Impairment Charges: The Good, The Bad and The Ugly

by Rick Wayman

"Impairment charge" is the new term 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). While impairment charges have since then gone relatively unnoticed, they will get more attention as the weak economy and faltering stock market force 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.

Impairment Defined
As with most generally accepted accounting principles, 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.

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 using overpriced stock. Over-inflated financial statements distort not only the analysis of a company but also what investors should pay for that stock. The new rules force companies to revalue these bad investments, much like what the stock market has done 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 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.

It's doubtful that very many corporate managements will face reality and take their medicine. Compensation packages will incite managers to delay the inevitable as they hope for a stock market rebound that will boost fair value.

A delay, however, could backfire and adversely impact EPS in 2003. According to the rules, 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 first year, impairment charges hit the income statement. Consequently, postponing may help results in 2002 but could reduce EPS in 2003.

The other bad thing is that investors will have a hard time evaluating how management is handling this issue. The process of allocating goodwill to business units and the valuation process will be hidden from investors, which will provide 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
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).

Let's also assume that NetcoDOA took out a bank loan in late 2000 that will mature in 2005. 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 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.