Abstract
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.
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Notes
The FASB subsequently issued ASU 2011–08 in September 2011 (FASB 2011), which loosened the provisions of SFAS 142. Specifically, ASU 2011–08 only requires that goodwill be tested for impairment when events and circumstances indicate that it is more likely than not that the fair value of a reporting unit is less than its carrying value. ASU 2011–08 became effective for fiscal years beginning after December 15, 2011. We exclude the post-2011 period from our primary results to avoid the confounding impact of ASU 2011–08. Results including the post-2011 period are qualitatively similar and are presented in section 4.3.6.
A recent study of trademarks by Markables provides evidence consistent with this possibility for trademarks. Markables studied the valuation of 4500 trademarks between 2003 and 2013 and concluded: “Overall, there is a clear global trend towards definite and shorter useful lives of trademarks. Appraisers become increasingly aware that all trademarks depreciate sooner or later, be it by regular amortization or by irregular impairment.” See http://www.markables.net/trademark_useful_life.
Under SFAS 121, firms could amortize goodwill over a period up to 40 years. Compustat, however, does not separately itemize goodwill amortization. The 5% reduction in goodwill is equivalent to an amortization policy of 20 years. We also examine alternative thresholds: 2.5%, 10%, and the higher of 5% or the median reduction in goodwill balance over the past three years. The results are similar using these alternative thresholds. In addition, we relax the requirement that negative special items be at least as large as the reduction of goodwill. The results are again robust with respect to this alternative approach.
We also find that the difference between the estimated and reported numbers is not significantly correlated with the variables in our subsequent tests, which include firm size, goodwill balance, book-to-market ratio, accruals, past year return, return on assets, equity issuance, and cash used for acquisitions.
We set missing GDWLIP to zero for firms with a positive goodwill balance.
For brevity, we report the results for the remaining tests with estimated impairment defined using a 0% threshold for the post-142 period. Results using a 5% threshold are qualitatively similar.
We also replicated our results computing ROA using operating income before amortization. SFAS 142 changed the accounting for goodwill amortization, so this change may have affected the ability of income to reflect firm performance. As a practical matter, our results are almost identical using income measured before amortization.
Given that IMPI has three different values (−1, 0, 1) and BTMG1 has two (0, 1), IRPOB can only take six different values each year. We combine the observations with the highest two IPROB values to form group 5.
We also examine the three-day cumulative stock return around the announcement of earnings including goodwill impairments. We find that the announcement of earnings with goodwill impairments generates significant negative stock returns in both the pre- and post-SFAS 142 periods and that the magnitude of the market reaction is smaller in the post-SFAS 142 period, consistent with the findings of Li et al. (2011). The smaller reaction in the post-SFAS 142 period is consistent with these impairments being less timely and hence more predictable.
In unreported tests, we also examine whether IPROB, the estimated probability of goodwill impairment from Equation (1), predicts future stock price declines. Note that IPROB is less suitable candidate for predicting future stock returns, because it incorporates BTMG1, reflecting expected goodwill impairments that have already been anticipated in stock prices. Consistent with this intuition, the results show that the return predictability of IPROB is somewhat weaker than that of IMPI.
Because we focus on the overvaluation of firms with a high likelihood of impairment, we hold the cutoffs for IMPI = −1 (i.e., low likelihood of impairment) constant in these sensitivity tests. An exception occurs when the GTA cut-off for IMP = 1 falls below 0.05, in which case we change the corresponding cutoff for IMPI = −1 accordingly. For example, when using a 0.03 GTA cutoff, IMPI is equal to one for observations with GTA > =3% and ROA < 0, minus one for observations with GTA < 3% and ROA > 5%, and zero otherwise.
See Robert G. Fox III, Professional Accounting Fellow, Office of the Chief Accountant, “Current SEC and PCAOB Developments” remarks to the AICPA (Dec. 8, 2008) http://www.sec.gov/news/speech/2008/spch120808rgf.htm.
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Acknowledgements
We thank Patricia Dechow, Sunil Dutta, Todd Kravet, Alastair Lawrence, Lakshmanan Shivakumar (the editor), Xiao-Jun Zhang, an anonymous reviewer, and workshop participants at the University of California Berkeley and the AAA Annual Meetings for helpful comments. Kevin Li and Richard Sloan acknowledge financial support from the University of California Riverside and the University of California Berkeley, respectively.
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Li, K.K., Sloan, R.G. Has goodwill accounting gone bad?. Rev Account Stud 22, 964–1003 (2017). https://doi.org/10.1007/s11142-017-9401-7
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DOI: https://doi.org/10.1007/s11142-017-9401-7