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How to Interpret Writedowns

There has been a recent spate of writedowns in the financial industry as a result of mortgage and credit market problems. While the enormity of these numbers may be staggering, writedowns are common occurrences in the business world. However, the magnitude and causes of writedowns vary. This installment of The Finance Professor will look at writedowns, from both economic and the accounting perspectives.

For starters, it's important to understand that companies will take a writedown (the downward valuation of an asset ) for a variety of reasons. Here are the most frequent rationales:

  • Goodwill impairment
  • Asset revaluation
  • Discontinued operations

Goodwill Impairment

When one company acquires another company, accounting rules state that the acquired company be consolidated into the financial statements of the acquiring company. In particular, it is the balance sheet that needs to be consolidated.

Consolidation accounting is very complex and is typically studied by accounting students in advance courses. However, I can boil down the implications of consolidating acquisition into one simple implication: goodwill. Goodwill represents the excess of the purchase price over the book value of a company. For example, say that "Alpha Corp." acquires "Beta Corp." for $5 billion. The book value of Beta Corp. is $4 billion before the companies are combined. Thus, Alpha will consolidate the assets , liabilities and equity of Beta onto its balance sheet but is missing $1 billion of value in the process. Accounting rules then require Alpha to record $1 billion of goodwill as a "non-current" asset.

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