Impairment: What You Need to Know

Accounting impairments are very common, often coming alongside a big miss in a company's headline earnings report. Before assuming the worst, investors should become familiar with this common accounting charge, and know how it works.

With the help of a historical example, let's make sense of accounting impairments, and what they mean for investors.

What impairments are and where they commonly come fromCompanies report the value of their assets on their balance sheet. If an asset is later determined to be too highly valued, an adjustment -- an impairment -- can be made to reduce an asset's value to reflect a more accurate value.

Impairments can affect any number of balance sheet items, but they're most commonly associated with goodwill. Microsoft stands as a great case in understanding how impairments, especially goodwill impairments, affect a company.

In 2007, Microsoft was looking for ways to grow its online advertising business. It later identified a company by the name of aQuantive, a promising online advertising company that would make for a good bolt-on acquisition to grow its business.

Ultimately, Microsoft figured that the company was worth approximately $5.9 billion, and it agreed to purchase the company at that price. But now it had to account for the acquisition. aQuantive's assets and liabilities were accounted for as assets and liabilities. But those assets only explained a portion -- less than $1 billion -- of the company's purchase price.

After all, Microsoft wasn't buying aQuantive just for its assets. It was buying the company for its expected future profits. And to balance out the difference between what Microsoft paid for aQuantive and the assets it received in the sale, it had to record $5.2 billion of goodwill on its balance sheet. (Goodwill is essentially a placeholder that says "this is how much we overpaid for a company's assets, with the assumption we'll make it back with earnings over time.")

Microsoft explained how it accounted for the aQuantive acquisition in its financial filings:

Source: Note 8 of Microsoft's 2008 Annual Report

As you can imagine, making projections about a company's value today based on the future is a little fuzzy. After all, aQuantive's ultimate value to Microsoft would be determined by its earnings over the next 10, 20, or even 100 years. Valuing a business requires a whole lot of guesswork, which will only be proven accurate or inaccurate as time goes on.

Each year, Microsoft had to review its goodwill for aQuantive. If the business was performing better than expected, it would simply leave goodwill as it was. If the business performed poorly, however, Microsoft would impair its goodwill balance to reflect its new expectations for the company.

Fast forward ...The aQuantive acquisition proved to be one of Microsoft's biggest acquisition blunders. Five years after its acquisition, in 2012, Microsoft reported its first-ever quarterly loss on its income statement. Many people, unfamiliar with accounting, saw this as an incredible event -- one of the most profitable technology companies in the world was suddenly losing money!

What really happened, though, was far more benign. Microsoft simply impaired goodwill by $6.2 billion to primarily reflect that the acquisition of aQuantive hadn't worked out to plan. That charge, which negatively affected earnings by roughly $6.2 billion that quarter, led to a net loss for the quarter.

Here's how it appeared on Microsoft's income statement for the year:

Source: Page 47 of Microsoft's 2012 Annual Report

Investors, of course, were unfazed. If Microsoft took a $6.2 billion impairment, then clearly its acquisition wasn't panning out well. And for it to take that charge meant that aQuantive, the company it acquired, probably wasn't a key driver of revenue or earnings in prior periods.

Thus, one could reasonably determine that this impairment, though significant in the sense that Microsoft wasted $6.2 billion on acquisitions in the past, wasn't necessarily a sign that things would be bad in the future. The stock hardly budged, even though the company's 26-year record of quarterly profitability had come to an end.

Impairments are kind of bad, maybeAt the end of the day, impairments are generally bad news in the sense that a company is writing down the value of one or many assets on its balance sheet. But in most cases, an impairment happens after the worst has come to fruition, and investors have come to expect them.

Under Generally Accepted Accounting Principles, or GAAP, used in the United States, the reversal of impairment losses is prohibited. Thus, companies tend to push off impairments for as long as they can, making impairments only when they are certain the losses are permanent.

So, in a way, impairments aren't exactly surprising. (Microsoft warned in advance that it planned to impair its goodwill balance prior to its fourth-quarter earnings in 2012.) But they aren't to be ignored. Impairments do have some significance -- a history of goodwill impairments would suggest a company isn't a very thoughtful acquirer of others, for instance, a claim many have made about Microsoft for years and years.

The article Impairment: What You Need to Know originally appeared on Fool.com.

Jordan Wathen has no position in any stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.