Capital Markets

A Case Against Impairment Testing

A decline in share price may not necessarily mean a company should test its goodwill for impairment.
David KatzOctober 7, 2010

CFOs shouldn’t automatically assume that a drop in share price should trigger a goodwill-impairment charge by their company, a new research report suggests.

To be sure, bad news from the market is the most common — and attention-getting — reason for an impairment test. But given the overall rebound in share prices since March 2009, companies that chose not to test their corporate goodwill for impairment “may have been right,” according to the report from the Georgia Tech Financial Analysis Lab. “A price decline in the absence of other developing problems may not be in and of itself a valid goodwill impairment triggering event.”

That’s because share prices are known to be fickle indicators. In one case cited in the study, which is culled from the 2008 and 2009 annual reports of 48 companies, Alcoa appears to have thumbed its nose at the market and chosen not to respond to a share-price drop with a goodwill-impairment test. “Management believes the Company’s forecasted cash flows constitute a better indicator of the current fair value of Alcoa’s reporting units than the current pricing of its common shares,” the company stated in its 2008 10-K.

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As the report’s authors suggest, Alcoa’s management may have been right. Like many other companies, the aluminum giant was under pressure to write down its goodwill after a devastating 2008. After its share price peaked at $43.15 on May 16 of that year, it went on a long dive to $8.06 on December 4, according to a CFO analysis of Capital IQ data. Then, however, it rose steadily to $17.45 on January 11, 2010, and has hovered around $12 through September.

Seven other companies in the study, which was authored by Georgia Tech professors Eugene Comiskey and Charles Mulford, also didn’t assume that a share-price decline or a drop in their market capitalizations should routinely spur an impairment test. They were EMTEC, Keynote Systems, Misonix, Parkvale Financial, Quanex Building Products, Schnitzer Steel Industries, and Tyson Foods.

goodwill impairment

Under pressure to test for impairment, especially in a recession, companies that choose not take a charge in the face of a share-price decline must mount a strong argument for that decision, according to Mulford. One common defense such companies make is that “just because their share price is depressed, it doesn’t mean that the operating units are depressed or that their values are impaired,” he says.

To be sure, many more companies test for goodwill impairment in response to stock drops and other triggers. Of the 40 other companies the Georgia Tech lab studied, 22 ultimately took a goodwill charge and 18 decided against one.

At least once a year, companies with goodwill — the premium that an acquiring company pays in excess of an acquired company’s book value — must evaluate it to gauge whether or not it is impaired. If it is impaired, the company must report a decrease in the goodwill’s value.

But when an event that the company regards as a possible trigger of an impairment occurs between annual testing times, the company must test its goodwill immediately. Under generally accepted accounting principles, there are seven such triggering events (see chart). The triggering event and the later evaluation of goodwill for impairment can lead to contentious debates among the CFO, other senior managers, auditors, and outside investors, says Mulford. The company’s senior executives may not think that an impairment is warranted, while auditors and outside investors may argue otherwise.

Why all the hubbub about a balance-sheet charge that doesn’t actually involve cash? “They still impact analyst assessments of future cash flows and call into question past prices paid for acquisition targets,” says Mulford. “Moreover, such impairments do reduce current period earnings and result in a direct reduction in shareholders’ equity.”