Using Real Activities to Avoid Goodwill Impairment Losses: Evidence and Effect on Future Performance

• Date: 01 April 2015
• Author: Andrei Filip,Luc Paugam,Thomas Jeanjean
• Published date: 01 April 2015
• DOI: http://doi.org/10.1111/jbfa.12107

Journal of Business Finance & Accounting

Journal of Business Finance & Accounting, 42(3) & (4), 515–554, April/May 2015, 0306-686X

doi: 10.1111/jbfa.12107

Using Real Activities to Avoid Goodwill

Impairment Losses: Evidence and Effect

on Future Performance

ANDREI FILIP,THOMAS JEANJEAN AND LUC PAUGAM∗

Abstract: We examine whether managers postpone the recognition of goodwill impairment

by manipulating cash flows and the consequences of such a strategy on future performance.

According to SFAS 142, an impairment loss must be recognized if the reporting unit’s total

fair value to which goodwill has been allocated is less than its book value. A growing body

of empirical evidence shows that managers delay the recognition of goodwill impairment in

accounting books. However, past literature is silent on how managers convince various gate-

keepers (e.g., auditors, financial analysts) that recognizing an impairment loss is unnecessary

although it seems economically justified. SFAS 142 requires managers to forecast future cash

flows to justify the decision to recognize, or not, an impairment loss. Therefore, we predict that

managers manipulate upward current cash flows to support their choice to avoid reporting an

impairment loss. We also test whether or not this real earnings management is detrimental to

future performance. Based on a sample of US firms over the period 2003–2011, we document

that firms suspected of postponing goodwill impairment losses exhibit significantly positive

discretionary cash flows compared to various control groups. We also find that this real activities

manipulation is detrimental to future performance.

Keywords: goodwill impairment, earnings management, cash flow management, real activities.

1. INTRODUCTION

Accounting for acquired goodwill has been subject to considerable debate. SFAS

142 (now codified in ASC 350), issued in 2001, abolished goodwill amortization but

requires goodwill to be tested periodically for impairment using estimates of its current

fair value. Estimates of the current fair value of goodwill rely on assumptions about

management’s future actions, including managers’ conceptualization and implemen-

tation of firm strategy. Such expectations are difficult to verify and audit. Standard

setters expect that managers will, on average, use estimates of goodwill’s fair value

to convey private information about future cash flows. Yet, this view is challenged by

agency theory which predicts managers will, on average, exploit the unverifiable in

goodwill accounting rules to manage financial reports opportunistically in line with

∗The Authors are from ESSEC Business School, Cergy-Pontoise 95021, France.

Address for correspondence: Luc Paugam, ESSEC Business School, Accounting and Management Control,

1 Avenue Bernard Hirsch, Cergy-Pontoise 95021, France. e-mail: paugam@essec.edu

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their own private incentives. Ramanna and Watts (2012) analyze a sample of firms with

market indications of goodwill impairment, and find a 69% frequency of goodwill non-

impairment. They find some evidence consistent with the prediction of agency theory

(positive association between goodwill non-impairment and CEO compensation, CEO

reputation concerns, and debt covenant violation concerns). In contrast, they find

no support for predictions explaining non-impairment related to the existence of

flexibility or with managers’ possessing positive private information about the firm.

Li and Sloan (2011) also show that goodwill impairments lag behind deteriorating

operating performance and negative stock returns by at least two years, and Hayn and

Hughes (2006) and Jarva (2009) also document a significant delay between economic

impairment and the recognition of an impairment loss.

In this study, we focus on goodwill impairment for several reasons. First, it plays

a critical role for investors’ ability to monitor managers’ capital allocation decisions.

Goodwill emerges from past acquisitions and impairment reflects management inabil-

ity to extract value from past acquisitions. Second, goodwill accounts for a significant

amount of public firms’ balance sheet.1Third, under SFAS 142, if there is a decline in

the value of a reporting unit, goodwill must be tested for impairment, making goodwill

the most sensitive asset type to a decline in firm value. Fourth, goodwill, unlike tangible

assets, is a specific non-listed asset that is not separable and for which the value is

estimated with discounted projected cash flows. It is the most sensitive asset for which

impairment tests rely on multiple fair value assessments allowing discretion in the

choice to impair the asset or not.2

Under US GAAP and IFRS, impairment tests are crucial to guarantee timely loss

recognition and maintain conservatism of the financial report (Amiraslani et al.,

2013; Kim et al., 2013; and Lawrence et al., 2013), as they ensure that assets are not

carried at more than their economic value. Standard setters and market regulators

have recently echoed concerns regarding untimely impairment in the US and Europe.

The SEC expressed concerns as a staff member indicated in 2008 that ‘it would not

be reasonable for a registrant to simply ignore recent declines in their stock price,

as the declines are likely indicative of factors the registrant should consider in their

determination of fair value, such as a more-than-temporary repricing of the risk

inherent in any company’s equity that results in a higher required rate of return or

a decline in the market’s estimated future cash flows of the company’ (Fox, 2008).

Hans Hoogervorst, Chairman of the IASB, also acknowledges his ‘concerns about

goodwill resulting from business combinations’ and admits that ‘[g]iven its subjectivity,

the treatment of goodwill is vulnerable to manipulation of the balance sheet and the

P&L’ (Hoogervorst, 2012). The European Securities and Markets Authority (ESMA)

‘found that significant impairment losses of goodwill recognized in 2011 were limited

to a handful of issuers, particularly in the financial services and telecommunication

industry’ (ESMA, 2013).3This remark illustrates regulators’ concerns about economic

1 Our sample covers all COMPUSTAT observations available from 2003 to 2011. Overall, approximately

60% of observations have goodwill. Goodwill accounts for a mean (median) of 16.7% (12.2%) of total assets

for observations with goodwill.

2 Tosome extent, brands are also entity-specific and subject to manipulation. However, in our sample and in

contrast with the amount of goodwill, other intangible assets account for a small fraction of total assets. The

median value of other intangible assets is only 2.7% of total assets (and brands account for only a fraction

of these other intangible assets).

3 The implementation of goodwill impairment testing under IFRS provides similar rules to SFAS 142 since

the revision of IAS 36 in 2004.

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USING REAL ACTIVITIES TO AVOID GOODWILL IMPAIRMENTLOSSES 517

impairments not always being booked in a timely manner. Finally, the press recently

discussed insufficient and untimely recognition of economic impairment for goodwill

as The Economist explained that ‘bosses go to inordinate lengths to delay recognizing

such supposedly irrelevant, non-cash losses’ (The Economist, 2013).

In this paper, we investigate two related research questions. First, we examine

how managers postpone goodwill impairment recognition. We investigate whether

managers use real activities to improve current cash flows in order to delay goodwill

impairment recognition. The reason for engaging in such a costly strategy is motivated

by the audit process of goodwill impairment testing. Auditors, along with other

gatekeepers (e.g., financial analysts) base their appreciation about the absence of

impairment on business plans developed by management. Such business plans consist

in projecting current cash flows over a finite horizon and a terminal value. The

higher the level of current cash flows, the more reasonable high level of future

cash flows and terminal value will appear to auditors. This creates an incentive for

managers to take various actions in order to increase current cash flows such as

cutting discretionary expenditures like research and development (R&D), advertising,

or selling, general and administrative (SG&A) expenses. Other means can be used to

increase operating cash flows, such as stretching suppliers’ payables, using products

in inventories to meet demand, collecting account receivables faster, and cutting on

various operating cash expense. Finally, investment in capital expenditures could also

be affected by a willingness to avoid booking economic impairment, as cutting capital

expenditures improves free cash flows used in valuation models. We contend that

managers enhance the credibility of their business plans by managing upward current

cash flows. Therefore, we hypothesize that firms that delay goodwill impairment tend

to have abnormally high current cash flows as a result of these actions.

Second, we investigate the future performance of firms avoiding impairment

recognition. Past research has established that real earnings management is costly

as it decreases future growth opportunities. Following this argument, postponing

goodwill impairment by using real activities to increase current cash flows should

be associated with lower future performance. An alternative view is that under the

threat of a goodwill impairment, firms are more efficient and, therefore, better

manage their operations and avoid making unnecessary expenditures and expenses.

Under this perspective, the use of real activities to delay goodwill impairment should

be associated with higher future performance. To discriminate between these two

competing arguments, we examine the operating and market performance of firms

up to two years after their decision to delay the recognition of an impairment loss.

We rely on two identification strategies to detect firms that postponed goodwill

impairment. Our first strategy consists in matching goodwill impairers with non-

impairers in the same industry, year and with the closest market-to-book (MTB) ratio

of equity at the beginning of the year. The goodwill impairment test is conducted

at the level of the reporting units to which goodwill has been allocated, for which

limited information is available to outsiders. Nonetheless, a firm’s outsiders, including

investors, analysts and researchers, often rely on market value at the firm level, such

as the market-to-book ratio (MTB), as a benchmark to assess whether book values are

overstated (e.g., Beatty and Weber, 2006; Ramanna and Watts, 2012; Roychowdhury

and Martin, 2013; Chen et al., 2014; and KPMG, 2014). Suspect firms, according

to our first identification strategy, are matched non-impairers as they do not report

impairment losses, whereas comparable firms decided to do so. As a robustness test,

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