Prof. Jayanth R. Varma’s Financial Markets Blog

A blog on financial markets and their regulation

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.

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