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Subject:  Re: Help me understand Impairment in layman's te Date:  12/15/2010  4:46 PM
Author:  TMFSandman Number:  2136 of 2244

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 article on goodwill accounting. It's a great site to look up investing words, definitely worth bookmarking:

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