GAAP and IFRS

Investors Can See Clearly Now

The market may react strongly to future charges for impairment of intangible assets.
Jennifer CaplanOctober 16, 2001

Break out the compasses. Starting early next year, many CFOs will be entering the uncharted territory of goodwill impairment charges.

The new disclosures come in the wake of companies’ adopting the Financial Accounting Standards Board’s Statement No. 141, Business Combinations, and Statement No. 142, Goodwill and Other Intangible Assets. And while finance chiefs still struggle with the nuances of implementing the standards’ impairment test for the first time, possibly the bigger mystery is how investors will respond to the data.

Thus far, the transition has largely been a non-event for investors. All public companies have been required to report the impact of the rules and have done so mostly by disclosing the earnings added back to their books after adjusting for goodwill that no longer needs to be amortized.

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Some industry experts, however, say investors might just start paying more attention when companies begin to test for goodwill impairment, take big goodwill write-downs, and start disclosing that information publicly. Croker Coulson, a partner at Coffin Communications, an investor-relations firm, thinks we’ll see a series of “headline-making, potentially record-setting losses” as companies begin to implement the new rules.

Tom Burnett, president of Merger Insight, a research affiliate of Wall Street Access, agrees. “This is definitely an area that will be very sensitive,” he notes. “Under the old rules, goodwill was being amortized, so you knew that companies were eating into it. Now it’s going to be hanging around, so it can have much more of an impact in a single stroke when it is written off.”

The impairment exam is a two-step process that first tests to see if existing goodwill is impaired and then determines the size of the impairment. One indication that a company’s goodwill may be impaired is that the intangibles on the company’s books greatly exceeds its market capitalization.

Burnett maintains that investors will pay more attention to those differences. “A high goodwill ratio to assets and equity will be a turn- off to investors,” he says. “If goodwill is more than 10 percent of equity or more than 5 percent of total assets, I think that will be a warning signal,” he adds.

But other analysts say the timing of goodwill impairment will move investors as much as the size of the write-downs. All companies are required to take the first step of their impairment tests within the first six months of adoption and disclose those results in the 10Q.

If necessary, companies have one year from adoption to complete the second stage of the impairment test. In the period that a goodwill- impairment charge is taken, companies are required to disclose the business unit that has taken the loss, the amount of the loss, and the remaining goodwill. They must also provide a description of the causes that led to the impairment. All impairment charges taken within the first year of adoption can be written off as the result of a change in accounting. Anytime thereafter, goodwill-impairment charges will need to be disclosed as operating expenses and taken as a hit to earnings.

Both FASB and investor relations firms encourage companies to disclose the results of their impairment tests and any write-downs associated with it in their 10Qs filed in the first quarter following adoption. Although the rules allow companies to take the charges within the first year as a change in accounting, companies that recognize those charges after the first quarter of adoption will have to restate their financial statements for preceding quarters.

“Investors are more likely to take notice of impairment charges taken after the first quarter of adoption,” says Coulson. “Restatements may send out a signal that perhaps there is not as much financial control as there should be. It could undermine credibility.” He maintains that the earlier companies can disclose potentially negative information, the less importance investors (and the Securities and Exchange Commission) are likely to place on that news.

Investors may indeed be less merciful with companies that take impairment charges late in the game, particularly after the first year of adoption. This is true in large part because they will now have more access to information about business combinations and the value of intangible assets. Greater transparency will enable investors to gauge the value of acquisitions for the overall business more easily. It will also help them to better evaluate management’s judgments. The rules require companies to disclose the value of their goodwill down to the reporting-unit level, as well as the primary reasons for an acquisition, the allocation of the purchase price, and descriptions of and amounts allocated to intangible assets.

“Investors will have a better feeling for what kind of acquisitions companies make,” says Louis Thompson, president of the National Investor Relations Institute. “If they are paying a lot more for an acquisition than its underlying value, then that tells investors something.” But he remains uncertain about the implications for share prices. “The market will punish companies for a lot of things. Whether this will be something that is uppermost in investors’ minds, is to be seen.”

A Crystal Ball?

Some companies could offer a potential preview of what’s to come. As the market has soured in recent months, they have been forced to take large impairment charges for declining goodwill even before adopting the new rules. JDS Uniphase, CMGI, and Nortel, for instance, used soaring shares at the height of the bull market to purchase companies that were often losing money and had little or no revenue. The value of their goodwill has since taken a nosedive with the market. JDS Uniphase took a $45 billion charge in July, and Nortel wrote down $12.3 billion of goodwill in June, as a consequence.

Analysts at Houlihan Lokey Howard & Zukin, an investment bank, followed 19 companies across industries that wrote off goodwill through July of this year, including JDS Uniphase, Nortel, Ariba, Aetna, and VeriSign. Companies that took impairment charges below 100 percent of their market capitalization saw share prices decrease an average of 1 percent. When the goodwill charge was above 100 percent of market capitalization, share prices dropped an average of 5 percent. JDS Uniphase, for example, took a $45 billion impairment charge in July, which amounted to 398 percent of the company’s total market cap. The day after the write-down was publicly announced, the company’s share price dropped almost 10 percent.

Although direct causality is hard to nail down, these findings may at least point to a correlation between big goodwill write-downs and drops in share prices. What’s more, large write-downs may not to be limited to the telecommunications and technology sectors, notes Karen Miles, senior vice president at Houlihan Lokey. “Companies across sectors that have had significant price drops, and made lots of acquisitions when prices were high, are the ones that are going to get hit,” she notes.

The Short Run

In the more immediate future, analysts contend, there is potential for confusion — and some ups and downs in share prices. As companies begin adopting the rules under different timetables, investors may find it hard to track the changes and make consistent comparisons. Patricia McConnell, an accounting analyst at Bear Stearns, believes that it could take up to 21 months before all companies are reporting on the same basis. Uncertainty could breed volatility.

Share prices may also fluctuate as investors react to the initial boost in earnings that many companies will experience, as goodwill amortization no longer erodes the bottom line. In theory a change in accounting for goodwill and intangibles should have no effect on a company’s shares, since it has no impact on cash flow. But some of the changes may have more of an effect on share prices than most people anticipate.

“We think there is going to be some stickiness in P/E multiples, since many investors only look at pricing in terms of P/E ratios for many industries and companies,” Miles notes. P/E multiples would have to adjust significantly for many companies if their market capitalization were to remain unchanged, she adds.

In a Bear, Stearns report, “The End of Pooling & Goodwill Amortization Is Near,” published in February, analysts maintain that companies that have traditionally been valued on a P/E basis are likely to experience the most significant fluctuations. Those that are valued on an EBITDA or cash-flow basis are least likely to see a change.

In the end, investors will need to weigh the importance of the noncash charges companies take when goodwill becomes impaired. In some cases, they will decide that there’s been no deterioration in a company’s underlying value. In others, investors may conclude that the impairment of goodwill may, indeed affect operational performance. Ultimately, they will probably have to make that calculation on a case- by-case basis.

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