Examination of firm performance following the early adoption of SFAS 142

• Published date: 02 May 2017
• DOI: https://doi.org/10.1108/IJAIM-09-2015-0062
• Pages: 138-176
• Date: 02 May 2017
• Author: Lei Han,Daniel F. Hsiao
• Subject Matter: Accounting & Finance,Accounting/accountancy,Accounting methods/systems

Examination of rm performance

following the early adoption of

SFAS 142

Lei Han

Department of Accounting, Niagara University, Niagara University,

New York, USA, and

Daniel F. Hsiao

Department of Accounting, Labovitz School of Business and Economics,

University of Minnesota-Duluth, Duluth, Minnesota, USA

Abstract

Purpose –The purpose of this study is to investigate the long-term performance of rms that early adopted

Statement of Financial Accounting Standard 142 (SFAS 142).

Design/methodology/approach –In particular, the paper focuses on a relatively lengthy time frame

after the standard became effective in 2002 and examines whether the rms which early adopted SFAS 142

exhibit different characteristics from their non-early adopting counterparts when comparing operating

returns, stock returns and earnings quality over the same time period. Prot margin, return on assets and

return on equity are used to measure operating returns; buy-and-hold return, Tobin’s Q and price-to-book ratio

are used to measure stock returns; and abnormal accruals and accruals quality are used to measure earnings

quality.

Findings –Based on a sample of 692 rm-year observations over ve years between 2002 and 2006, the

authors nd that early adopters tend to exhibit lower operating performance (most noticeable when

measuring prot margin and return on assets) and lower earnings quality following the early adoption of

SFAS 142 than non-early adopters. However, little relation is found between post-adoption market returns and

the choice to early adopt SFAS 142.

Research limitations/implications –This study helps ll the gap in accounting literature by

investigating the long-term performance of rms post adoption of SFAS 142. The empirical results may

provide greater understanding of the rms choosing to early adopt SFAS 142, and offer additional insight to

guide standard setters on similar accounting issues in the future.

Originality/value –This study’s research questions attempt to identify potential differences in operating

and stock performance and earnings quality by comparing early adopters and non-early adopters of SFAS 142

over a ve-year period between 2002 and 2006, which extends the research beyond the relatively short window

covered by prior research, and also takes into consideration Statement of Financial Accounting Standard 141

(SFAS 141)-R “Business Combination”, issued in 2007, to supersede SFAS 141 of 2001.

Keywords Firm performance, Early adoption, SFAS 142

Paper type Research paper

1. Introduction

In June 2001, the Financial Accounting Standards Board (FASB) issued Statement of

Financial Accounting Standard 141 (SFAS 141) “Business Combination” and Statement of

Financial Accounting Standard 142 (SFAS 142) “Goodwill and Other Intangible Assets”.

Both rules established guidelines to write off goodwill as impairment losses; however, the

latter statement fundamentally changed the accounting treatment of goodwill by eliminating

amortization and requiring an annual goodwill impairment test. In the initial year,

companies were allowed to early adopt the new provisions, and the FASB encouraged the

The current issue and full text archive of this journal is available on Emerald Insight at:

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IJAIM

25,2

138

Received 7 September 2015

Revised 26 January 2016

16 February 2016

Accepted 17 February 2016

InternationalJournal of

Accounting& Information

Management

Vol.25 No. 2, 2017

pp.138-176

©Emerald Publishing Limited

1834-7649

DOI 10.1108/IJAIM-09-2015-0062

early adoption of SFAS 142 in particular by allowing any impairment write-off for the rst

two quarters of the year to be treated as a one-time accounting charge (i.e. reportable

below-the-line as a special item and separating from operating income), as long as the

impairment charge was taken before June 30, 2002 (Cowin et al., 2007). It appears that some

rms, especially those with large amounts of goodwill, had an incentive to take advantage of

the early adoption provision by recognizing impairment charges below the line in the year of

adoption so as to avoid impairment losses directly charged against operating revenues in the

future. Yet, little is known about whether the rms that adopted SFAS 142 early actually

exhibit different characteristics from their non-early adopting counterparts, or the effect

early adoption had on their long-term performance. This study lls this gap in the literature.

Several rms had the choice to early adopt SFAS 142. Airgas, Inc., for example, became an

early adopting rm, announcing in August 2001 its adoption of the new standard retroactive

to April 1, 2001:

We decided to adopt early because we believe the new standard better reects the dynamics of our

business. Airgas has always generated strong cash ow, which was not fully reected in our book

earnings. For example, in scal year 2001, we generated $0.52 of net earnings per share and $0.94 of

free cash ow per share,” commented Roger Millay, senior vice president and chief nancial ofcer“.

The full year impact on earnings per share is expected to be $0.20. Therefore, our previously issued

earnings guidance of $0.55 per share is raised to $0.75 per share including the $0.05 of Project One

net costs. (Airgas’ press release, 08/13/2001)[1]

Some studies provide early evidence that adopting rms similar to Airgas, Inc. may have

taken advantage of the immediate earnings benet by applying the new rules (Huefner and

Largay, 2004;Jordan and Clarke, 2004;Sevin and Schroeder, 2005). Specically, this line of

research suggests rms with a signicant amount of goodwill on account may have chosen

to early adopt the standards with the intent of beneting future earnings by taking a big bath

sooner (Jordan and Clarke, 2004;Sevin and Schroeder, 2005;Zang, 2008). Comparing rm

performance one year before the rule change in 2001 to one year after in 2002, Sevin and

Schroeder (2005) argue that smaller rms were more negatively affected by the market and

were more likely than larger rms to engage in big bath earnings management. Early

accounting studies such as Sevin and Schroeder (2005), however, only examine rm

performance over a short period of time limited to one year (i.e. one-year period of 2002) after

the new accounting regulation, providing a relatively narrow understanding of a rm’s

future performance.

Although there is a paucity of studies exploring the relationship between early adoption

of SFAS 142 and future performance, related research suggests early adoption of the

provision may in fact have implications for a rm’s future performance. For example, a

hypothesized relationship between the choice to adopt SFAS 142 early and rms’ future

performance is consistent with the notion of signaling theory, which has been applied to

empirical studies of dividend policy (John and Williams, 1985;Miller and Rock, 1985),

voluntary disclosure (Al-Akraa and Jahangir-Ali, 2012;Cheung et al., 2010;Hamrouni et al.,

2015;Hassan and Mohd-Saleh, 2010;Huang et al., 2015;Lajili and Zéghal, 2006) and

recognition of corporate social responsibility expenditures (Lys et al., 2015). In another

related example, Anagnostopoulou (2008) points out that causality may work in the opposite

direction in the relationship between current research and development (R&D) spending and

future protability, considering that protable rms actually have necessary funds to spend

on R&D.

Research on market reaction to impairment losses related to SFAS 142 also provides some

insight into the nature of the relationship between early adoption and future performance.

Zang (2008) documents that the market reacts negatively to announcements of unexpected

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Early adoption

of SFAS 142

initial impairment losses, and that the negative association is greater among highly

leveraged rms. Similarly, Bens et al. (2011) nd that market reaction is weaker for rms

with low information asymmetry, as well as for those that incur high costs to implement

impairment tests. Chen et al. (2008), on the other hand, provide evidence regarding the

market’s anticipation of impairments. In particular, their study nds that initial impairment

per SFAS 142 is associated with lower returns in prior years. They also detect that the

recognition lag by documenting prior returns partially incorporated the rst year’s

impairment (compared to initial year’s returns), and nd the association between the rst

year’s impairment and contemporaneous return suggests that, to some extent, rms’

impairments are recognized in a timely fashion. Answering the call of Chen et al. (2008) for

additional evidence, our study tests the effects of goodwill impairment over an extended

period following the 2001 rule change.

In another line of research, Li et al. (2005) examine the negative impact of the impairment

loss in various reporting regimes, which includes the pre-SFAS 142 period, the transition

period and the post-SFAS 142 period, and nd signicantly less market reaction after the

transition period. Ramanna and Watts (2012), however, document that some rms with

non-zero goodwill and potential goodwill impairment did not take write-offs to recognize

impairment loss. They argue that this line of accounting research, which relies only on a

sample of rms that recognized impairment losses, may lead to biased inferences.

Finally, some prior studies do show a positive association between early adoption of

accounting rules and earnings management (Ayers, 1986;Pincus and Wasley, 1994;Nelson

et al., 2002), suggesting that rms use the multi-year adoption permitted by accounting

regulators as a tool to manage earnings (Phillips, 2005). Using these different schedules when

adopting a particular standard, early adopters tend to have a higher interest coverage ratio

and a higher leverage ratio. However, early adopters of SFAS 142 generally tend to be

nancially healthier, managerially more stable and are more motivated to smooth earnings

and manage income upward through the positive income effect of early adoption. The choice

of early adoption, therefore, is more often tied to an objective to smooth earnings than to take

a big earnings bath (Phillips, 2005). Early adoption may also be used as a sign that adopting

rms are open to incorporate new accounting regulation changes.

Thus, the situation surrounding early adoption of SFAS 142 raises some interesting

research questions, namely:

RQ1. How do rms that early adopted SFAS 142 differ from their non-early-adopting

counterparts?

RQ2. Does the strategy of earnings smoothing or big bath play a role in affecting

long-term operating performance post SFAS 142?

RQ3. Does early adoption affect earnings quality?

RQ4. Does the stock market treat these two groups differently post-SFAS 142?

In other words, do early adopting rms exhibit better stock returns following their decision?

Our research attempts to identify potential differences in operating and stock performance

and earnings quality by comparing early adopters and non-early adopters of SFAS 142 over

a ve-year period between 2002 and 2006, a relatively long window compared to the prior

research, and also takes into consideration SFAS 141-R, “Business Combination”, issued in

2007, to supersede SFAS 141 of 2001.

Multiple measures of operating returns, stock returns and earnings quality are used in the

study. In particular, prot margin (Prots), returns on assets (ROA) and returns on equity

(ROE) are used to measure operating performance, whereas buy-and-hold returns (BH),

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