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With the fourth-quarter 2008 reporting period in full swing, many companies are taking hits to income and book value, courtesy of asset impairment charges. My advice? Pause before adding yet another egg to your basket of worry.
An impairment charge is pretty much what it sounds like: It's a cost associated with an asset's decline in value. An asset is deemed impaired only when its future undiscounted cash flow falls beneath book value -- or, in other words, when it's evaluated to be worth less than what a company paid for it.
Impairment may be assessed in either of two asset categories: intangible assets, such as goodwill, patents, brand names, and business relationships; and tangible assets, such as buildings and equipment. To the benefit of companies and their shareholders, an impairment against either type of asset is a non-cash charge.
Stung, but not discouraged
Here's the thing: When sniffing out impairments, accountants are required by regulation to check their optimism at the door. This means that future cash flow calculations are based exclusively on an asset's present market value. So in terms of reported fourth-quarter 2008 results, a withering economy has ostensibly been extrapolated into the future for the full life of company assets.
If that doesn't seem fair -- never mind realistic -- check in with ConocoPhillips (NYSE: COP ) , which just took $34 billion in impairment charges because of lower commodity prices. Will oil bounce around beneath $50 for the next couple of decades? Or how about the $1.6 billion charge BHP Billiton (NYSE: BHP ) took related to its mining cutbacks? Moving on to goodwill impairment, SUPERVALU (NYSE: SVU ) was recently handed a $3.3 billion charge against a fourth-quarter ending market cap of about $2.75 billion. Management specifically pointed out that this charge would not have been recorded in absence of accounting regulations.
Don't get me wrong. A string of impairment charges over time suggests that management is consistently overpaying for the acquisition and/or development of assets. Moreover, impairment charges may be a sign that accountants have concerns about near-term cash flow.
However, impairment charges can eventually deliver an upside. Once assets are restated at lower present values, they don't get written back up under U.S. accounting rules when the good times start to roll again. That means that depreciation and depletion expenses are locked in at lower amounts against rising cash flow, with the possibility of improved income results.
Perhaps the regulations aren't so unfair after all.