Ebook Evidence from goodwill non-impairments on the effects of using unverifiable estimates in financial reporting
SFAS 142 requires managers to use estimates of their firms‘ discounted future values to determine goodwill write-offs. Such estimates are different from the discretion historically afforded in financial reporting in that they are ex post unverifiable. For example, under the standard, a manager of a single reporting-unit firm can avoid a goodwill write-off despite market indications to the contrary by generating a hypothetical firm value that exceeds the firm‘s liquid market value. Ex post, if the firm value used to justify non-impairment is not realized, the manager can claim it was due to factors outside her control (e.g., macroeconomic conditions). It is difficult to verify or falsify such a claim in a court of law (the claim cannot be objectively characterized as true or false, Ollman v. Evans, 750 F.2d 970, D.C. Cir., 1984). By promulgating SFAS 142, standard setters must implicitly assume that managers will, on average, use unverifiable discretion to convey private information on future cash flows. In contrast, agency theory predicts managers will, on average, use unverifiable discretion opportunistically. We test these alternate predictions in the paper.
We investigate managers‘ implementation of the goodwill impairment test in SFAS 142 in a sample of firms with market indications of goodwill impairment. We examine whether the goodwill non-impairment is associated with managers‘ private information on future cash flows (as standard setters likely expect) and/or with agency based motives. We do not find evidence to confirm the private information argument, but we do find evidence consistent with the agency argument.
To generate the sample with market indications of goodwill impairment, we begin with a sample of firm-years that have both: (i) book goodwill; and (ii) equity-market values greater than equity-book-values. From this sample, we retain only observations that end each of the two subsequent fiscal years with book-to-market ratios (BTM) above one (where book values are calculated before the effect of any goodwill impairment, but after the effect of any other write-off). The condition BTM > 1 for two consecutive years suggests goodwill impairments are expected by the market. We investigate the extent and determinants of goodwill non-impairment at the end of the second fiscal year, conditional on the firms having non-zero goodwill balances at the beginning of that fiscal year.
There are 124 firm-years on COMPUSTAT that meet our sample selection criteria between the years 2003 and 2006. The relatively small sample size is due in part to firm attrition (firms with BTM > 1 are more likely to be acquired, delisted, etc., as discussed later). The frequency of goodwill non-impairment in sample firm-years (i.e., the second fiscal year) is 69%. Further, 57% of firms do not impair in either the first or the second fiscal years with BTM >1.
It is possible that managers of sample firms avoid goodwill write-offs because they have (or believe they have) private information on positive future cash flows. We identify firms likely to have favorable private information as those firms with either positive net share-repurchase activity or positive net insider buying. Both activities suggest management believes the firm is undervalued. We find that 41% of the sample shows evidence of favorable information asymmetry (per the definition above). We next examine whether sample firms with favorable information asymmetries have a higher non-impairment frequency than all other sample firms. If this is the case, the evidence can support the argument that managers‘ private information drives non-impairments. We find the non-impairment frequency among firms with positive information asymmetry (71%) is statistically indistinguishable from non-impairment frequency among all other firms (68%). Overall, the data do not confirm that the high frequency of non-impairment in the sample is due to management‘s possession of favorable private information.
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