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Goodwill Impairment Used for Earnings Management Goodwill Impairment Used For Earnings Management Student name: Navdeep Mander Student number: 6063829 Date of final version: 17-08-2015 Word count: 18,284 MSc Accountancy & Control, variant Accountancy Amsterdam Business School Faculty of Economics and Business, University of Amsterdam Supervisor: dhr. drs. J.J.F. van Raak Statement of Originality This document is written by student Navdeep Mander who declares to take full responsibility for the contents of this document. I declare that the text and the work presented in this document is original and that no sources other than those mentioned in the text and its references have been used in creating it. The Faculty of Economics and Business is responsible solely for the supervision of completion of the work, not for the contents. 2 Abstract The purpose of this thesis is to examine whether goodwill impairments are used as a tool for earnings management when earnings are unexpectedly high or low. This thesis will particularly examine U.S. companies after the issuance of standard SFAS 142 and the time period examined is from 2005-2014. Based on a sample of 3059 firm-year observations I have found a positive relation between goodwill impairment and earnings management. I will specifically examine whether managers use big bath accounting or income smoothing through the use of goodwill impairment. This study contributes to existing literature from Van de Poel et al. (2008) and Francis et al. (1996) as there is evidence that earnings are managed when earnings are either unexpectedly low in the recession period from 2007-2009. I also contribute to the existing literature by looking at whether a new CEO with a maximum tenure of three year in a firm with unexpectedly low earnings uses bath accounting by impairing goodwill. Based on my findings, I document that (1) there is no positive relation found between new CEOs taking a bath when earnings are unexpectedly low, (2) overall firms with unexpectedly low earnings use bath accounting by impairing goodwill, (3) firms with unexpectedly high earnings smooth income by impairing goodwill, (4) in the recession there is a positive relation between unexpectedly low earnings and the impairment amount, (5) there is a negative relation between unexpectedly high earnings and impairment amount in the period from 2007-2009. 3 Table of Contents Statement of Originality .......................................................................................................................... 2 Abstract ................................................................................................................................................... 3 1 Introduction .......................................................................................................................................... 5 2 Goodwill Impairment and Earning Management ................................................................................. 9 2.1 Goodwill Impairment .................................................................................................................... 9 2.1.1 Definition of goodwill ............................................................................................................. 9 2.1.2 Internally generated goodwill and externally acquired goodwill ........................................... 9 2.1.3 APB 17 opinion ..................................................................................................................... 10 2.1.4 Differences APB 17 and SFAS 142 ........................................................................................ 10 2.1.5 Impairment method ............................................................................................................. 11 2.1.6 SFAS 141 and SFAS 142 goodwill impairment ...................................................................... 11 2.1.7 Goodwill impairment used for earnings management ........................................................ 12 2.1.8 Empirical evidence goodwill impairment ............................................................................. 12 2.1.9 Goodwill impairment before and after the financial crisis .................................................. 14 2.2 Earnings management ................................................................................................................. 14 2.2.1 Definition of earnings management .................................................................................... 14 2.2.2 Accrual accounting and Earnings Management ................................................................... 16 2.2.3 Motivations for earnings management ................................................................................ 18 2.2.4 Capital market expectations and valuation .......................................................................... 19 2.2.5 Contracts written in terms of accounting numbers ............................................................. 20 2.2.6 Big bath accounting and Income smoothing ........................................................................ 21 2.3 Hypothesis Development ............................................................................................................ 22 3 Methodology ...................................................................................................................................... 26 3.1 Sample Selection ......................................................................................................................... 26 3.2 Development of the model ......................................................................................................... 26 3.2.1 Dependent Variable.............................................................................................................. 28 3.2.2 Independent variables .......................................................................................................... 28 3.2.3 Control Variables .................................................................................................................. 29 4 Results ................................................................................................................................................ 31 4.1 Descriptive statistics .................................................................................................................... 31 4.2 Main analysis ............................................................................................................................... 34 4.3 Control variables ......................................................................................................................... 41 5 Conclusion .......................................................................................................................................... 43 6 Bibliography ........................................................................................................................................ 45 4 1 Introduction There has been controversy on how to account for goodwill for decades (Bloom, 2009). The main approach used in the past has been the amortization of goodwill over a certain period. Due to the growing significance of intangible assets and goodwill this is justified. Internationally the two dominating accounting frameworks used are International Financial Reporting Standards (IFRS) and US Generally Accepted Accounting Principles (US GAAP) (Daske, 2006). However, this paper will mainly focus on a sample selection of U.S. companies which use accounting standards conform to the U.S. GAAP for the accounting of goodwill. It is a controversial problem whether the accounting of goodwill impairment leads to more earnings management. After many years of discussions and consideration, the FASB decided that better information was needed regarding intangibles (Massoud and Raiborn, 2003). The major basis underlying SFAS 142 was that goodwill does not necessarily decrease in an orderly way. In addition the statement identified that externally purchased goodwill may indeed have an indefinite useful life and therefore should not be amortized over the arbitrary maximum period of 40 years. The FASB declares that the approach of goodwill impairment and the elimination of goodwill amortization has the ability to better assess the drop in value of the goodwill (Zang, 2008). In addition, the impairment of goodwill gives a better representation of the economic value of goodwill. The factors used in the impairment test are dependent on many assumptions made by the manager. This is because it is their responsibility to calculate the impairment of goodwill. SFAS 142 requires managers to approximate the fair value of goodwill in order to determine the write off of goodwill (Ramanna and Watts, 2012). The goodwill is measured as the excess of price paid for a business acquisition over the fair value of the business (Jerman and Manzin, 2008). The Statement of Financial Accounting Standards 142 addresses the accounting of goodwill and other intangible assets. This is a fundamental standard issued by the Financial Accounting Standards Board (FASB) which eliminated the amortization of goodwill and replaced it by the goodwill impairment test. The amortisation method was eliminated because it did not give a faithful representation of the true economic value of goodwill. IAS 22 which required amortization was criticized as the balance sheet amounts did not reflect the true economic value of the goodwill (Lhaopadchan, 2010). Under this standard
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