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Author: DoubleMyNet Add to my Favorite Fools Ignore this person (you won't see their posts anymore) Number: of 2209  
Subject: Help me understand Impairment in layman's terms Date: 12/15/2010 8:40 AM
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Okay, I was checking out the 2009 10-K filing for MWA because I wanted to learn more about this "impairment" charges that resulted in a major loss of operating income that year.

I understand "restructuring" but not "impairment". Google couldn't answer my question.

My question is what specific transaction would create an impairment that would result in a loss of operating income?

I gotta say this. I love this fool's site. My knowledge is growing by the week.
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Author: JustMee01 Big red star, 1000 posts Add to my Favorite Fools Ignore this person (you won't see their posts anymore) Number: 2134 of 2209
Subject: Re: Help me understand Impairment in layman's te Date: 12/15/2010 11:34 AM
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Impairment charges are confusing unless you’re an accountant. In the interest of saving others’ time, I’ll take a crack at explaining it with the caveat that I’m not accountant. If someone finds an inaccuracy they can correct it or affirm it if it is accurate. As I understand it, an impairment charge is the removal of goodwill from the balance sheet. Goodwill is the excess in dollars paid for the acquisition of an asset. In this case, it’s the amount of money paid for US Pipe and Mueller Co. that exceeds the dollar value of all its plants, property and equipment.

Here’s an investopedia page that runs through it: http://www.investopedia.com/articles/analyst/110502.asp


Consider a small company “Wachusett Widgets” with one plant and equipment worth $1MM in total, and no debt, generating $100K in profit annually. Another company, ABC Conglomerate, looks at the business as an opportunity to buy a new product line that it thinks it can expand. They do their due diligence and decide that the cash flows from WW are worth paying $1.5MM for. When ABC finishes the purchase of WW, they consolidate WW’s assets on to their own balance sheet. But, WW has only $1MM in assets, and ABC PAID $1.5MM. To make things match up correctly, ABC adds $1MM to PP&E (plants, property and equipmenty) and also records $0.5MM in “goodwill” to reflect the extra amount paid.

At regular intervals, a company is required to verify that the goodwill assigned to their assets still makes sense. Let’s say that WW sales really got walloped in the recession, and they were operating at a loss. ABC is required by accounting regs to verify that WW is STILL worth $1.5MM. The tests are complicated and based on undisclosed estimates of future cash flow and comparison with the market value of other similar companies. If the accounting test reflects a lower value for WW, then ABC won’t be allowed to carry that goodwill on their balance sheet, since it inaccurately reflects the value of WW. They’ll have to write that goodwill down by taking an impairment charge. When they take that charge, they reduce the goodwill on ABC’s books by reducing goodwill $0.5MM and taking a one-time non-cash charge of $0.5MM against earnings. There’s no cash lost, but there is value lost from the balance sheet. The impairment charge is how that’s folded into the reporting of earnings.

In this case, a quick scan reveals that MWD wrote off all of US Pipe’s goodwill and part of Mueller Co.’s goodwill, removing the excess above physical value of the PP&E that were originally paid to acquire those companies:

Excerpt from pp.32-3 of 10-K

We test our goodwill and other noncurrent assets for possible impairment at least annually as of September 1 and more frequently in the event that
certain conditions exist indicating impairment may have occurred. The testing is a two-step process. Step 1 compares the fair value of a reporting unit to its
carrying value. We have identified each of our segments as a reporting unit. Step 2 is a more detailed analysis of the fair value of each reporting unit’s
individual assets and liabilities and is performed if Step 1 indicates possible impairment. Our Step 1 testing as of September 1, 2008 did not indicate
possible impairment. Subsequent to September 1, 2008, equity markets in the United States and our stock market capitalization in particular decreased
significantly. We considered these decreases as such a condition to perform interim impairment testing. Our valuation for the Company was based on a
combination of our estimate of our future cash flows and the market comparable valuations of similar companies. Our estimate of future cash flows extends
a number of years into the future. These estimates are complex, subjective and uncertain and reflect our estimate of the business conditions in the future,
over which we may have very little control. Choosing an appropriate discount rate to apply to these estimated cash flows is also complex and subjective. We
use our estimated future cash flows as the best information of future cash flows available to our investors. We use the market comparable valuations as a
reasonable method to value the risks investors perceive in companies like ours. We weight our cash flow estimates at least as heavily as the market
comparable data. At December 31, 2008, our Step 1 testing indicated possible impairment so we proceeded to Step 2 testing.

At December 31, 2008, we reported estimated goodwill impairment charges of $59.5 million for U.S. Pipe, completely impairing its goodwill, and
$340.5 million against Mueller Co.’s prior goodwill balance of $718.4 million, subject to additional fair value analysis. Any additional impairment charge
was not expected to exceed $200 million. During the three months ended March 31, 2009, however, our common stock began trading at prices significantly
lower than prior periods, especially beginning in February. Our lower market capitalization prompted us to perform a second interim impairment assessment
at March 31, 2009. This testing led to the conclusion that all of our remaining goodwill was fully impaired. During the three months ended March 31, 2009,
we recorded additional goodwill impairment charges of $376.8 million for Mueller Co. and $92.7 million for Anvil.
In conjunction with the testing of goodwill for impairment, we also compared the estimated fair values of our identified other intangible assets to their
respective carrying values and determined that the carrying amount of trademarks and trade names at Mueller Co. had been impaired. At March 31, 2009,
we recorded an impairment charge against these assets of $101.4 million. Mueller Co.’s trademarks and trade names have a remaining carrying value of
$263.0 million at September 30, 2009.


Hope it helps,

Peter

P.S. Remember that I'm NOT an accountant and not as experienced as others running around these boards. Just trying to pitch in to make less typing for others. Hopefully someone else can affirm the explanation or correct my gibberish if it's in error.

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Author: DoubleMyNet Add to my Favorite Fools Ignore this person (you won't see their posts anymore) Number: 2135 of 2209
Subject: Re: Help me understand Impairment in layman's te Date: 12/15/2010 12:18 PM
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Peter, it's the stock market, there's no thing as a sure bet. But I appreciate your input. It will take a few days to get my mind wrapped around this.

Any additional explanation from other fools will be appreciated here. It is a fairly interesting case study for me here. It sounds like a case of buying high and then writing off the loss against income for the year they impair the loss. Is that like breaking even? (over the first couple of years, I mean.)

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Author: TMFSandman Big red star, 1000 posts Feste Award Nominee! Old School Fool Coverage Fool CAPS All Star Add to my Favorite Fools Ignore this person (you won't see their posts anymore) Number: 2136 of 2209
Subject: Re: Help me understand Impairment in layman's te Date: 12/15/2010 4:46 PM
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It sounds like a case of buying high and then writing off the loss against income for the year they impair the loss.

Sometimes it can be a case of this, yes.

When a company buys another company at higher than book value then the balance of the purchase price minus the book value is thrown on the balance sheet as goodwill.

The acquiring company then has to test annually to see if the carrying value of the goodwill is still worth the price they paid for it. Say a big pharma company buys a smaller pharma company that has a promising new drug. 1 year later, the drug fails some clinical trial and the promising new drug no longer has any future. In this case, the acquiring company will likely need to take an impairment charge against the goodwill asset that's on the balance sheet.

Though the impairment charge is a non-cash charge now, it does represent that the company overpaid for the acquisition in the first place. When looking at companies, it's always good to see if they have a habit of taking impairment charges on their acquisitions. If they do, then you have to look at those impairment charges as an ongoing expense rather than something that is one-time in nature.

These days there are companies that can trade at several multiples to book value, and if you throw a 20% or so buyout premium to the current market cap, you can easily get to a point where most of the purchase price for a company ends up as goodwill, especially if it is a tech or service sector company. Take a look at Microsoft. Even though it is fairly cheap these days, it still trades at 5 times book value. If you were to buy Microsoft, most of the company would be recorded as goodwill on your balance sheet. Most of what makes up the earnings power of Microsoft (its people and intellectual property) just doesn't show up on the balance sheet.


Here's a good investopedia.com article on goodwill accounting. It's a great site to look up investing words, definitely worth bookmarking:
http://www.investopedia.com/articles/fundamental/04/011404.a...


Mike

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Author: TMFSandman Big red star, 1000 posts Feste Award Nominee! Old School Fool Coverage Fool CAPS All Star Add to my Favorite Fools Ignore this person (you won't see their posts anymore) Number: 2137 of 2209
Subject: Re: Help me understand Impairment in layman's te Date: 12/15/2010 11:50 PM
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Thought I'd throw out an impairment of a different flavor.

In 2009 the price of oil and natural gas cratered. GAAP accounting standards require exploration and production (e&p) companies to write down oil and gas reserves that are no longer economically worth drilling for at the current price. This rule resulted in some pretty huge non-cash impairment charges to earnings in 2009. Take a look at the income statement on page 80 of Chesapeake Energy's 10-K:

http://www.sec.gov/Archives/edgar/data/895126/00011931251004...

You'll see under Operating Costs an $11.1 billion charge for "Impairment of natural gas and oil properties and other assets." Go one page further down to the cash flow statement and you'll see this non-cash charge added back in.

So if you look at pretty much any e&p's financial statements for 2009 you not only get reduced income due to the lower sales price of oil and natural gas, but you get a second whammy from the non-cash impairment charge.

Though this impairment is GAAP-approved I wouldn't put it in the same category as the permanent asset impairment example I made up about the pharma company. That is, unless you believed that the price of oil was going to stay at $25.00 a barrel and natural gas at $2.00/mcf.

Mike

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