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.

Over time, Alpha will be required to

amortize the goodwill balance into expense. This takes a long period of time and is the proper course of action if the acquisition works as planned. However, from time to time a company can make a mistake when they make an acquisition.

Recently,

eBay

(EBAY) - Get Report

reported its

quarterly results. When doing so, eBay

took an impairment to write down the value of its Skype acquisition (now eBay's "communications" segment, or unit). According to eBay's Form 10-Q:

We conducted our annual impairment test of goodwill as of August 31, 2007 in accordance with SFAS No. 142, "Goodwill and Other Intangible Assets." As a result of this test, we concluded that the carrying amount of our Communications reporting unit exceeded its fair value and recorded an impairment loss of approximately $1.4 billion during the quarter ended September 30, 2007. The impairment charge includes the impact of the earn out settlement payment described below and was determined by comparing the carrying value of goodwill in our Communications reporting unit with the implied fair value of the goodwill. We determined the fair value of the Communications reporting unit using the income approach, which requires estimates of future operating results and cash flows discounted using an estimated discount rate. Our estimates resulted from an updated long-term financial outlook developed as part of our strategic planning cycle conducted annually during our third quarter. Our estimates of future operating results for our Communications reporting unit are for an early stage business with limited financial history, as well as developing revenue models. These factors increase the risk of differences between projected and actual performance that could impact future estimates of fair value of the Communications reporting unit.

Asset Revaluation

From time to time, a company will recognize that certain assets on their balance sheet are not worth their "carrying" value and decide to

revalue (or reprice) these assets.

If a company discovers that it holds an asset that is worth more than it once was, then that is good news. The company may choose to continue to carry that asset at its "adjusted" cost (initial cost

minus

depreciation) or realize the

appreciation by selling the asset at its

market value.

However, if an asset is worth less than its carrying value, then a company may decide to take an impairment and write down the value of the assets. For example, let's say a company has old

inventory that it can no longer sell because it has rolled out a new product. The company might write down the inventory to recognize its reduced valuation.

When it comes to investments and

derivative securities, the revaluation is more complex. In September 2006, the Financial Accounting Standards Board (

FASB) issued SFAS (statement of financial account standards)

No. 157: Fair Value Measurements.

According the FASB, investments must be valued based on a number of assumptions, including

risk. The issuance of SFAS-157 was made effective just as the mortgage and credit markets were beginning to

deteriorate. As those problems persisted, it became apparent that the investments in mortgages, mortgage derivatives and asset-backed securities needed to be revalued in accordance with SFAS-157. Hence, a slew of

investment banks and

commercial banks have taken large-scale writedowns on their portfolio of mortgage and related investments during this most recent quarterly reporting season (see

"Writedown Talk Whipshaws Citi").

Discounted Operation

On occasion, in the natural course of business, a company will close a division, eliminate jobs or shutter some locations. This is sometimes done as part of a bigger plan for corporate restructuring or a major strategic event.

For example, earlier this year,

Darden Restaurants

(DRI) - Get Report

closed 54 Smokey Bones and two Rocky River Grillhouse locations and announced its intention to sell the remaining Smokey Bones restaurants. In addition, nine Bahama Breeze locations were closed. All of the results and impairments for the closed or held-for-sale units were categorized as discontinued operations. In the process, Darden took an impairment charge for the closings.

The process of restructuring or closing operations of a company may transcend many quarters. As a result, in order to differentiate the impact of the restructuring or closings while the company is still conducting its normal operations, the company will segregate its reporting into continuing operations and discontinued operations.

A Look at Inverness Medical Innovations

Many times when a company takes a writedown it

does

signal a problem and in those circumstances the stock will be met with selling. However, sometimes the writedown is received as a welcome relief and a constructive effort by the company to, as the old song goes, "accentuate the positive and eliminate the negative." Other times, it is just a necessary evil of conducting business or acquiring other companies.

For example, take a look at the following excerpt from

Inverness Medical Innovations'

(IMA)

recent quarterly earning report:

The Company's GAAP generally accepted accounting practices results for the third quarter of 2007 include amortization of $19.9 million, the write-off of $169.0 million of in-process research and development acquired in connection with the Biosite acquisition, $0.5 million of restructuring charges, $3.3 million of stock-based compensation expense, and a $6.3 million charge related to the write-up to fair market value of inventory acquired in connection with the Biosite and Cholestech acquisitions. GAAP results for the third quarter of 2006 include amortization of $6.4 million, the write-off of $5.0 million of in-process research and development acquired in connection with the Clondiag acquisition, a $1.2 million restructuring charge, $1.3 million of non-cash stock-based compensation expense and $1.3 million of prepayment penalties and a write-off of debt origination costs upon early extinguishment of related debt. These amounts, net of tax, have been excluded from the adjusted cash basis net income per common share for the respective quarters.

None of these accounting revisions were seen as onerous or out of the ordinary. And the action taken by the company was not seen as a tacit admission of some sort of strategic business failure. As a result, the earnings and

revenues from Inverness Medical Innovations were excellent and the stock rose to a new all-time high.

Homework Time

  • Observe the reaction to a company's writedown.
  • Read a few earnings reports or press releases that contain a writedown and ascertain the writedown type.

At the time of publication, Rothbort was long IMA, although positions can change at any time. Scott Rothbort has over 20 years of experience in the financial services industry. In 2002, Rothbort founded LakeView Asset Management, LLC, a registered investment advisor based in Millburn, N.J., which offers customized individually managed separate accounts, including proprietary long/short strategies to its high net worth clientele. Immediately prior to that, Rothbort worked at Merrill Lynch for 10 years, where he was instrumental in building the global equity derivative business and managed the global equity swap business from its inception. Rothbort previously held international assignments in Tokyo, Hong Kong and London while working for Morgan Stanley and County NatWest Securities. Rothbort holds an MBA in finance and international business from the Stern School of Business of New York University and a BS in economics and accounting from the Wharton School of Business of the University of Pennsylvania. He is a Professor of Finance and the Chief Market Strategist for the Stillman School of Business of Seton Hall University. For more information about Scott Rothbort and LakeView Asset Management, LLC, visit the company's Web site at www.lakeviewasset.com. Scott appreciates your feedback; click here to send him an email.