Recently, most of us must have come across the news that Hindalco plans to write off a couple of billion dollars from its net worth on account of asset impairment. This triggered an idea of trying to analyse impairment charges and its effect. In this article, we try and take a look at the same.
Definition: Impairment charge is a term used for writing off worthless goodwill. Goodwill may be developed internally or acquired from others during acquisition. Generally, the cost of internally developed goodwill is charged to revenue and therefore that is not part of the issue under analysis.
The initial cost of goodwill is reported on the asset side in the balance sheet of an acquirer. The value of goodwill is represented by the amount by which the fair value of liabilities assumed in the acquisition exceeds the fair value of identifiable tangible and intangible assets.
This goodwill is tested annually to determine whether if the recorded value (carrying value) of goodwill is greater than the fair value. If the carrying amount of goodwill exceeds its fair value, an impairment loss is recognized. That loss is equal to the carrying amount of goodwill that is in excess of its fair value, and it is presented as a separate line item on financial statements.
Effects of impairment charges: Accounting impairment charges correctly would prove to be of significant value for the investors and the company as well. Companies' balance sheets are inflated with goodwill due to the acquisitions made during the boom time as most of them end up overpaying for the assets in the acquisitions. These inflated balance sheets misguide the investors while they value the company. However, using the impairment charges enables the companies to revalue these assets.
Investors can use impairment charges as a tool to evaluate the management of the company and its past investment decisions. Accounting for impairment charges is an indirect way of companies to admit of overpaying for the past acquisitions. Companies that account for one time impairment charges should be viewed more favorably as it indicates the transparency which the management is working with. While companies those who tend to use series of recurring charges in order to set off the losses over a period time can be viewed as manipulative.
Impairment charges of significant amount could result in reduced equity value which can consequently impact the debt equity ratio for the company. This could be unfavorable for the company as it might lead to breaking of debt covenants. Moreover it also adversely impacts the ability of company to raise debt.
If the company delays the reporting of impairment charges and plans to use a recurring way, this can hurt the earnings of the company over a period of time. Furthermore, it also shows the inability of management to handle the issue.
To conclude, investors should analyse the impairment risks associated with the company and keep a close track on how the management is handling the issue. Although the impairment charges does not impact the cash flows of the company, however it can be used as a tool to judge the capability of the management during times of crisis.