Vedanta recently took an impairment charge of ₹19,956 crore on the goodwill relating to its Cairn India assets. Tata Steel has announced that it will take an impairment charge of ₹6,500 crore on its books soon. Big-ticket write-offs; so, what exactly are impairment charges?

What is it?

Ever bought a plot or flat and felt you paid more? Companies sometimes do the same. After investing substantial sums to buy an asset or build it from scratch, they find the asset is worth less than its value in the books.

In finance-speak, the carrying cost of the asset is higher than the amount recoverable from it. In such a case, the company takes a write-down of the asset’s value; that’s an impairment charge.

Recoverable value can be the selling price of the asset today or the present value of future cash flows that are likely from using that asset. Usually, it’s the latter factor falling short that causes companies to book impairment charges. The charge is usually reflected in the profit and loss account.

Impairment charges apply to all assets, save inventory, construction contracts and financial investments. But What can cause the recoverable value of a factory or land to drop? Blame it on market dynamics. Take Vedanta. It it decided that the price decline on crude oil was so steep — and prospects of a price recovery so bleak — that Cairn India’s cash flows wouldn’t match up to its expectations at the time of the acquisition.

Both market factors and company-specific factors can cause a decline in recoverable value. But impairment charges don’t always have to run to thousands of crore. Factors such as change in usefulness of an asset can also result in a lower recoverable value, prompting a write-down.

Why is it important?

If an asset doesn’t generate the expected cash flow, the company stands to lose money over the long term. Taking an impairment charge bundles potential losses and front-ends them.

Tata Power, for example, wrote off ₹1,800 crore from the cost of its key Mundra power plant in 2011-12, as changes in Indonesia’s coal export policies and low power tariffs dented the plant’s profitability. Tata Steel took a ₹8,356 crore impairment charge in 2012-13 on its European steel business as well as some operations in South Africa and Thailand. It has now decided to take a further ₹6,500 crore in impairment costs in the 2014-15 fiscal, on part of its UK business and projects in other countries. That said, the manner in which the valuation is done and when and to what extent impairment is taken depends on the company.

Why should I care?

As an investor, you must read impairment charges as an effort by a company to clean up its books and confess to its mistakes. Markets often use book value — a measure of a company’s assets — to price its stock. Impairments, by adjusting assets to their true value, draw a more correct picture of a company’s financial position. Inflated asset values can skew prices investors pay for a stock, especially if they are key assets and the amounts are huge. Unexpected losses stemming from these assets, or poor cash flows can come back to haunt investors.

The bottom line

Yes, it is a transparent practise for companies to declare their assets are worth less than what they thought. But the frequency with which companies are taking such charges show that companies, just like investors, are buying when prices are too high.

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