Prof. Jayanth R. Varma's Financial Markets Blog

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Impairment test equals integrity test

I have a piece in today’s Financial Express arguing that the impairment test in the year end financials is a test of the integrity of Indian corporate sector.

Corporate India faces a significant test of the integrity of its financial statements at the end of this financial year when it has to apply an “impairment” test to a variety of assets under accounting standard AS 28. If assets are impaired, they have to be written down and the loss has to be charged to the profit and loss account.

Though AS 28 came into effect for listed companies from the year 2004-05, this is the first time that a large number of companies will be confronted with potential impairment on a large scale. Under AS 28, the requirement to carry out an impairment assessment arises only when there are external or internal indications that an asset may be impaired. The significant worsening of the domestic and global economic environment, sharp declines in market prices and deterioration in the economic performance of many assets would trigger the application of the impairment test for several classes of assets during this year.

There are four important categories of assets where impairment is likely to have taken place. These are: (a) goodwill from recent acquisitions (particularly, international acquisitions), (b) mines and other natural resource assets, (c) commercial real estate, and (d) capacity rendered redundant by demand destruction.

Indian companies made large international acquisitions at high prices during the boom. The current market value of several of the acquired companies would be well below what was paid for them. Their current and forecasted operating performance would also be much worse than what was projected at the time of acquisition. This would normally lead to a heavy impairment charge.

Some kinds of acquisitions would probably escape this charge. For example, if a foreign company was acquired mainly for its brands and marketing network or for its technology, the acquired company might not have an independent set of cash flows that can be used for an impairment test. In this case, the impairment test may have to be applied to the entire consolidated business. Companies whose shares are trading above book value are unlikely to be in the situation where the entire business is impaired and so no impairment charge may be needed.

Commercial real estate is another prime candidate for an impairment test because of the steep correction in market prices. Here again, if the real estate was bought for corporate offices or for other purposes which do not produce identifiable cash flows, impairment charges may not result unless the whole business is impaired. Real estate that was bought for development or for letting out or for producing revenue directly (as in infrastructure projects or retail stores) would be prime candidates for impairment.

Similarly, the sharp fall in commodity prices could trigger impairment charges for many natural resource assets like mines in India or abroad that were bought at the height of the boom.

Finally, the global recession has created excess capacity in a variety of industries. New capacity is coming on stream while even the old plants are running below capacity. Many of these assets might have to face an impairment charge. In many cases, it may be possible to argue that the low capacity utilisation is a temporary phase. But in some industries, the demand destruction has been too large for such a sanguine view.

Companies whose shares are trading below book value are in a worse situation. Their entire business may be impaired and they may have to write down many assets including unproductive corporate assets (ranging from art collections to aircraft) which have seen huge declines in price.

Banks and financial companies are in a separate league because the treatment of their impaired loans and investment is governed by different regulations. These losses are bound to rise, too, but that is another story altogether.

Stock markets are forward looking and are likely to have already factored in the deterioration in asset values in their valuation. Recognising this known loss in the published accounts would not cause a further drop in share prices. On the contrary, markets are likely to reward companies which are honest about what has happened, reflect this reality in their accounting and have a realistic plan to deal with their problems.

Markets are more likely to punish companies that try to avoid an impairment charge by using various accounting subterfuges. Such companies would be telling the world that their accounts cannot be trusted at all and that they are Satyams in the making. That would force the market to assume the worst and mark down even assets that are not actually impaired.

Many companies, however, do not seem to understand this. They appear to be under the delusion that all would be fine with the world if only they can find a way to avoid admitting the impairment that has taken place. That is why I think that the impairment test could end up being an integrity test for Indian accounting.

Posted at 12:15 pm IST on Mon, 2 Mar 2009         permanent link