Abstract
Due to the concerns about the annual SFAS 142 impairment test, the FASB has recently added a project to its technical agenda to evaluate potential alternatives for measurement of goodwill. Motivated by the FASB’s consideration of a change in goodwill accounting, I examine the impact of SFAS 142 on the usefulness of goodwill write-offs and goodwill balances. I find that goodwill write-offs and goodwill balances are more strongly associated with stock returns and stock prices respectively after SFAS 142 than before SFAS 142. Furthermore, in the post-SFAS 142 period, I find that the association between stock prices and goodwill is lower for firms that avoid the recognition of the existing goodwill impairments, and that goodwill write-offs are more negatively associated with stock returns for firms where managers have more discretion over the impairment testing process. Overall, the findings suggest that despite the concerns of critics over the reliability of fair value estimates of goodwill, (1) SFAS 142 has improved the usefulness of goodwill numbers from investor perspective, and (2) investors see through the differences in reliability of reported goodwill numbers. These results have implications for standard-setting as the FASB considers new alternatives for goodwill accounting.
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Notes
The expressions “goodwill impairment losses”, “goodwill write-offs”, and “SFAS 142 write-offs” are used interchangeably throughout the paper.
Concerns over the SFAS 142 impairment test date back to the issuance of the standard in 2001. At the issuance of the standard, the FASB has expressed the belief that the standard will better reflect the economics underlying goodwill and other intangibles and thus lead to more useful information for investors. However, given the inherent subjectivity in valuing goodwill and managers’ incentives to exercise their discretion opportunistically, a wide variety of commentators on the exposure draft issued prior to the issuance of the standard expressed concerns about the reliability of goodwill estimates under the standard. For example, Morgan Stanley Dean Witter in its comment letter stated “We believe that the guidelines on measuring fair value are ambiguous and may lead to unreliable estimates….without a liquid market, the transaction value you allude to depends on the intrinsic value in use to a specific party and will vary depending on who the willing buyer may be.” Consistent with this argument, Ramanna and Watts (2012) provide evidence that non-impairment (not recording impairment when there are market indications of impairment) is increasing in financial characteristics that serves as proxies for greater unverifiable fair value based discretion. These characteristics are: (1) number and size of reporting units and (2) unverifiable net assets in reporting units.
Note that potential leakages of information prior to the announcement of goodwill write-offs reduce the power of market reaction tests to detect an effect even if it exists.
As explained in Sect. 4 in further detail, the expectation model is based on a market value to book value comparison. A firm is likely to take a SFAS 142 write-off if its market value is less than its book value.
The examination of timeliness of write-offs is a reasonable way to estimate the reliability of the reported intangible numbers. Firms that delay the recognition of the existing intangible impairments, in effect, overstate their reported intangibles while firms that accelerate the recognition of intangible impairments understate their reported intangibles.
In order to minimize the effects of amortization on earnings, most companies elected to amortize goodwill primarily over the 40-year period (Duvall et al. 1992).
The standard provides the following as examples of such events or circumstances: (a) a significant adverse change in legal factors or in the business climate, (b) an adverse action or assessment by a regulator, (c) unanticipated competition, (d) a loss of key personnel, (e) a more-likely-than-not expectation that a reporting unit or a significant portion of a reporting unit will be sold or otherwise disposed of, (f) the testing for recoverability under Statement 121 of a significant asset group within a reporting unit, (g) recognition of a goodwill impairment loss in the financial statements of a subsidiary that is a component of a reporting unit.
Required disclosures include the following (SFAS 142, paragraphs 44–47): (1) information about the changes in the carrying amount of goodwill from period to period (in the aggregate and by reportable segment), (2) the carrying amount of intangible assets by major intangible asset class for those assets subject to amortization and for those not subject to amortization, and (3) the estimated intangible asset amortization expense for the next five years.
In SFAS 142, the FASB notes that: “The changes included in this Statement (SFAS 142) will improve financial reporting because the financial statements of entities that acquire goodwill and other intangible assets will better reflect the underlying economics of those assets. As a result, financial statement users will be better able to understand the investments made in those assets and the subsequent performance of those investments…The appropriate balance of both relevance and reliability and costs and benefits were central to the Board’s conclusion that this Statement will improve financial reporting.” (SFAS 142 summary section).
Reporting units are either the same as segments or one level below segments. It would be ideal to use reporting unit level data to test the cross-sectional hypotheses. However, outsiders cannot access reporting unit level data. I acknowledge that the use of entity level data is a limitation of the tests.
Financial press (e.g., Tergesen 2002) mentions that the excess of book value over the market value can be construed as an indicator of goodwill impairment.
In 2002, the transition year, firms adopting SFAS 142 are allowed to treat the initial or adoption period goodwill impairment loss as a below the line item (SFAS 142, paragraph 56). After the transition period, goodwill write-offs are treated as part of operating expenses and thus affect operating income.
An alternative explanation is that there are differences in the number of acquisitions across the pre- and post-SFAS 142 periods. In untabulated results, I do not find any statistically significant difference in the number of acquisitions across the pre- and post-SFAS 142 periods.
Specifying an expectation model is much more crucial (and more difficult) for short-window information content tests.
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Acknowledgements
I thank Anwer Ahmed, Holly Ashbaugh, Daniel Bens, Donal Byard, Joachim Gassen, Ryan LaFond, William Rees, Ed Swanson, Terry Shevlin, Senyo Tse, Mike Wilkins, and seminar participants at Texas A & M University and Humboldt University of Berlin. I am grateful for research support from PSC-CUNY fund at Baruch College at City University of New York. An earlier version of this paper was titled “Evidence on the effects of SFAS 142 on investor valuation of goodwill write-offs and goodwill balances.”
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Appendix: The estimation of goodwill amortization
Appendix: The estimation of goodwill amortization
The procedure involves using of available Compustat data on goodwill, intangible assets, and intangibles amortization to estimate goodwill amortization. Similar to Jennings et al. (2001), I use the following steps:
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(a)
If Compustat reports equal amounts for goodwill and intangible assets, I assume that all intangibles are goodwill and that goodwill amortization equals intangibles amortization.
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(b)
If Compustat reports both goodwill assets and intangibles amortization for a given year but also reports intangible assets as zero or missing, I assume that all intangibles are goodwill and that goodwill amortization equals intangibles amortization.
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(c)
If goodwill exceeds 90% of intangible assets, I assume that goodwill and intangibles are amortized at the same rate and set goodwill amortization equal to intangibles amortization multiplied by the ratio of goodwill to intangible assets.
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(d)
If goodwill was <90% of intangible assets and that Securities Data Corporation database did not report any acquisitions and dispositions during the year, I estimate goodwill amortization to be the change in goodwill during the year.
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(e)
If goodwill was <90% of intangible assets and that Securities Data Corporation database reports acquisitions and dispositions during the year, I estimate goodwill amortization to be the change in goodwill adjusted for net acquired goodwill during the year.
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Guler, L. Has SFAS 142 improved the usefulness of goodwill impairment loss and goodwill balances for investors?. Rev Manag Sci 12, 559–592 (2018). https://doi.org/10.1007/s11846-016-0223-y
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DOI: https://doi.org/10.1007/s11846-016-0223-y