It is common for public companies to generate growth through acquisitions. Often, it’s easier for a firm to purchase a business than to try a build one from the ground up. Not all acquisitions work out. Sometimes, companies realize over time that they overpaid, or that the acquired business unit isn’t generating the kind of revenues everyone expected.
When a company has an asset that was purchased for one amount of money but is unexpectedly now worthless (and the company believes it will not be able to recover the loss) that asset is deemed “impaired.”
Impairment and Write-Offs
In early 2000, AOL and Time Warner combined in a $165 million merger of two media and internet behemoths. The merger was a big deal at the time but proved to be one of the most disastrous transactions in the history of corporate America.
By the end of 2002, it was apparent that the merger did not bring the kind of financial results people anticipated. In fact, the new combined company reported a net loss of $98.7 billion in 2002. This included a “write-down” or “write-off” of more than $45 billion stemming from AOL and other businesses that lost value. Essentially, AOL was being declared an impaired asset.
Impaired Assets and Goodwill
To understand the concept of impaired assets, it helps to understand the financial concept of goodwill. In simple terms, goodwill is the value placed on intangible aspects of a business and is usually referenced when a company acquires another company for more than book value. For example, let’s say Company A is valued at $100 million, but Company B acquires it for $125 million. The $25 million is referred to as goodwill and can be recorded on Company B’s balance sheet. That goodwill may stem from the value of a company’s brand or reputation, or some other intangible reason.
Over time, however, it may become apparent that the acquired company was not worth paying a premium for. Perhaps now that company is barely worth the $100 million it was originally valued for, let alone the additional $25 million. When this happens, a company can claim a “goodwill impairment” on its balance sheet and the value of the goodwill is reduced. Companies are required to test their goodwill annually for impairment.
In the case above involving AOL and Time Warner, the major losses were recorded as “goodwill impairments.”
Impairment Is Not the Same as Depreciation
All assets have a lifespan. If a company purchases a large amount of machinery, it can expect that machinery to become less useful and valuable over time. This gradual loss of value is called depreciation.
Depreciation and impairment are not the same thing. Companies can plan on assets depreciating in value and will account for it in their financial statements. For example, if a company paid $10 million for machinery in 2010, it will list that value in the balance sheet at first. But, the company will report a smaller value in each future year until the machinery no longer has value.
The key difference between depreciation and impairment is that depreciation is expected, while impairment is unexpected.
Impairment and Operations
It’s not unusual for companies to claim large impairments while still legitimately claiming to be doing well overall.
This may seem counterintuitive—how can a company claim to be thriving when it is also declaring a major loss of value from a business unit?
This phenomenon stems from the fact that write-downs of impaired assets are separate from operating performance. A company can report increases in revenue and profits while at the same time writing down the loss of value of a business unit.
In 2002, when AOL Time Warner reported a $45 billion fourth-quarter loss, it also reported that revenue rose from $10.6 billion to $11.4 billion.
Impairment write-downs are often referred to as “one-time charges.” When a company reports quarterly and annual earnings, it may cite net profit or loss “minus one-time charges.” The theory here is that once an impairment is written off, it no longer has an impact on the company’s earnings moving forward. Thus, company executives will argue that potential investors should look at the company’s performance minus one-time charges to determine the real health of a company.
If you are an investor and read about a company taking a major charge due to an impaired asset, dig a little bit deeper into the company’s balance sheet. You may be able to see that the company is still increasing revenues, expanding product lines and growing its profit margin. By focusing on the company’s day-to-day operations and paying less attention to one-time impairment charges, you may learn that the company is actually undervalued based on its share price.
Investors should still take note of these major charges and be cognizant of how often a company writes down big impairments on its balance sheet. Too many impairments could mean the company has made a series of bad acquisitions that could continue to impact business results.