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External audit and goodwill write-off

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Abstract

Building on agency theory, we investigate whether and how salient external auditor characteristics (size, audit fees, non-audit fees, tenure) impact on the reported goodwill write-off. We use a sample of US firms applying SFAS 142. We find that Big-4 auditors are more prone to limit underestimated write-offs rather than overestimated write-offs and that auditors require higher fees from companies underestimating the write-offs. The findings are consistent with the auditors’ preference for more conservative goodwill and earnings values, which reduce their litigation and reputation costs. This preference can converge with the managerial interest to use unnecessary overestimated goodwill write-offs for earnings management purposes (e.g. to smooth the income or take big baths). Our findings do not support the hypotheses that non-audit fees and tenure affect the goodwill write-off. Our paper contributes to prior literature on external audit and financial accounting choices. Our study suggests that leniently audited discretional fair value estimates are likely to compromise the role of auditing (and of financial reporting) as an external control mechanism. Our study can contribute to the current policy debate around goodwill accounting.

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Notes

  1. “Audit procedures dealing with management’s assumptions are performed in the context of the audit of the entity’s financial statements. The objective of the audit procedures is therefore not intended to obtain sufficient competent audit evidence to provide an opinion on the assumptions themselves. Rather, the auditor performs procedures to evaluate whether the assumptions provide a reasonable basis for measuring fair values in the context of an audit of the financial statements taken as a whole” (SAS No. 101, p. 1882).

  2. There is ample literature suggesting that a change in auditors, if initiated by the auditor (i.e. resignations), is associated with their perceptions of the client risk (Landsman et al. 2009; Krishnan and Krishnan 1997). The audit risk is influenced by several causes, including the client’s financial reporting quality, internal control system and the management integrity (Johnstone and Bedard 2004; Carcello and Palmrose 1994). When the financial reporting quality, measured for example through the use of discretionary accruals (in our case, by the discretionary use of goodwill write-offs) is low, the auditor’s reputation and litigation costs are more at risk than the financial distress of the client (Bonner et al. 1998; DeFond 2004). Within the fraud categories linked with the litigation risk, prior literature includes asset overvaluation (or expense undervaluation) but not asset undervaluation (or expense overvaluation) (Bonner et al. 1998). Following this common belief over time, there has been a sort of displacement leading academic literature to focus mainly on income-increasing accruals and conservative auditor behaviour. However, DeAngelo (1981) did pioneering work by defining the “quality of audit services (…) to be the market-assessed joint probability that a given auditor will both (a) discover a breach in the client's accounting system, and (b) report the breach”. Thus, we derive that the auditor should detect any (opportunistic) discretionary use of the GAAP, regardless of their effect on the income. Therefore, the auditor should assume a prevention role for both the direction of the manipulation, either income-increasing or income-decreasing accruals. Hence, we add to this literature by providing empirical evidence that large auditors are more effective at preventing aggressive or “non-conservative” accounting choices and are not interested in goodwill write-offs overestimations.

  3. At present, there are strong national regulations for auditors’ qualifications and independence. With reference to the independence issue, the Sarbanes–Oxley Act requires that audit committees (instead of management) appoint auditors and decide on their pay. In addition, Rule 2-01 of Regulation S-X addresses a set of restrictions to safeguard auditor independence both in mindset and for compliance with generally accepted standards and processes. The rule determines constraints to any financial and business relation between the auditor and the audited firm and identifies certain non-audit services as risky to auditors’ independence, e.g. bookkeeping, appraisal or valuation services, management functions or human resources and so forth. The Sarbanes–Oxley Act requires that all services (with minor exceptions) be approved in advance by the audit committee and that such approvals be disclosed to investors on a periodical basis in public reports. In accordance with the Statements on Auditing Standards, the independent auditor should then be professionally qualified with the education and experience sufficient to ensure that material misstatements are detected and that his/her opinion is based upon reasonable procedures and in accordance with GAAS (CPAs 1972).

  4. The estimation of discretionary goodwill write-off requires that we consider only impairing firms (Chao and Horng 2013). We estimate the discretionary loss on the basis of economic factors. By design, in almost all the cases, firms with zero impairment will have a negative discretionary write-off. In the robustness check, we estimate the discretionary write-off using a Heckman two-stage model. However, we consider only the discretionary write-offs of impairing firms in the analyses (Chao and Horng 2013, Table 6, p. 64). A similar procedure is also found in Godfrey and Koh (2009).

  5. We define the large auditing firms as the first four auditing firms during the period sample 2003–2007 that this paper covers, or the “Big-4”: PricewaterhouseCoopers, Ernst & Young, Deloitte and KPMG.

  6. The GTA (goodwill on totals assets) variable can be a useful instrumental variable (IV). The goodwill is the cumulative effect of past acquisitions, also made by different CEOs. It incorporates the benefits of lagged variables, since it affects the current choice of a large auditor, while such a choice does not affect acquisitions made years before. Also, the mere presence of a goodwill, as a result of past acquisitions, does not affect the impairment per se (most public companies have goodwill) because the impairment is related to current performance and estimates about future perspectives.

  7. The change in the stock return and the market-to-book ratio may capture the same phenomenon from different perspectives. The change in the stock return may measure the change in the market value. The market-to-book ratio, especially when below 1, suggests that the goodwill is impaired at a specific point in time. A firm with a negative change in its market value may still keep a high MTB ratio. A firm with a positive change in its market value may still have a MTB ratio below 1. Thus it can be useful to capture both the change dimension (through the change in the stock return) and the relation between the market and book value.

  8. We thank an anonymous reviewer for suggesting this analysis.

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Acknowledgements

This paper benefited from the financial support of the SIR programme of the Italian Ministry of Education, University and Research (MIUR).

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  1. Department of Economics and Management, University of Pisa, Via C. Ridolfi, 10, 56124, Pisa, Italy

    Silvia Ferramosca, Giulio Greco & Marco Allegrini

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  1. Silvia Ferramosca
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Correspondence to Silvia Ferramosca.

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Ferramosca, S., Greco, G. & Allegrini, M. External audit and goodwill write-off. J Manag Gov 21, 907–934 (2017). https://doi.org/10.1007/s10997-016-9369-x

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