Using Real Activities to Avoid Goodwill Impairment Losses: Evidence and Effect on Future Performance

We examine whether managers postpone the recognition of goodwill impairment by manipulating cash flows and the consequences of such a strategy on future performance. According to SFAS 142, an impairment loss must be recognized if the reporting unit's total fair value to which goodwill has been allocated is less than its book value. A growing body of empirical evidence shows that managers delay the recognition of goodwill impairment in accounting books. However, past literature is silent on how managers convince various gatekeepers (e.g., auditors, financial analysts) that recognizing an impairment loss is unnecessary although it seems economically justified. SFAS 142 requires managers to forecast future cash flows to justify the decision to recognize, or not, an impairment loss. Therefore, we predict that managers manipulate upward current cash flows to support their choice to avoid reporting an impairment loss. We also test whether or not this real earnings management is detrimental to future performance. Based on a sample of US firms over the period 2003–2011, we document that firms suspected of postponing goodwill impairment losses exhibit significantly positive discretionary cash flows compared to various control groups. We also find that this real activities manipulation is detrimental to future performance.     

The implications of unverifiable fair-value accounting: Evidence from the political economy of goodwill accounting

I study the evolution of SFAS 142, which uses unverifiable fair-value estimates to account for acquired goodwill. I find evidence consistent with the FASB issuing SFAS 142 in response to political pressure over its proposal to abolish pooling accounting. The result is interesting given this proposal was due in part to SEC concerns over pooling misuse. I also find evidence consistent with lobbying support for SFAS 142 increasing in firms’ discretion under the standard. Agency theory predicts such unverifiable discretion can be used opportunistically.     

The effect of SFAS 142 on the ability of goodwill to predict future cash flows

This study examines the effect of Statement of Financial Accounting Standards No. 142 (SFAS 142) on the ability of goodwill to predict future cash flows. SFAS 142 allows substantial managerial discretion and leads to a significant magnitude of economic impact on financial statements, resulting in critical debates over the consequence of its adoption. I find that the ability of goodwill to predict future cash flows has improved since the Financial Accounting Standards Board (FASB) adopted SFAS 142. Furthermore, sub-sample analyses fail to reveal compelling evidence that reporting discretion induced by SFAS 142 is used opportunistically or informatively, contrasting with the pervasive view based on the opportunistic reporting hypothesis. Overall, contrary to the position of critics of SFAS 142, the results support the view taken by the FASB and proponents of SFAS 142: eliminating systematic amortization and adopting fair value estimates improve representational faithfulness of goodwill reporting.     

Economic Determinants and Information Environment Effects of Earnouts: New Insights from SFAS 141(R)

Contingent considerations (earnouts) in acquisition agreements provide sellers with future payments conditional on meeting certain conditions. Prior research provides evidence that acquiring firms use earnouts to minimize agency costs associated with acquisitions. Using earnout fair value information, recently mandated by SFAS 141(R), we provide new insights into the economic determinants to include earnout provisions in acquisition agreements, including motivations to resolve moral hazard and adverse selection problems, bridge valuation gaps, and retain target firm managers. We document variations in initial earnout fair value estimates and earnout fair value adjustments that correspond with these underlying motivations. We also provide evidence that target managers stay longer with the firm after the acquisition when earnouts are included primarily to retain target managers. Finally, we demonstrate that earnout fair value adjustments required by SFAS 141(R) provide valuable information to market participants and are negatively associated with the likelihood of contemporaneous and future goodwill impairments.     

The relative and incremental value relevance of goodwill before and after SFAS No. 142

We explore the value relevance of goodwill against two benchmarks: other accounting information and long-lived tangible assets. Prior research suggests that fair value estimates for goodwill must be inferred from other available information because of the nature of goodwill, including its intangibility. Such inferences are highly discretionary and may limit the usefulness of reported goodwill estimates. Because Statement of Financial Accounting Standards (SFAS) No. 142 relies exclusively on fair value estimates to subsequently measure goodwill, reported values considering management’s increased discretion may be less reliable and less value relevant when presented in conjunction with other accounting information. However, the subsequent accounting measurement for goodwill is not dissimilar from the subsequent measurement for long-lived tangible assets, which are also subject to impairment. In general, impairment measurement is subjective; management may have greater insight, even in the presence of management incentives and other accounting information, that may help confirm or disconfirm investors’ own goodwill estimates. Using other accounting information and long-lived tangible assets as benchmarks for the value relevance of goodwill, we find that reported goodwill provides greater value relevance relative to other accounting information after SFAS 142 and that the difference between the value relevance of goodwill and other long-lived tangible assets is also significantly greater following SFAS 142.     

Has goodwill accounting gone bad?

Prior to SFAS 142, goodwill was subject to periodic amortization and a recoverability-based impairment test. SFAS 142 eliminates periodic amortization and imposes a fair-value-based impairment test. We examine the impact of this standard on the accounting for and valuation of goodwill. Our results indicate that the new standard has resulted in relatively inflated goodwill balances and untimely impairments. We also find that investors do not appear to fully anticipate the untimely nature of post-SFAS 142 goodwill impairments. Overall, our results suggest that, in practice, some managers have exploited the discretion afforded by SFAS 142 to delay goodwill impairments, thus temporarily inflating earnings and stock prices.     

Financial reporting changes and the internal information environment: Evidence from SFAS 142

Using the adoption of SFAS 142 as an exogenous shock, we examine the effect of changes in financial reporting on firms’ internal information environment. We argue that complying with SFAS 142 induces managers to acquire new information and therefore improves their information sets. Interviews with executives and auditors confirm this argument. Using a difference-in-differences design, we find that firms affected by SFAS 142 (i.e., treatment firms) experience an improvement in management forecast accuracy in the post-SFAS 142 period. The increase is smaller for those with stronger monitoring in the pre-SFAS 142 period and greater for those with a higher likelihood of goodwill impairment. Furthermore, treatment firms with improvements in management forecast accuracy have higher M&A quality, internal capital allocation efficiency, and performance in the post-SFAS142 period. Overall, our findings indicate that changes in external financial reporting can lead to better corporate decisions via their impact on the internal information environment.     

Economic consequences of SFAS 142 goodwill write‐offs

This paper examines the economic consequences of goodwill write‐offs under Statement of Financial Accounting Standards No. 142 (SFAS 142). Although write‐off firms have performed poorly, it is evident that deteriorating economic performance explains only a small proportion of write‐offs. After controlling for endogeneity of write‐off choice, I fail to find evidence that investors and analysts fixate on SFAS 142 goodwill write‐offs. I also provide evidence that write‐off firms pay higher audit fees, suggesting that auditors charge higher fees in response to extra audit effort. These results are consistent with the principles of market efficiency, analyst‐forecast rationality and efficient audit pricing.     

Assessing the Value of Growth Option Synergies from Business Combinations and Testing for Goodwill Impairment: A Real Options Perspective

Goodwill is an intangible asset, and therefore hard to measure and difficult to account for. This article argues that the two‐stage impairment test for acquired goodwill under SFAS 142 has several limitations. Most important, it measures aggregate rather than acquired goodwill, making it very difficult to separate acquisition‐related goodwill from aggregate enterprise goodwill after a business combination. As a consequence, any potential deterioration of acquired goodwill value could be concealed by increases in internally generated goodwill. As an alternative, the authors propose a real options approach to managing a business unit portfolio as a better framework for conducting the goodwill impairment test. A real options approach to testing goodwill for impairment—as opposed to the standard fair value assessment based on DCF analysis—not only accounts for deterioration in the value of goodwill, but also captures upward potential. It enables tracking of the changes in goodwill value from one period to the next, providing a less biased estimate of its real value at each point in time.     

Do Firms Manage Fair Value Estimates? An Examination of SFAS 142 Goodwill Impairments

Abstract:  I find that goodwill write-offs under Statement of Financial Accounting Standards No. 142 (SFAS 142) are associated with future expected cash flows as mandated by the standard. However, there are indications that goodwill write-offs lag behind the economic impairment of goodwill. Additional analysis reveals that the association between goodwill write-offs and future cash flows is insignificant for firms with contemporaneous restructuring. I hypothesize that this finding is due to agency-based motives. Finally, I examine a sample of non-impairment firms in which there are indications that goodwill is impaired. I fail to find convincing evidence that these firms are opportunistically avoiding impairments.     

Is the Selection of the Amortization Period for Goodwill a Strategic Choice?

This study examines whether the choice of amortization life for purchased goodwill is predictive of the firm's post-acquisition earnings levels, given that shorter lives could lead to a dilution in earnings. Our findings support this interpretation. Further, consistent with Andrade (2001), we demonstrate a link between post-acquisition earnings changes and stock performance. These results suggest that the amortization life chosen is a reliable predictor of the success of the acquisition both in terms of earnings changes and future stock performance. These findings are relevant since the information concerning the life chosen was eliminated by the adoption of SFAS No. 142.     

Managerial discretion to delay the recognition of goodwill impairment: The role of enforcement

Under International Financial Reporting Standards, managers can use two approaches to increase the estimated fair value of goodwill in order to justify not recognizing impairment: (1) make overly optimistic valuation assumptions, and (2) increase future cash flow forecasts by inflating current cash flows. Because enforcement constrains the use of optimistic valuation assumptions, we hypothesize that enforcement influences the relative use of these two choices. We test this hypothesis by comparing a sample of 1,958 firms from 36 countries that are likely to delay recognizing goodwill impairment (suspect firms) to a sample of control firms. First, we find that firms in high‐enforcement countries use a higher discount rate to test goodwill for impairment than firms in low‐enforcement countries. We also find a more positive association between discount rate and upward cash flow management for suspect firms than for control firms. This result is consistent with suspect firms substituting optimistic valuation assumptions with inflated current cash flows. Second, we find that, relative to control firms, suspect firms exhibit higher upward cash flow management in high‐enforcement countries than in low‐enforcement countries. Third, we show that suspect firms in high‐enforcement countries are more likely to eventually impair goodwill.     

Timeliness of impairment recognition: Evidence from the initial adoption of SFAS 142

This research investigates the timeliness of impairment recognition from the initial adoption of Statement of Financial Accounting Standards no. 142, Goodwill and Other Intangible Assets (SFAS 142). Using a sample of firms reporting goodwill at yearend 2001, we examine the lag between incorporation in returns and recognition in earnings of 2002 goodwill impairments to provide market-based evidence on the timeliness of goodwill impairments upon the adoption of the new rule. First, our results indicate that the market anticipated the initial adoption write-offs. Second, while the concurrent association between stock returns and newly incurred impairment losses indicates timely recognition of impairments after the new standard, the market also anticipated the new impairment losses subsequent to initial adoption. This indicates that timeliness can be improved further after the adoption of SFAS 142.     

GAAP goodwill and debt contracting efficiency: evidence from net-worth covenants

We study the role of goodwill in promoting contracting efficiency and the effect of SFAS 141 and 142 on this role. We provide three main results. First, when a lending agreement contains some type of minimum net-worth covenant, the probability of a tangible net-worth covenant is decreasing in the borrower’s goodwill. Second, the use of tangible net-worth covenants has increased since the promulgation of SFAS 141 and 142. Finally, covenant slack is not significantly related to the use of tangible net-worth covenants relative to net-worth covenants. These results suggest that contracting parties realize efficiency gains by permitting borrowers’ actions to be restricted by the value of GAAP goodwill. However, recent changes in GAAP have reduced the contracting usefulness of goodwill.

Fair Value Accounting and Debt Contracting: Evidence from Adoption of SFAS 159

We examine how fair value accounting affects debt contract design, specifically the use and definition of financial covenants in private loan contracts. Using SFAS 159 adoption as our setting, we find that a small but significant proportion of loans (14.5%) modify covenant definitions to exclude the effects of SFAS 159 fair values. Only a limited number of these modifications exclude assets elected at fair value (less than 7%), while all exclude liabilities elected at fair value. Notably, we document that covenant definition modification is unassociated with ex ante fair value elections. We find that covenant definition modification positively varies with common incentive problems attributed to fair value accounting and negatively varies with benefits attributed to fair value accounting. Our results suggest that fair value accounting is not uniformly detrimental for debt contracting and fair value adjustments are included when they are most likely to improve performance measurement.     

The change in the value relevance of accounting information after mergers and acquisitions: evidence from the adoption of SFAS 141(R)

This study examines how and why investors change the use of their information sources in valuation between book value and earnings after mergers and acquisitions (M&A) in both pre- and post-SFAS 141(R) periods. We find that investors generally put less weight on earnings but more weight on book value after M&A than before M&A, and that such a change is particularly strong after the adoption of SFAS 141(R). By looking at goodwill, other intangible assets and other balance sheet accounts that SFAS 141(R) amended, we further find that SFAS 141(R) improves the value relevance of book value components after M&A.     

Overpaid acquisitions and goodwill impairment losses — Evidence from the US

The purpose of this study is to shed light on the reliability of accounting goodwill numbers by examining whether many goodwill impairment losses arise from overpayment for the target at the time of the acquisition, rather than from a subsequent deterioration of goodwill values. A second related objective is to assess whether the goodwill impairment test introduced by SFAS 142 improved the ability of accounting standards to timely capture situations in which the amount of goodwill is overstated and should thus be written down.     

Why do pro forma and Street earnings not reflect changes in GAAP? Evidence from SFAS 123R

This study examines how key market participants??managers and analysts??responded to SFAS 123R??s controversial requirement that firms recognize stock-based compensation expense. Despite mandated recognition of the expense, some firms?? managers exclude it from pro forma earnings and some firms?? analysts exclude it from Street earnings. We find evidence consistent with managers opportunistically excluding the expense to increase earnings, smooth earnings, and meet earnings benchmarks but no evidence that these exclusions result in an earnings measure that better predicts future firm performance. In contrast, we find that analysts exclude the expense from earnings forecasts when exclusion increases earnings?? predictive ability for future performance and that opportunism generally does not explain exclusion by analysts incremental to exclusion by managers. Thus our findings indicate that opportunism is the primary explanation for exclusion of the expense from pro forma earnings and predictive ability is the primary explanation for exclusion from Street earnings. Our findings suggest the controversy surrounding the recognition of stock-based compensation expense may be attributable to cross-sectional variation in the relevance of the expense for equity valuation, as well as to differing incentives of market participants.     

Debt contracting and the goodwill debate

Extant literature offers mixed evidence on the quality of goodwill after the promulgation of SFAS 141/2 (Li and Sloan, 2017; Lee, 2011; Chen et al., 2008). We reconcile these conflicting findings by examining the role of managerial incentives in determining the efficacy of SFAS 141/2 in improving the quality of goodwill reporting. Using the context of debt contracting, we find that the value-relevance of goodwill is higher for firms that include goodwill in debt covenants in the post-SFAS 141/2 period. We also find that in the post-period, firms that include goodwill in their debt contracts appear to take timelier impairments. In addition, debt contracts in these firms also have tighter covenant thresholds, further corroborating the increased value-relevance of goodwill under the current impairment regime. We also document a relatively higher frequency of covenant violation for firms that use goodwill in their debt contract in the post-SFAS 141/2 period. Taken together, our results inform ongoing discussions regarding the accounting for goodwill and provide new insight into understanding of debt contracting and the role of accounting standards therein.     

Discussion of “The implications of unverifiable fair-value accounting: Evidence from the political economy of goodwill accounting”

Ramanna [2007. The implications of unverifiable fair-value accounting: evidence from the political economy of goodwill accounting, Journal of Accounting and Economics] provides interesting and novel evidence on how firms use contributions from their political action committees (PACs) to members of Congress as a means of lobbying for preferred positions on the two exposure drafts that led to SFAS-141 and SFAS-142. My discussion raises some concerns about his main conclusion: that pooling firms lobbied the FASB to obtain a “fair-value”-based impairment rule to facilitate their ability to manipulate financial statements. I offer a more benign explanation and make some other observations about how this line of research could proceed in the future.