Evidence from Recent Research and Suggestions for Auditors
"Is there any point to which you would wish to draw my attention?"
"To the curious incident of the dog in the night-time."
"The dog did nothing in the night-time."
"That was the curious incident," remarked Sherlock Holmes.
The legendary fictional detective Sherlock Holmes, in this excerpt from "Silver Blaze" by Sir Arthur Conan Doyle, illustrates that the absence of something, when it is expected, can provide strong evidence of actions not directly observed. This article extends Holmes's thinking to the case of goodwill accounting. Recent academic research provides evidence about curious incidents of "goodwill non-impairment" - that is, the absence of goodwill impairment losses when, like a dog barking, they are expected.
When Statement of Financial Accounting Standards (SFAS) 142 was proposed as a possible replacement for goodwill amortization, some academics and practitioners were concerned that the unverifiable fair value estimates used to measure goodwill impairment losses would provide an opportunity for companies to manage earnings by delaying the recognition of impairment losses. After SFAS 142 was enacted in 2001, accounting researchers had to wait until enough years of earnings data existed to look for evidence of goodwill-related earnings management. Only now, with the recent release of three working papers, are we getting a first glimpse into the existence of goodwill non-impairment and how companies use the discretion in the goodwill standard to manage earnings. This article discusses these three studies within the context of Exhibit i, which presents reporting possibilities for companies that have goodwill assets. The columns describe whether the goodwill has become impaired; the rows describe the accounting choice made by the firm in response.
If the economic value of a goodwill asset has decreased, then the goodwill has become impaired (Exhibit 1, first column). Goodwill impairment standards require companies to report the current-year decline in value as a loss in current-year net income. Companies that follow the standards would be in box A. Companies with impaired goodwill that choose to either not report the loss or report an understated loss would be in box B (i.e., goodwill non-impairment). Firms in box B may have used accounting discretion to avoid reporting a loss; nevertheless, they are not following the intent of the impairment reporting standard.
The three studies report evidence that goodwill non-impairment does exist (i.e., that there are firms in box B). In addition, the non-impairment is associated with incentives managers have to overstate earnings. They find evidence that recorded goodwill impairment losses are absent when they would cause company earnings to be negative or would cause earnings decreases. Impairment losses are also absent when they would decrease CEO compensation, damage CEO reputations, and cause bond covenant violations. Finally, evidence suggests that an impairment loss is not recorded at the time a goodwill asset generates cash flows, as implied by economic theory, but rather much later. Therefore, these studies indicate that early concerns of academics and practitioners were warranted; companies appear to be using the discretion in goodwill impairment reporting standards to manage earnings.
Goodwill Accounting Standards
In June 2001, FASB enacted two standards related to the accounting for goodwill. The first, SFAS 141 (now found in ASC section 805-30), required that business acquisitions would henceforth be accounted for using the purchase method. Under the purchase method, the purchaser compares the fair value of all acquired net assets (total identifiable assets minus liabilities) with the sum of the fair value of consideration paid for the acquisition. The difference is accounted for as a goodwill asset at the time of the purchase. …