"Dear Shareholders, we have achieved more than satisfactory results this year. Our EBITDA is above target and growing faster than our competitors’. Do not be misled by our plummeting profits. Profits are negatively affected by large impairments, which are merely accounting adjustments." With this statement Mr. Locksmith, the CEO of S&S Ltd., attempts to draw shareholders’ attention away from the group’s negative financial performance. A few days later, a disgruntled employee publicly reveals that S&S Ltd. uses impairments to adjust profits.
These two revelations send the value of S&S Ltd.’s shares to a historically low price. Investors seem to have lost confidence that the company is showing reliable values for its assets and fear that large impairments are a symptom of unwise management. In particular, investors are aware that impairments may reveal a dangerous inability of management to base the company’s investments on reliable predictions.
In response, S&S Ltd.’s chairman asks the board of directors to appoint a new controller. The chairman recommends Mr. Fairman, whose reputation for integrity and accounting knowledge should restore the investors’ confidence in S&S Ltd.
Mr. Fairman addresses the board of directors, saying, "Impairments represent the best estimate of significant, unexpected, and sudden revisions of the future economic benefits expected from assets. There are few asset categories that are not potentially subject to impairment. There is no room for a cavalier approach with impairments because each time one is announced, it means the admission that an asset was previously overestimated and money was wasted for its overpriced acquisition."
Mr. Fairman then explains his team’s plan of action. Following an internal communication campaign to ensure that the concept and scope of impairment is well understood by all relevant S&S Ltd. employees, the team will clarify procedures for proper asset valuation, distinguishing the book value from the value based on the forecast of future economic benefits. Next, the team will establish clear procedures for impairment tests. In particular, assets will be organized into groups to help evaluate their ability to contribute to the creation of cash for the company. Special attention will be given to goodwill. Mr. Fairman himself, in consultation with the directors and the auditors, will oversee the calculation of the discount rates that will be used to evaluate the assets’ expected cash flows. A new finance expert will be appointed and charged with the task of setting consistent procedures for the sensitivity analyses that test the validity of the assets’ evaluations.
The public announcement of this initiative is well received by S&S Ltd.’s investors, with an immediate effect of a rapid increase of S&S Ltd.’s share price.
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