REPRESENTATIONAL FAITHFULNESS AND GOODWILL IMPAIRMENT LOSSES

REPRESENTATIONAL FAITHFULNESS AND GOODWILL IMPAIRMENT LOSSES Faello, Joseph Alabama A & M University ABSTRACT The purpose of this paper is twofold. First, I examine representational faithfulness in financial accounting with respect to goodwill impairment losses. Statement of Financial Accounting Standard No. 142 Goodwill and Other Intangible Assets (SFAS 142) provides for write-downs of goodwill (goodwill impairment loss) when circumstances change and likely result in a reduction in the goodwill s carrying value. The 2001 recession is expected to affect firms financial position and performance in a negative manner and provide the impetus for writing down goodwill. Results show firms goodwill impairment losses are negatively associated with profitability and positively associated with its capacity to write-down goodwill. These results support representational faithfulness in financial reporting. Second, I review recent literature in accounting for goodwill impairment losses and identify three streams of research. A stream of research that examines unintentional errors in applying SFAS 142 is underrepresented and provides an opportunity for future studies. Accounting academics would find this study useful as it provides additional support for the informativeness in firms accounting for goodwill impairment losses and a meaningful discussion of recent literature. Key words: Goodwill impairment losses, Representational faithfulness Representational Faithfulness, Page 1

Introduction Conceptually, when accounting managers record a goodwill impairment loss, the purpose is to align the carrying value of the intangible asset (goodwill) with its underlying economic value. Thus, recording the goodwill impairment loss supports the representational faithfulness in financial reporting. Accounting managers who act in this manner convey the private financial information about the firm to the public which results in investors revising their expectations regarding the firm s future prospects (Li et al. 2011, p. 750). In addition, recording the goodwill impairment loss strengthens the relation between accounting information and stock returns, improving value relevance (Chen et al. 2004). Accounting managers reasoning behind recording the goodwill impairment loss is that a single event (or series of events/factors) has (have) impacted the firm s financial position or performance in a negative manner. Thus, a negative relation is expected between indicators of a firm s financial position/performance and the firm s recorded goodwill impairment loss. The purpose of this research paper is twofold. First, this study examines the relation between key financial ratios and reported goodwill impairment losses at the time of a significant event occurring in the general economy that is expected to negatively impact firms. The significant event chosen for this study is the 2001 recession. Second, alternative explanations behind the recording of goodwill impairment losses are discussed with an emphasis on recent literature. Accounting academics would find this study useful as it provides additional support for the informativeness in firms accounting for goodwill impairment losses and a meaningful discussion of the recent literature in this area. The remainder of this research paper is organized as follows: Background Information and Related Studies; Hypothesis Development; Research Design; Results; Discussion of Goodwill Impairment Loss Research; and Conclusion Representational Faithfulness, Page 2

Background Information and Related Studies The Financial Accounting Standards Board (FASB) describes faithful representation in its Conceptual Framework, Statement of Financial Accounting Concepts No. 8 (SFAC 8, para. QC 12) as follows: Financial reports represent economic phenomena in words and numbers. To be useful, financial information not only must represent relevant phenomena, but it also must faithfully represent the phenomena that it purports to represent. To be perfectly faithful representation, a depiction would have three characteristics. It would be complete, neutral, and free from error. Of course, perfection is seldom, if ever, achievable. The Board s objective is to maximize these qualities to the extent possible. In the context of a firm s recording a goodwill impairment loss, faithful representation should result in aligning the goodwill s carrying value with its economic value. That is, the valuation of the goodwill on the balance sheet should not be materially different from the asset s true economic value. Goodwill should be tested for impairment when an event occurs or circumstances change that likely reduce fair value below the asset s carrying value (SFAS 142, para. 28). Included in the examples of events or circumstances provided by the FASB is a significant adverse change in legal factors or in the business climate (SFAS 142, para. 28). The adverse change in business climate selected for this study is the 2001 recession. The National Bureau of Economic Research (NBER) reported in November 2001 that the expansionary phase of the economy had peaked in March 2001 (NBER, 2001). The peak in economic activity indicates the end of economic expansion and the beginning of the recession. A recession represents a significant reduction in economic activity for an extended period of time, including declines in industrial production, employment, and real income. A recession impacts an individual firm in a variety of ways. The firm s financial position and performance should deteriorate because of the decline in economic activity in the general economy. Evidence of the firm s financial deterioration becomes apparent with a weakening of key financial ratios such as liquidity and profitability ratios. A stream of academic research supports the informative side of goodwill impairment loss reporting. Accounting managers who faithfully represent the goodwill s carrying value convey private financial information about the firm to the public which results in investors revising their expectations regarding the firm s future prospects (Li et al. 2011, p. 750). Representational Faithfulness, Page 3

Godfrey and Koh (2009) examine the relation between goodwill impairment losses and firms underlying investment opportunities (IOS). IOS is comprised of six variables: investment intensity; geometric growth in the market value of assets; market-to-book value of assets; research and development expense to total assets; market-to-book value of equity; and earningsto-price ratio (Godfrey and Koh 2009, p. 128). The IOS represents a firm s investment opportunities at the time it records a goodwill impairment loss. The authors hypothesize that a firm s economic circumstances are negative at this time and they predict a negative association between IOS (independent variable) and the goodwill impairment loss (dependent variable). Using an ordinary least squares regression, the results support the authors prediction and provide evidence that financial reporting reflects underlying economic conditions with respect to accounting for goodwill impairment losses. Li et al. (2011) study the relation between abnormal returns and unexpected goodwill impairments. The authors hypothesize that market returns and financial analysts earnings forecasts are negatively related to a firm s announcement of a goodwill impairment loss. Results support the authors hypotheses. They conclude that the announcement of a goodwill impairment loss makes available to the public the firm s private financial information, enabling financial statement users to revise their expectations about the firm s prospects. These results support the informative role of financial reporting. Jarva (2009) examines the relation between future cash flows and goodwill impairment losses. The author hypothesizes that goodwill impairment losses (independent variable) are positively associated with expected future cash flows (dependent variable). He finds goodwill impairment losses are significantly associated with one- and two-year ahead cash flows and concludes, the evidence is consistent with the notion that goodwill write-offs are, on average, more closely related to economic factors than opportunistic behavior (Jarva 2009, p. 1083). Overall, these results support the FASB s Conceptual Framework and one of the fundamental qualitative characteristics of financial information representational faithfulness. Empirical results show that a firm s recording of a goodwill impairment loss is supported by the firm s underlying economic circumstances. Hypotheses Development Assessing goodwill for impairment became necessary under generally accepted accounting principles (GAAP) with the implementation of the then new goodwill accounting standard, Statement of Financial Accounting Standard No. 142 Goodwill and Other Intangible Assets (SFAS 142). SFAS 142 became effective for fiscal years beginning after December 15, 2001. For fiscal years commencing January 1, 2002, the economic conditions present at the time increased the likelihood of firms recording a goodwill impairment loss. The NBER reported in Representational Faithfulness, Page 4

November 2001 that the expansionary phase of the economy had peaked in March 2001 (NBER, 2001). The peak in economic activity indicates the end of economic expansion and the beginning of a recession. With respect to the asset goodwill, firms goodwill should decline in value. Goodwill declines because the expected income derived from goodwill likely will not be realized. Given the commencement of the recession in 2001 and the necessity for goodwill impairment testing effective for fiscal years beginning after December 15, 2001, firms would likely record goodwill impairment losses during year-ends 2002 and 2003. Goodwill is not the only asset impacted by the recession. Customers are slow to pay their bills and inventory turns over less frequently. The current ratio is a measure of liquidity with the major components of current assets consisting of cash, accounts receivable, and inventory. A recessionary period should impact the current assets section (numerator) of the current ratio in a negative manner because of declining cash balances, increasing bad debt write-offs, and the higher likelihood of inventory write-downs. For the current liability section (denominator), firms lower cash balances from slow paying customers means accounts payable balances likely would increase. Thus, the combined effects on the numerator and denominator of the current ratio is likely to reduce firms liquidity and their current ratios. The first hypothesis is stated as: H1: The magnitude of the annual goodwill impairment loss is negatively related to the firm s liquidity. The economic downturn during 2001 resulted in lower corporate profits. During the 1990 s, after-tax profits averaged 5.9%, but in 2001 after-tax profits averaged 3.3% (NCPA 2002). Thus, the second hypothesis is: H2: The magnitude of the annual goodwill impairment loss is negatively related to the firm s profitability. Firms with a significant amount of goodwill would have a greater capacity to write-down because goodwill represents a greater proportion of total assets. Given the economic downturn, these firms would be most likely to write-down goodwill. The third hypothesis is: H3: The magnitude of a goodwill write-down is positively related to the firm s capacity to writedown. In summary, this study hypothesizes that the magnitude of the goodwill impairment loss reported for 2002/2003 (i.e., the first year of implementing SFAS 142) is negatively related to the firm s liquidity and profitability, and is positively related to firm s capacity. Representational Faithfulness, Page 5

Research Design The research design is cross-sectional using the 2002 2003 data from the Compustat Annual Industrial, Research, and Full Coverage file (April 2004 version). Only firms with year-ends between December 1, 2002 and November 30, 2003 were included in the sample. Since SFAS 142 is effective for fiscal years beginning after December 15, 2001, essentially December 2002 year-ends were the first firm year-ends subject to the new annual goodwill impairment test standard. Financial institutions (Compustat SIC codes 6000 to 6999) were excluded from the sample because of the unique financial reporting requirements of this group. Further, the sample only included those firms that had goodwill on their balance sheet and recorded an annual goodwill impairment loss. Firms with going concern issues were also removed from the study. These firms were defined as firms where the total of the current year s income before extraordinary items plus the prior year s ending common equity balance is less than zero. Common equity (Compustat mnemonic CEQ) consists of common stock outstanding, capital surplus, retained earnings, and treasury stock adjustments. SFAS 142 still requires expensing internally developed goodwill (SFAS 142, para.10). Internally developed goodwill is not the subject of this study. Also, a transitional goodwill impairment test is required under SFAS 142, paragraph 56. The transitional test accommodates the change in accounting principle to the new standard and is not the subject of this study. The focus of this study is on the initial year s annual goodwill impairment loss reported by firms. This type of loss is included in continuing operations (i.e., whereas the transitional provision s loss is not included in continuing operations) and would carry greater weight in the decisionmaking of important financial statement users (e.g., financial analysts). The annual goodwill impairment loss is presented in the income statement as a separate line item before income from continuing operations (unless the impairment loss is related with a discontinued operation). Information on the number of firms sampled is as follows: Total firms with year-end between December 1,2002 and November 30, 2003 9,946 Less firms without goodwill (6,437) Less firms with missing data (719) Less misclassified firm (1) Less firms in SIC range 6000-6999 (financial institutions) (83) Less firms with negative common equity (409) Subtotal 2,297 Less firms without recognizing an annual impairment loss (2,039) Subtotal 258 Less firms with extreme observations ( 3) Total number of firms in sample 255 Representational Faithfulness, Page 6

The model is an ordinary least squares regression with the annual goodwill impairment loss recognized in the fiscal year as the dependent variable. GWILL= B 0 + B 1 (SIZE) + B 2 (LEVERAGE) + B 3 (LIQUIDITY) + B 4 (PROFITABILITY) + B 5 (CAPACITY) + е where GWILL = annual goodwill impairment loss for the first year that SFAS 142 was implemented (December 2002 to November 2003 year-ends), scaled by prior year s sales; SIZE= natural logarithm of prior year s sales; LEVERAGE = natural logarithm of: [(long-term debt + preferred stock) / common equity]; LIQUIDITY = natural logarithm of the current ratio; PROFITABILITY = natural logarithm of: [(income before extraordinary items + prior year s common equity) / prior year s common equity]; and CAPACITY = (goodwill + annual goodwill impairment loss) / prior year s total assets. Common equity consists of common stock outstanding, capital surplus, retained earnings, and treasury stock adjustments; SIZE is the natural logarithm of prior year s sales and is a control variable. LEVERAGE, also a control variable, is captured by the natural logarithm of the long-term debt plus preferred stock to common equity ratio. LIQUIDITY is represented by the natural logarithm of the current ratio. PROFITABILITY consists of the natural logarithm of the sum of income before extraordinary items and prior year s common equity divided by prior year s common equity. This profitability ratio was selected over other traditional profitability ratios (e.g., return on equity or return on assets) because the natural logarithm is indeterminate for negative profitability ratios. The natural logarithms reduce skewness and produce distributions that are a closer approximation to a normal distribution (Foster, 1986). I expect LIQUIDITY and PROFITABILITY to be negatively associated with the annual goodwill impairment loss (H1 and H2 respectively). CAPACITY is represented by goodwill plus the annual goodwill impairment loss scaled by prior year s total assets and is expected to be positively associated with the goodwill impairment loss (H3). The prior year s goodwill figure was not available for all firms in the COMPUSTAT database. Thus, the annual goodwill impairment loss was added back to the ending goodwill balance to determine the firm s capacity to take a write-down. Representational Faithfulness, Page 7

Results Descriptive statistics in raw data format are provided in Table 1. The mean LIQUIDITY is below 2:1 (1.9170), whereas the mean PROFITABILITY is below 1.00 (0.8523). These statistics indicate a weakened financial state for firms. In particular, PROFITABILITY below 1.00 indicates sample firms on average incurred a loss. Table 2 provides the Pearson correlations. The highest correlation is between the LEVERAGE and LIQUIDITY variables at -0.35. These results do not indicate any potential multicollinearity issues between the independent variables. Table 3 displays the results for the ordinary least squares regression of the goodwill impairment loss. The sign for LIQUIDITY is negative as predicted, but it is not significant. An explanation for this lack of significance is that the recessionary drag on firms liquidity may not be evident until the recession s second year. Further, the economic expansion prior to the recession during the late 1990 s enabled firms to build-up cash reserves. Thus, the insignificance of the LIQUIDITY is not entirely surprising. As a result, hypothesis H1 is not supported by the results. The result for PROFITABILITY is as predicted. The sign is negative and significant at a p-value <.01. Firms with lower profits tend to have higher goodwill impairment losses. This result supports H2 and the representational faithfulness in financial reporting. That is, during a recession when profitability declines, the expectation is that firms will write-down assets because of their impairment. The sign for CAPACITY is positive and significant as predicted. Firms with a greater capacity to write-down goodwill did so during the recession s first year, indicating the recession s detrimental impact on firms investment in goodwill. This result supports H3. The result for LEVERAGE is interesting. The variable is significant at the.05 level of significance (p-value =.0251) and its sign is negative. On the one hand, firms with debt are frequently subject to debt covenants. These covenants impose boundaries on a firm s activities. For example, a debt covenant may require a firm to maintain profitability. Thus, a firm may be less inclined to record a goodwill impairment loss, even during a recessionary period. On the other hand, empirical evidence supports the link between higher leverage and asset write-downs (Strong and Meyer 1987; Elliot and Shaw 1988; and Zucca and Campbell 1992). For example, firms may use the recession as an excuse to take a big bath and write-down assets including goodwill. Also, one expects a positive association between goodwill and leverage because debt is frequently used as a means to finance an acquisition that initially creates the goodwill. Perhaps, further research in this area could resolve the conflicting expectations between goodwill impairment losses and leverage. Representational Faithfulness, Page 8

Table 4 provides an illustration of interpreting the natural logarithm of the raw variable with respect to the dependent variable. For example, liquidity was represented by the current ratio. If the current ratio is 1.1, then the natural logarithm of 1.1 is.09531. Multiplying.09531 by the variable s coefficient of -.00692 gives the effect on the dependent variable (-.0006595). In summary, a significant association exists between proxies for profitability and capacity as expected. The results strongly support the representational faithfulness in financial reporting as firms with lower profits tend to write-down goodwill to a greater extent during a recessionary period, and firms with a greater portion of their assets invested in goodwill also tend to take greater goodwill impairment losses. The result for liquidity, although in the expected negative direction, is not significant. Overall, the results support representational faithfulness with respect to firms recording a goodwill impairment loss during a recessionary period. Table 1: Descriptive Statistics (n = 255) Variable Mean Standard Deviation Min. Max. SIZE (millions) 5,025.9500 11,051.4400 3.5210 86,734.0000 LEVERAGE 298.0600 4,713.1300 0.0002 75,264.2500 LIQUIDITY 1.9170 1.3615 0.3270 11.3050 PROFITABILITY 0.8523 0.5209 0.0169 6.6058 CAPACITY 0.2200 0.1702 0.0049 0.9205 Variables are defined as follows: SIZE = prior year s sales in millions of dollars LEVERAGE = (long-term debt + preferred stock) / common equity LIQUIDITY = current assets / current liabilities PROFITABILITY = (income before extraordinary items + prior year s common equity) / prior year s common equity CAPACITY = (goodwill + annual goodwill impairment loss) / prior year s total assets Common equity consists of common stock outstanding, capital surplus, retained earnings, and treasury stock adjustments. Representational Faithfulness, Page 9

Table 2: Pearson Correlations (n = 255) SIZE LEVERAGE LIQUIDITY PROFITABILITY CAPACITY SIZE 1.000 LEVERAGE 0.300 1.000 LIQUIDITY -0.156-0.350 1.000 PROFITABILITY 0.277-0.012 0.051 1.000 CAPACITY -0.205-0.060-0.083-0.148 1.000 Variables are defined as follows: SIZE = natural logarithm of prior year s sales in millions of dollars LEVERAGE = natural logarithm of: [(long-term debt + preferred stock) / common equity] LIQUIDITY = natural logarithm of: current assets / current liabilities PROFITABILITY = natural logarithm of: [(income before extraordinary items + prior year s common equity) / prior year s common equity] CAPACITY = (goodwill + annual goodwill impairment loss) / prior year s total assets Common equity consists of common stock outstanding, capital surplus, retained earnings, and treasury stock adjustments. Table 3: Ordinary Least Squares Regression of Goodwill Impairment (n = 255) Variable Sign Predicted Co-efficient t-value p-value Intercept +/- 0.0453 0.48 0.6321 SIZE +/- -0.01301-1.18 0.2372 LEVERAGE +/- -0.02250-2.25 0.0251 LIQUIDITY - -0.00692-0.18 0.8574 PROFITABILITY - -0.18007-5.09 <.0001 CAPACITY + 0.54192 4.19 <.0001 R-square: 0.2232; Adjusted R-square: 0.2076 Variables are defined as follows: SIZE = natural logarithm of prior year s sales in millions of dollars LEVERAGE = natural logarithm of: [(long-term debt + preferred stock) / common equity] LIQUIDITY = natural logarithm of: current assets / current liabilities PROFITABILITY = natural logarithm of: [(income before extraordinary items + prior year s common equity) / prior year s common equity] Representational Faithfulness, Page 10

CAPACITY = (goodwill + annual goodwill impairment loss) / prior year s total assets Common equity consists of common stock outstanding, capital surplus, retained earnings, and treasury stock adjustments. Table 4: Interpretation of Transformed Variables Effect on Variable Raw Ln of Raw Variable Coefficient Dependent Variable Variable SIZE 1.1 0.09531-0.01301-0.0012400 LEVERAGE 1.1 0.09531-0.02250-0.0021445 LIQUIDITY 1.1 0.09531-0.00692-0.0006595 PROFITABILITY 1.1 0.09531-0.18007-0.0171625 CAPACITY 1.1 0.09531 0.54192 0.0516504 Key: Ln = natural logarithm Co-efficients are from Table 3. Effect on Dependent Variable = Ln of Raw Variable X Co-efficient Discussion of Goodwill Impairment Loss Research When a firm records a goodwill impairment loss, the relation between the asset s (goodwill s) carrying value and economic value leads to one of the three following results reported on the balance sheet: 1. Goodwill s carrying value Goodwill s economic value This result indicates that a firm s recording of a goodwill impairment loss faithfully represents the firm s economic conditions. Accounting substance and economic substance of events are in alignment. 2. Goodwill s carrying value ~ Goodwill s economic value (because of earnings management) This result indicates a weak approximation in equivalency between accounting substance and economic substance that is purposely undertaken by a manager to satisfy his or her self-interests. Principal-agent theory (Jensen and Meckling 1976) suggests a manager Representational Faithfulness, Page 11

(agent) may act in his or her own interests when an owner (principal) is not actively involved in the business and can not monitor the manager s actions. Further, contracting incentives (e.g. manager s bonus plan or debt covenants) may provide the manager with the motivation to take advantage of the situation. Watts and Zimmerman (1986) provide a foundation for the role of contracting incentives in accounting. For example, the manager may be reluctant to write-down goodwill because it prevents the manager from receiving a bonus; or, the manager may resist writing down goodwill because the writedown results in a debt covenant violation. 3. Goodwill s carrying value ~ Goodwill s economic value (because of unintentional error) Under this scenario, an error in misapplying GAAP in determining the goodwill impairment loss causes the misalignment between accounting substance and economic substance. The methodology in determining the annual goodwill impairment loss under SFAS 142 is complex and subjective. Goodwill is created when an acquiring firm pays a premium when it acquires another business. The acquiring firm allocates the goodwill to its reporting unit(s) which is (are) either operating segment(s) or a level below operating segment that has its own separate financial reporting available (SFAS 142, para. 30). The allocation of goodwill to reporting units is a subjective process as integration of an acquired business into an acquiring firm s operations often affects more than one reporting unit. Under SFAS 142, the testing for goodwill impairment is performed at the reporting unit level. It is a two-stage process. First, the fair value of the reporting unit is compared to its carrying value. If the fair value is less than the carrying value, then the second stage must be performed. The purpose of the second stage is to determine the amount (if any) of the goodwill impairment loss. Here, the implied value of the reporting unit s goodwill is compared to the goodwill s carrying value. If the implied value is less than the carrying value, then a goodwill impairment loss is recorded for the amount of the excess of carrying value over implied value. The goodwill s implied value is determined by hypothetically assuming that the business combination occurred on the date of testing for goodwill impairment. Further, the fair value of the reporting unit employed in stage one and the implied value of goodwill used in stage two are frequently determined by management s estimates of discounted cash flows because publically accessible fair values are unavailable (i.e., a stock price is available for a company whose shares are publically traded, but not for the company s segments). Overall, the entire process of recording goodwill as a result of a business combination and subsequently recording a goodwill impairment loss when the goodwill is determined to be impaired requires management s use of estimates (e.g., determining cash flows and discount rates for reporting units) and subjective judgment (e.g., determining how to allocate goodwill to the reporting units). Both, the use of estimates and exercising judgment are subject to human error. Representational Faithfulness, Page 12

The academic literature in support of the first and second results is extensive and dates back prior to the adoption of SFAS 142. In support of the first result (goodwill s carrying value goodwill s economic value), in addition to this research paper, Godfrey and Koh (2009), Li et al. (2011), and Jarva (2009) provide evidence of the informative side in financial reporting with respect to a firm s recognition of a goodwill impairment loss. Given the information content of a reported goodwill impairment loss, the logical conclusion is that the goodwill s carrying value and economic value are in alignment. In support of the second balance sheet result (goodwill s carrying value ~ goodwill s economic value, due to earnings management), studies focus on manager s incentives to manipulate and time the recording of goodwill impairment losses. Riedl (2004) examines the impairments of long-lived assets (including goodwill), but his study period (1992-1998) pre-dates the implementation of SFAS 142. Nonetheless, his findings show a weak association between economic indicators (e.g., percent change in U.S. Gross Domestic Product) and asset writedowns; in addition, Riedl finds a stronger association between asset write-downs and big bath financial reporting. Hayn and Hughes (2006) examine the ability to predict a firm s goodwill impairment loss from its financial statements note disclosures concerning goodwill. They find note disclosure information is lacking in predicting a goodwill impairment loss and recognition of the impairment loss lags behind the economic impairment by approximately three to four years. Regarding the timing of the write-down, this result suggests managers delay the release of bad news. Beatty and Weber (2006) examine the timing and presentation of goodwill impairment losses on the income statement during the first year firms adopted SFAS 142. First year adopters had two goodwill write-downs to address the transitional provision for the initial adoption of SFAS 142 and the annual goodwill impairment loss test. The transitional provision is excluded from income from continuing operations whereas the impairment loss determined from annual testing is included in income from continuing operations. The authors conjecture that an accounting manager may have an incentive to recognize a significant loss under the transitional provision immediately, in order to reduce potential future losses that would be included in income from continuing operations. The belief is that a charge to continuing operations reflects more poorly on managerial performance than a transitional charge. Various contracting incentives (e.g., debt contracting, bonus, etc.) provide the motivation for this behavior. In summary, the authors findings indicate firms record goodwill impairment losses do not align accounting carrying value with economic value, but are motivated by contracting incentives. Gu and Lev (2011) provide evidence that the initial overpayment of an acquired firm on the acquisition date provides the acquiring firm with a strong incentive to subsequently write-down goodwill. The authors hypothesize that pressure on firms to grow leads to overpricing of Representational Faithfulness, Page 13

acquisitions by the acquiring firm and overestimating the benefits of the business combination. Subsequent goodwill write-downs by the acquiring firm is a necessary component of a dysfunctional investment strategy (Gu and Lev 2011, p. 1995). Overall, the empirical evidence suggests managers manipulate the timing and presentation of goodwill impairment losses. Further, contracting incentives tend to provide the motivation behind this behavior. The effect of this behavior results in the recognition of goodwill impairment losses that weakly align accounting carrying values with their corresponding economic values. The third balance sheet result (goodwill s carrying value ~ goodwill s economic value, due to unintentional error) is a relatively unexplored area of accounting research. Prior research tends to focus on the informative and earnings management perspectives as indicated in the discussion above. However, the use of estimates and judgment in applying SFAS 142 can lead to miscalculations in determining a goodwill impairment loss. For example, the acquiring firm can overestimate the goodwill allocation to one reporting unit (and underestimate the goodwill allocation to another reporting unit). When the goodwill impairment loss test is performed, the reporting unit with the overestimated goodwill would incur a goodwill impairment loss. This loss can not be recovered because U.S. GAAP does not permit recovery of goodwill writedowns. Consequently, accounting carrying value and economic value are not in alignment because of an initial misallocation of goodwill to the reporting units on the acquisition date. Such an occurrence is not unreasonable given the subjectivity in allocating goodwill. Schultze (2005) provides numerical examples whereby application of SFAS 142 may lead to inconsistent conclusions. For example, Schultze points out that internally generated goodwill can easily get mixed up with the acquired goodwill subsequent to the business combination. Benefits generated from the internally generated goodwill could offset declines in the acquired goodwill resulting in no recognition of an impairment loss. In effect, the firm has capitalized its internally generated goodwill, but it is disguised as acquired goodwill. (Schultze 2005, p. 287). In another example, Schultze shows an increase in the fair value of net identifiable assets (e.g. increase in investing activities by the reporting unit) results in the recognition of a goodwill impairment loss (Schultze 2005, pp. 287-288). That is, the reporting unit creates positive net present value from its investments, but must record a goodwill impairment loss due to the mechanics of SFAS 142. In summary, accounting academics have focused on the informative and earnings management perspectives with respect to goodwill impairment studies. A third alternative, unintentional errors, is another research stream that requires further study. The complexity and subjectivity in the estimation of a goodwill impairment loss can easily result in a misalignment of the goodwill s carrying and economic values. Representational Faithfulness, Page 14

Conclusion The purpose of this study is twofold. First, this paper examines the relation between key financial ratios and reported goodwill impairment losses at the time of the 2001 recession. The 2001 recession negatively impacted many firms. The intangible asset, goodwill, is no exception. Results show a significant negative association between firms profitability and goodwill impairments. Also, results show a significant positive association between firms capacity to write-down goodwill and the reported goodwill impairment loss. These results support the representational faithfulness in financial reporting desired by the FASB. Second, the discussion of recent research in accounting for goodwill impairment losses identifies three research streams: 1. Goodwill s carrying value Goodwill s economic value 2. Goodwill s carrying value ~ Goodwill s economic value (because of earnings management) 3. Goodwill s carrying value ~ Goodwill s economic value (because of unintentional error) The first two streams are represented by informative and earnings management studies respectively. The third stream of research is a potential growth area for academics as the complexity and subjectivity in accounting for goodwill provides untapped opportunities for further study. Representational Faithfulness, Page 15

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