part of the financial information that investors can review as part of their company analysis and investment decision-making process.