Evidence on the use of unverifiable estimates in required goodwill impairment

SFAS 142 requires managers to estimate the current fair value of goodwill to determine goodwill write-offs. In promulgating the standard, the FASB predicted that managers will, on average, use the fair-value estimates to convey private information on future cash flows. The current fair value of goodwill is unverifiable because it depends in part on management??s future actions (including managers?? conceptualization and implementation of firm strategy). Agency theory predicts managers will, on average, use the unverifiable discretion in SFAS 142 consistent with private incentives. We test these hypotheses in a sample of firms with market indications of goodwill impairment. Our evidence, while consistent with some agency-theory based predictions, does not confirm the private information hypothesis.     

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 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.     

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.     

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.     

Interaction between securitization gains and abnormal loan loss provisions: Credit risk retention and fair value accounting

This study investigates whether managers use asset securitization gains to substitute loan loss provision (LLP) management for earnings management, and, if so, whether the percentage of credit risk retained affects such a relationship. The literature provides evidence that managers have used securitization transactions to boost earnings. Using 2001?2014 data for a sample of bank holding companies, I find that managers use securitization gains and LLPs as partial substitutes and that earnings management from securitization gains grows at an increasing rate to substitute income increasing LLP management as the level of risk retention increases. These findings are consistent with the argument that the higher the level of risk retention, the greater the potential impact on achieving earnings targets, given banks’ exercise of discretion over securitization gains through estimation of fair value of retained interest. In addition, I document that the substitution effect between the two tools is non‐existent in the post‐SFAS 166/167 period. Taken together, the findings have timely implications for accounting standards by informing the effect of risk retention that I measure through earnings management techniques. Moreover, my findings provide additional support for improved disclosures on assets‐backed securities.     

The impact of SFAS No. 141 on earnings predictability of merging firms: Evidence from the initial year of implementation

This study examines the impact of SFAS 141 on earnings predictability of merging firms. I expect a relative improvement in analysts’ earnings forecast accuracy for merging firms versus non-merging peers after SFAS 141 adoption. I restrict the post-SFAS 141 sample to the initial year of SFAS 141 implementation. This research design disentangles effects of SFAS No. 141 from those of SFAS No. 142. The evidence from analysis of 48 pairs of merging and matched non-merging firms is consistent with expectations and confirms the increase in earnings predictability for merging firms versus their non-merging peers post-SFAS 141. Results of additional tests suggest that earnings predictability improvement more likely follows from extended disclosure requirements and the other changes in the Purchase Method (“better purchase” issue) than from the elimination of Poolings-of-Interest (“purchase vs. pooling” issue).     

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.     

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.     

Disclosure versus recognition: the case of expensing stock options

The SFAS 123R comment process generated over 6,500 comment letters, most of which were against the standard’s enactment. This outpouring of emotion indicates that many believe that disclosure versus recognition matters. Our paper provides evidence for the debate whether managers’ discretion, motivation, and accuracy of stock option estimates differ under the recognition and disclosure reporting regimes. We compare firms that are mandatorily forced to recognize stock options expense with those voluntarily choosing to do so. First we find that mandatory firms (versus voluntary) with more intensive stock option granting tend to understate option estimates, especially in the post SFAS123R period. Our results suggest that a higher recognition cost motivates firms for doing so. Second, we find that mandatory firms with lower future operating risk have better accuracy in the post SFAS123R period, as compared to themselves in the pre SFAS123R period and voluntary firms in the post SFAS123 period. Our results support the notion that the informativeness of option estimates explains the level of accuracy. The findings of this paper add to the debate on the benefits of recognizing stock option expenses.     

Effect of derivative accounting rules on corporate risk-management behavior

I examine the effect of the accounting standard for derivative instruments (SFAS No. 133) on corporate risk-management behavior. I classify a derivative user as an “effective hedger” (EH firm) if its risk exposures decreased after the initiation of the derivatives program, and as an “ineffective hedger/speculator” (IS firm) otherwise. I find that volatility of cash flows and risk exposures related to interest rate, foreign exchange rate, and commodity price decrease significantly for IS firms but not for EH firms, suggesting that IS firms engaged in more prudent risk-management activities after the adoption of SFAS No. 133.     

An examination of restructuring charges surrounding the implementation of SFAS 146

This paper provides evidence on how the adoption of Statement of Financial Accounting Standards (SFAS) No. 146, Accounting for Costs Associated with Exit or Disposal Activities (SFAS 146), has changed (1) restructuring-related earnings management, (2) the effect of restructurings on future operating performance, and (3) stock price responses to restructuring announcements. I find that restructuring charges reported after SFAS 146 have a weaker association with smoothing behavior. More importantly, I document that an improvement in future earnings following a normal restructuring charge is attenuated under SFAS 146, consistent with the standard’s adoption resulting in smaller and more frequent (i.e., more persistent) restructuring charges. I further document that the market places a higher valuation multiple on restructuring charges in the post-SFAS 146 regime, compared to the pre-SFAS 146 regime. Therefore the overall results suggest that the market appears to understand the higher persistence of restructuring charges reported under SFAS 146 and values the charges accordingly.     

The mixed attribute model in SFAS 133 cash flow hedge accounting: implications for market pricing

In this study, we examine the pricing of cash flow hedge adjustments reported in other comprehensive income (OCICF), under the mixed attribute model in SFAS 133 Accounting for Derivative Instruments and Hedging Activities. Our OCICF pricing investigation integrates empirical research on the derivatives use that gives rise to such mark-to-market adjustments with the accounting information pricing literature. Based on this integration, we generalize mispricing theory for the SFAS 133 mixed attribute model and predict both the direction and magnitude of OCICF pricing. Screening on U.S. multinationals with ex ante exposure to currency risk, we provide evidence of OCICF mispricing in the expected direction, consistent with the notion that SFAS 133 cash flow hedge accounting results in a mixed attribute problem (Gigler et al. in J Account Res 45:257–287, 2007). Moreover, we find that both OCICF gains and losses are inversely related to future cash flows and of the expected magnitude, consistent with our predictions based on valuation theory (for example, Ohlson in Rev Account Stud 4:145–162, 1999). Our results support the Financial Accounting Standards Board’s concern that the SFAS 133 mixed attribute model does not provide the information necessary for investors to understand the net economic effects of derivatives use (FASB in Accounting for financial instruments and revisions to the accounting for derivative instruments and hedging activities. FASB, Norwalk, 2010).     

Do firms understate stock option-based compensation expense disclosed under SFAS 123?

Focusing on the four key option pricing model inputs—expected option life, expected stock price volatility, expected dividend yield, and the risk-free interest rate for the expected life of the option—this study finds that firms understate option value estimates and, thus, stock-based compensation expense disclosed under SFAS 123. As predicted based on incentives and opportunities for management to understate SFAS 123 expense, the understatement of option value estimates is increasing in proxies for the magnitude of the expense, is greater for firms with weaker corporate governance, and, to a lesser extent, is increasing in the excessiveness of executive pay. The findings are strongest for the expected option life and expected stock price volatility input assumptions, consistent with firms’ greater latitude in determining these inputs. We find weaker evidence of understatement associated with the expected dividend yield assumption, and none for the interest rate assumption, consistent with these inputs being less amenable to discretion. Taken together, our findings raise some concern that the exercise of management discretion adversely affects the overall reliability of SFAS 123 expense.

Further evidence of earnings management and opportunistic behavior with principles-based accounting standards: The case of conditional asset retirement obligations

FASB Interpretation No. 47 (FIN 47) clarifies the diverse accounting practices for conditional asset retirement obligations (CAROs) that arose under SFAS No. 143, which is classified as a principles-based standard by the SEC. Prior research suggests that the subjectivity in SFAS No. 143 provides management with the opportunity to manage earnings and avoid the recognition of CAROs. This study examines firms that recorded adjustments for CAROs upon FIN 47 adoption. We demonstrate that effective monitoring is essential to promote adherence with principles-based standards, and that gatekeepers may not be effective when standards are ambiguous. Univariate tests and logistic regressions reveal that FIN 47 adopters have audit committees with a greater number of financial experts and are audited by BIG 4 firms. Particular firm-specific factors are also found to be associated with the adoption decision. The results also indicate that newly-reported obligations related to asbestos in firm-owned property and restoration costs for leased premises were subject to prior management discretion. This study extends existing literature on SFAS No. 143 and FIN 47 and studies examining earnings management with principles-based standards. The case of FIN 47 provides further evidence that significant opportunities for earnings management and discretion exist within a principles-based accounting environment, particularly when standards lack clarity. It also confirms the critical role of monitoring by the audit committee and external auditors to promote adherence with the substance of such standards.     

Accounting standard’s effectiveness on equity overstatement – Conservatism when it matters

This paper evaluates the effectiveness of FASB’s standards on accounting conservatism when a firm is likely overstating assets or understating liabilities. Specifically, this paper considers whether conservatism increases due to SFAS 87, 106, 121, 142, and 123R, conditional on the firm being an aggressive reporter. To test these standards, I perform two time-series analyses from 1976 though to 2010. The first analysis compares the number of observations with a book to market ratio (BTM) greater than one to all observations at the industry level. The second determines whether each standard is correlated with a reduction in the probability of a firm having a BTM greater than one. I use the BTM greater than one to identify firms that should be more conservative (avoid equity overstatement), and to exclude those that are biasing earnings to artificially low levels. The results are consistent with only some of the standards, SFAS 106 (Employers’ Accounting for Postretirement Benefits Other Than Pension) and SFAS 142 (Goodwill and Other Intangible Assets), being effective in reducing equity overstatement.     

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.     

Value relevance and timeliness of transitional goodwill-impairment losses: Evidence from Canada

Focusing on transitional goodwill-impairment losses (losses) recorded by Canadian firms following the adoption of revised standards on purchased goodwill, we investigate the value relevance and timeliness of mandatory changes in accounting principles accounted for using the retroactive method. We find a negative relationship between reported losses and share price. Such a finding is consistent with investors perceiving losses as being sufficiently reliable measurements of a reduction in the value of goodwill to incorporate them in their valuation assessments. We find also that investors put a higher valuation weight on losses reported by firms that are expected to record a loss. In addition, we show that investors perceive that there are reduced opportunities for managerial discretion when there is a more effective audit committee. Finally, our results show that returns lead losses, i.e., that losses represent a catch-up adjustment to reflect the cumulative effect of using the impairment approach for the first time. Overall, our evidence supports U.S. standard setters' decision, through SFAS 154, to favour enhanced comparability and consistency over the potential costs of frequent restatements. Our results also show that fair-value measurements can be relevant even when the financial statement elements of interest are inherently bound to measurement error and subject to significant managerial discretion. They support the notion that reliability is about faithful representation, not precision.     

Information asymmetry of fair value accounting during the financial crisis

We examine whether US banks’ fair value net assets, measured according to the three-level hierarchy introduced in SFAS 157, are associated with information asymmetry during the 2008 financial crisis. Our results show that bid–ask spread, a proxy for information asymmetry, is positively associated with fair value net assets, and the degree of association is contingent upon the three-level hierarchy, with bid–ask spreads being lowest for Level 1 (the most transparent valuation inputs) and highest for Level 3 (the least observable). Also, there is some evidence that SFAS 157 led to a reduction in bid–ask spread, and we find that quarterly changes in Level 1 and Level 2 fair value net assets are significantly associated with changes in bid–ask spread in 2008 when the spread was rapidly rising, but not in 2009 when it was falling. Our findings suggest that the three-level hierarchy under SFAS 157 provides investors with useful information, and fair value is associated with uncertainty, as measured by bid–ask spread, before and during the financial crisis.     

Strategic revenue recognition to achieve earnings benchmarks

I examine whether managers use discretion in revenue recognition to avoid three earnings benchmarks. I find that managers use discretion in both accrued revenue (i.e., accounts receivable) and deferred revenue (i.e., advances from customers) to avoid negative earnings surprises, but find little evidence that discretion is used to avoid losses or earnings decreases. For a common sample of firms with both deferred revenue and accounts receivable, I find evidence that managers do not prefer to exercise discretion in either account. However, further tests show that managers preferred to use discretion in deferred revenue before the Sarbanes–Oxley Act of 2002 went into effect, consistent with them choosing to manage an account with the lowest real costs to the firm (i.e., future cash consequences). My results suggest that the revenue recognition joint project undertaken by the FASB and IASB to reduce managerial estimation in revenue recognition may have the unintended consequence of leading to greater real costs imposed on shareholders as firms are likely to use even greater discretion in accounts receivable.