October 7th, 2022


Impairment occurs when fair value is below amortized cost. Some business decisions, including the sale of assets, could well result in an impairment charge.

Our cash-based return on capital model is excellent at catching future impairment charges under GAAP, especially as one of the tests in the Standard is a drop of total firm market value below book. We concern ourselves with impairments likely to reduce cash flows, as most impairments are recorded as non-cash GAAP events. The impact on future cash flows is to be determined.

Impairments may also lead to covenant violations due to cash flows or collateral impacts.

You recall the worldwide credit crisis was exacerbated by FAS 157 and its fair value provision, which forced firms to mark inactive securities to market. This was later replaced with other conditions, including the income approach used by our firms with no need to sell portfolio holdings to supplant cash and whose portfolio consists of non-active fixed income instruments. Assets for sale are shown in OCI (other comprehensive income), and currently show, for our portfolio, no deviation from normal.

Though the impairment-related Standard calls for an annual review, a change to interim reporting may be called for, especially for firms with inflated inventory and goodwill, the latter which may not be amortized or deducted for tax purposes. Impairments are normally set at the individual unit level.

Taxable M&A goodwill may result in tax-deductibility and needs to be studied, including the impact on future taxation.

Our cash flow-based models already incorporate fair asset values into our value estimate. Assets reported below their ability to produce cash are thus late to the game. The same is true for assets such as PP&E, which may be near the end of their useful life for accounting purposes yet are fully capable of producing goods for years to come.

The Inflation Reduction Act may prove to be the most important new legislation impacting cash flows and valuation, requiring a comprehensive understanding of firm accounting (both global and domestic) and actual cash tax. Tax credits and incentives have sway over taxes due otherwise.

The alternative tax provision for a minimum 15% based on a firm’s book income must be evaluated in conjunction with the many offsets;[1] as far as the 1% tax on buybacks is concerned, it is of minor influence, and could be overcome if the firm is to issue stock or to repurchase other securities. CT Capital has the abilities necessary to dissect the data in an appropriate form, which is then plugged into our valuation models.

Free cash flow estimates require getting the fingernails dirty and normalizing results, transactions, accruals, and estimates within the line entries, and, later, tax credits. Most analysts use simplistically lazy models.

[1] In this provision the Act generally establishes the 15% tax liability for firms having a $1B average annual adjusted financial statement income. It is an alternative minimum tax to the extent that its “tentative minimum tax” exceeds its regular US federal income tax liability plus its liability for the base erosion anti-abuse tax (BEAT). Impacted firms do receive a credit against future liability.

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