You must predict the future, yet the future is not reliably predictable.

The difficulty of predicting the future even a few years ahead. 

An unresolvable contradiction exists: to perform present value analysis, you must predict the future, yet the future is not reliably predictable. 

The miserable failure in 1990 of highly leveraged companies such as Southland Corporation and Interco, Inc., to meet their own allegedly reasonable projections made just a few years earlier-in both cases underperforming by more than 50 percent-highlights the difficulty of predicting the future even a few years ahead. 

Investors are often overly optimistic in their assessment of the future. 

A good example of this is the common response to corporate write-offs. This accounting practice enables a company at its sole discretion to clean house, instantaneously ridding itself of underperforming assets, uncollectible receivables, bad loans, and the costs incurred in any corporate restructuring accompanying the write-off. 

Typically such moves are enthusiastically greeted by Wall Street analysts and investors alike; post-write-off the company generally reports a higher return on equity and better profit margins. Such improved results are then projected into the future, justifying a higher stock market valuation. 

Investors, however, should not so generously allow the slate to be wiped clean. When historical mistakes are erased, it is too easy to view the past as error free. It is then only a small additional step to project this error-free past forward into the future, making the improbable forecast that no currently profitable operation will go sour and that no poor investments will ever again be made. 

How do value investors deal with the analytical necessity to predict the unpredictable? 

The only answer is conservatism. 

Since all projections are subject to error, optimistic ones tend to place investors on a precarious limb. Virtually everything must go right, or losses may be sustained. 

Conservative forecasts can be more easily met or even exceeded. 

Investors are well advised to make only conservative projections and then invest only at a substantial discount from the valuations derived therefrom.

Impairment charge

"Impairment charge" is the term for writing off worthless goodwill.

These charges started making headlines in 2002 as companies adopted new accounting rules and disclosed huge goodwill write-offs.

Impairment charges will get more attention as the weak economy and faltering stock market force more goodwill charge-offs and increase concerns about corporate balance sheets.

Accounting regulations that require companies to mark their goodwill to market will be a painful way to resolve the mis-allocation of assets that occurred during the exuberant business period. In several ways, it will help investors by providing more relevant financial information, but it also gives companies a way to manipulate reality and postpone the inevitable. If the economy and stock markets remain weak, many companies could face loan defaults.

Individuals need to be aware of these risks and factor them into their investing decision-making process. There are no easy ways to evaluate impairment risk, but there are a few generalizations that should serve as red flags indicating which companies are at risk:

1. Company made large acquisitions.
2. Company has high (greater than 70%) leverage ratios and negative operating cash flows.
3. Company's stock price has declined significantly.

Non-operating items, Provisions and Reserves

Strict accounting rules exist for dealing with nonoperating expenses and one-time charges.

For determining value, however, these entries and the financial statements require adjustments.

These entries provide relevant information concerning past performance and future cash flows.



Assessing impact of nonoperating charges

A three-step process can aid in assessing the impact of nonoperating charges:

1. reorganize the income statement into operating and nonoperating items, 
2. search the notes for embedded one-time items, and 
3. analyze each extraordinary item for its impact on future operations.

Noncash expenses usually

• lower an asset or 
• increase a provision account in the liabilities.

In evaluating a business, there are four types of provisions:

1. ongoing operating provisions,
2. long-term operating provisions,
3. non-operating restructuring provisions, and
4. provisions created to smooth income.

Depreciation, Amortisation and Impairment Charge

Depreciation is actually focussed on matching the cost of an asset over its useful economic life.

Tangible assets are depreciated.

Intangible assets are amortised.

An impairment charge is a one-off reduction in the value of an asset.

SILVER BIRD GROUP BERHAD

THE PRELIMINARY PROPOSED CORPORATE AND DEBT RESTRUCTURING SCHEME (“PCDRS”) OF SBGB AND ITS SUBSIDIARIES (COLLECTIVELY KNOWN AS THE SBGB GROUP”))


                                                               Notes  RM’000
Shareholders’ funds as at 31 October 2011        213,423
Property, Plant & Equipment impairment       1    (98,005)
Goodwill impairment                                     2    (36,730)
Receivables impairment                                3  (110,754)
Cash reduction                                             4      (6,442)
Inventory reduction                                      5      (5,232)
Payables adjustments                                   6    (25,302)
Increased borrowings                                   7    (14,212)
Others                                                         8         (407)
                                                                     ------------
                                                                       (297,084)
                                                                      ________
Shareholders’ funds as at 29 February 2012      (83,661)
                                                                       =======


http://announcements.bursamalaysia.com/EDMS/edmsweb.nsf/all/FCE47820DA0472AF482579ED004296E5/$File/Silver%20Brid%20Financial%20Position%20reconciliation.pdf

http://announcements.bursamalaysia.com/EDMS/edmsweb.nsf/LsvAllByID/FCE47820DA0472AF482579ED004296E5?OpenDocument

Notes

1. Impairment to fair value, after taking into consideration additional depreciation since 31 October 2011, write down of assets that should have been expensed to profit & loss as opposed to being capitalized, movements in acquisitions and disposals, write-offs of assets that cannot be physically identified, write backs of assets that were not previously taken up, and possibly adjustments to assets that may have been suspected to be capitalized above fair market value arising partly from the preliminary forensic investigation.

 2. In view of the net liabilities position of the Group, goodwill is impaired in totality. 

 3. Adjustments have been made for movements in the ordinary course of business between 31 October 2011 and 29 February 2012, and which may relate to the losses incurred during the said period, provisions for doubtful debts and suspected financial irregularities arising from the preliminary findings of the forensic investigation.

4. Adjustments have been made for movements in the ordinary course of business between 31 October 2011 and 29 February 2012, and which may relate to the losses incurred during the said period, and after reconciling for transactions relating to suspected financial irregularities arising from the preliminary findings of the forensic investigation.

5. Adjustments have been made for movements in the ordinary course of business between 31 October 2011 and 29 February 2012, and which may relate to the losses incurred during the said period, and for obsolete inventories and inventories that cannot be physically identified. 

 6. Adjustments have been made for movements in the ordinary course of business between 31 October 2011 and 29 February 2012, and which may relate to the losses incurred during the said period, and for provisions relating to suspected financial irregularities arising from the preliminary findings of the forensic investigation.

7. Increased borrowings can be related to additional net borrowings of the Group between 31 October 2011 and 29 February 2012. Certain facilities, such as bonds, were paid off, whilst additional borrowings were drawn down, in particular bankers acceptances, during the period.

8. Others, relate to the write-off of investment in KPF Quality Foods Sdn Bhd, and increased deferred taxation provisions. The basis of arriving at the 29 February 2012 position is set out in the notes to the financial position.

Flash Profits: One-time event that impacts earnings

Any one-time event that impacts earnings, such as a gain from the sale of an asset or a one-time loss resulting from a catastrophic event or the write-off of a potential debt, should be lifted out of the earnings figures and set to one side.

These occurrences should be recognized for what they are and judged accordingly.  They are in no way indicative of the outlook for future earnings.

A one-time sale of assets tends to make overall corporate profits look better in the year it occurs.  Yet the sale decreases the total assets of the company.  There is no real gain.

In an established, well-managed company, daily operations finance themselves with cyclical shortfalls covered by short-term borrowing, so never should a one-time gain be used to cover ordinary expenses.  

There is no real gain from the one-time sale of assets unless the money is used for one of the following:

• Restore the asset base
• Reduce debt
• Contribute substantially to future earnings.

Taking a Hit - Accounting Write Off or Write Down

Corporate accountants write off or write down items under several sets of circumstances.

• They may write a debt off the books that they are convinced will never be collected.
• They may mark down the value of an asset that is no longer worth what it once was.

Excessive write-offs in one year can, in some circumstances, lead to greater than normal profits in the next.  It is an old management trick to take all write-offs or write-down during a period when earnings aren't looking so good anyway.  

• The company decides to load all the bad news into one accounting period rather than several fairly bad ones, but the contrast between the bad quarter or year and the subsequent good one appears dramatic.
• This jump in earnings thrills the investing public (the company did lousy last year, but look how it's come around!)  But again, the better earnings may turn out to be a  brief aberration.  The following year the company's earnings fall back into the old ways.

Yet done frankly and for the right reasons, write-downs may lead to real and long-lasting improvement in earnings.  

• They make a difference when the company is saying:  "This was a problem; we've faced up to it.  The adjustment will allow the income statement to accurately reflect the condition of our company in the years ahead."

For alert investors, losses or gains that result from a single episode can be a boon.

• If other investors overreact to the news in either a positive or negative way, it may create a chance to buy or sell at an advantageous price.

Impairment Charges: The Good, The Bad and The Ugly

Impairment Charges: The Good, The Bad and The Ugly
by Rick Wayman

"Impairment charge" is the new term for writing off worthless goodwill. These charges started making headlines in 2002 as companies adopted new accounting rules and disclosed huge goodwill write-offs (for example, AOL - $54 billion, SBC - $1.8 billion, and McDonald's - $99 million). While impairment charges have since then gone relatively unnoticed, they will get more attention as the weak economy and faltering stock market force more goodwill charge-offs and increase concerns about corporate balance sheets. This article will define the impairment charge and look at its good, bad and ugly effects.

Impairment Defined

As with most generally accepted accounting principles, the definition of "impairment" is in the eye of the beholder. The regulations are complex, but the fundamentals are relatively easy to understand. Under the new rules, all goodwill is to be assigned to the company's reporting units that are expected to benefit from that goodwill. Then the goodwill must be tested (at least annually) to determine if the recorded value of the goodwill is greater than the fair value. If the fair value is less than the carrying value, the goodwill is deemed "impaired" and must be charged off. This charge reduces the value of goodwill to the fair market value and represents a "mark-to-market" charge.

The Good

If done correctly, this will provide investors with more valuable information. Balance sheets are bloated with goodwill that resulted from acquisitions during the bubble years, when companies overpaid for assets by using overpriced stock. Over-inflated financial statements distort not only the analysis of a company but also what investors should pay for that stock. The new rules force companies to revalue these bad investments, much like what the stock market has done to individual stocks.

The impairment charge also provides investors with a way to evaluate corporate management and its decision-making track record. Companies that have to write off billions of dollars due to impairment have not made good investment decisions. Managements that bite the bullet and take an honest all-encompassing charge should be viewed more favorably than those who slowly bleed a company to death by deciding to take a series of recurring impairment charges, thereby manipulating reality.

The Bad

The accounting rules (FAS 141 and FAS 142) allow companies a great deal of discretion in allocating goodwill and determining its value. Determining fair value has always been as much an art as a science and different experts can arrive honestly at different valuations. In addition, it is possible for the allocation process to be manipulated for the purpose of avoiding flunking the impairment test. As managements attempt to avoid these charge-offs, more accounting shenanigans will undoubtedly result.

It's doubtful that very many corporate managements will face reality and take their medicine. Compensation packages will incite managers to delay the inevitable as they hope for a stock market rebound that will boost fair value.

A delay, however, could backfire and adversely impact EPS in 2003. According to the rules, impairment charges that occur within the first year of adopting the new accounting rules (calendar 2002 for most corporations) are accounted for as a charge to equity. After the first year, impairment charges hit the income statement. Consequently, postponing may help results in 2002 but could reduce EPS in 2003.

The other bad thing is that investors will have a hard time evaluating how management is handling this issue. The process of allocating goodwill to business units and the valuation process will be hidden from investors, which will provide ample opportunity for manipulation. Companies are also not required to disclose what is determined to be the fair value of goodwill, even though this information would help investors make a more informed investment decision.

The Ugly

Things could get ugly if increased impairment charges reduce equity to levels that trigger technical loan defaults. Most lenders require companies who have borrowed money to promise to maintain certain operating ratios. If a company does not meet these obligations (also called loan covenants), it can be deemed in default of the loan agreement. This could have a detrimental effect on the company's ability to refinance its debt, especially if it has a large amount of debt and in need of more financing.

An Example

Assume that NetcoDOA (a pretend company) has equity of $3.45 billion, intangibles of $3.17 billion and total debt of $3.96 billion. This means that NetcoDOA's tangible net worth is $28 million ($3.45 billion of equity less debt of $3.17 billion).

Let's also assume that NetcoDOA took out a bank loan in late 2000 that will mature in 2005. The loan requires that NetcoDOA maintain a capitalization ratio no greater than 70%. A typical capitalization ratio is defined as debt represented as a percent of capital (debt plus equity). This means that NetcoDOA's capitalization ratio is 53.4%: debt of $3.96 billion divided by capital of $7.41 billion (equity of $3.45 billion plus debt of $3.96 billion).

Now assume that NetcoDOA is faced with an impairment charge that will wipe out half of its goodwill ($1.725 billion), which will also reduce equity by the same amount. This will cause the capitalization ratio to rise to 70%, which is the limit established by the bank. Also assume that, in the most recent quarter, the company posted an operating loss that further reduced equity and caused the capitalization ratio to exceed the maximum 70%.

In this situation, NetcoDOA is in technical default of its loan. The bank has the right to either demand it be repaid immediately (by declaring that NetcoDOA is in default) or, more likely, require NetcoDOA to renegotiate the loan. The bank holds all the cards and can require a higher interest rate or ask NetcoDOA to find another lender. In the current economic climate, this is not an easy thing to do.

(Note: The numbers used above are based upon real data. They represent the average values for the 61 stocks in Baseline's integrated telco industry list.)

Conclusion

New accounting regulations that require companies to mark their goodwill to market will be a painful way to resolve the misallocation of assets that occurred during the dotcom bubble (1995-2000). In several ways, it will help investors by providing more relevant financial information, but it also gives companies a way to manipulate reality and postpone the inevitable. If the economy and stock markets remain weak, many companies could face loan defaults.

Individuals need to be aware of these risks and factor them into their investing decision-making process. There are no easy ways to evaluate impairment risk, but there are a few generalizations that should serve as red flags indicating which companies are at risk:
1. Company made large acquisitions in the late 1990s (notably the telco and AOL).
2. Company has high (greater than 70%) leverage ratios and negative operating cash flows.
3. Company's stock price has declined significantly since 2000.

Unfortunately, the above can be said about most companies.

by Rick Wayman, (Contact Author Biography)

http://www.investopedia.com/articles/analyst/110502.asp?viewed=1