THE EFFECT OF GOODWILL IMPAIRMENT ON SHARE PRICES.

AuthorStunda, Ronald A.
PositionReport

INTRODUCTION

In 1997 the Financial Accounting Standards Board (FASB) enacted Concepts Statement No.6 in which the board decided that goodwill is an asset (Johnson & Petrone, 1999). Prior to the development of accounting standards on goodwill, there were many options related to goodwill accounting, these options were varied between asset based methods as capitalization and the elimination methods as the immediate write-off against reserves (Lewis & Pendrill, 2004). Amortization is another option that was widely used and it enabled companies to match the cost of intangible assets over the period deemed to benefit from their acquisition.

Essentially, goodwill is a residual of the total fair value of an acquisition less the fair value of the identifiable net assets acquired. The first definition describing goodwill emerged in the 1880s where goodwill was considered being the difference between the purchase price and the book value of an acquired company's assets (Johnson & and Tearney, 1993). Currently, FASB accounts for goodwill under the provisions of Statement of Financial Accounting Standards No. 142 (SFAS 142) Goodwill and Other Intangible Assets. Basic elements of the SFAS 142 require the cost of an acquisition to be measured at the date of the announcement of acquisition by the acquirer of the net assets of the acquiree.

Goodwill is to be allocated among reporting units, which are operating segments of an enterprise. Goodwill is not amortized, it is instead considered to have an indefinite life. Practically, goodwill's life is limited, it is simply unknown what that limited life is. As a result, a periodic test of goodwill is necessary to assess potential impairment. Most goodwill research has concentrated on the usefulness of the new standard as compared to the previous practices. Hitz and Kuhner (2002) analyzed the usefulness of impairment charge in decision making through comparing the net income prior to and after goodwill write-offs to current period income. Chen, Mohlbek, and Warfield (2004) found that the new rules of goodwill accounting outperform the previous enactments.

On the other hand Wiese (2005) favored the amortization approach. Chambers (2006) concluded that that goodwill accounting under SFAS 142 does not improve financial reporting compared to amortization-based accounting. Zhang and Zhang (2006) discovered that management is motivated to allocate more purchase price to goodwill. When the payment is made in form of stock-for-stock acquisitions rather than cash payment, then the existence of goodwill overpayment becomes evident (Loughran & Vijn, 1997). Little research has been conducted to assess goodwill impairment from the perspective of the effect on net income relative to share prices.

Defond and Hung (2003) assess similarities and differences among industry firms, they found that different industries possess differing amounts of capital intensity and risk, thereby affecting cash flow and accounting earnings. Industry membership, among other things, has been found to affect auditor choice (Carcello & Neal 2003), analysts' forecasts (Sinha, Brown, & Das 1997), corporate mergers (Stunda, 2017), and defined benefit plans (Towers & Watson 2016).

To date, no research has attempted to assess the linkage between goodwill impairment and the effect that it may have on share prices across major industries. This study extends prior research on the subject of goodwill by exploring the impact that goodwill write-downs have on security prices in general, and by specific industry.

LITERATURE REVIEW

Sundararajan (1995) analyzes the two manners in which goodwill may be presented; the first is the residual approach that considers goodwill as a leftover amount. Goodwill represents the excess of purchase price over the fair market value of the acquiree's net assets and cannot be identified separately. The second is the excess profit approach where goodwill is the difference between the combined company's profits over normal earnings for a similar business. The second definition states that goodwill is the present value of the projected future excess normal earnings that may be generated by the acquiree. This concept is difficult to measure given the uncertainty related to the future earnings as well as the difficulty attributed to the probable discount rate to use.

Goodwill is an asset that cannot be determined unless an acquisition takes place (Ramanna, 2007). Firms may undertake business combinations for several reasons; the main reason is related to the expansion issue. Although firms can expand through internal growth as investment projects are carried out, external growth is usually used. An important aspect connected to business combinations is the impact of acquisitions on shareholder returns. Several previous studies examined this issue using the event studies technique. Kusnadi and Sohrabian (1999) explored the impact of acquisitions on shareholders returns within the insurance sector. Their findings revealed that the acquiring firms do not obtain any significant abnormal returns. On the other hand, Duso et al. (2006) found a positive relationship between acquisitions and profitability. While these and other studies speak in general about the business combination, none address the issue of goodwill or goodwill impairment and the associated effects on share prices.

The general approach, in accordance with SFAS 142, in accounting for goodwill is to assess for impairment periodically and write down if required. The associated impact is driven to the income statement, thus affecting net income. A significant number of prior researchers associate accounting earnings with security prices (Ball & Brown, 1968; Beaver, Lambert, & Morse, 1980; Basu, 1997; Ball, Kothari, & Robin 1998). All of these studies incorporate a research design that associates accounting earnings to changes in market values of equity. These studies indicate, (with varying degrees of significance depending on such factors as firm size, firm risk or industry type of the firm), that there is an overall significant positive relationship between accounting earnings and a firm's security price. In addition, prior research on industry membership indicated that investors view earnings differently dependent upon the industry (Defond & Hung, 2003; Carcello & Neal, 003; Sinha, Brown, & Das 1997; Stunda, 2017; Towers & Watson, 2016). This study attempts to bridge the gap in answering the research questions; does goodwill impairment have impact on share price? If so, does that impact vary among industries?

HYPOTHESIS DEVELOPMENT

Information content of accounting earnings associated with goodwill write-downs

The relationship between accounting earnings and security returns was first propounded by Ball and Brown (1968). The premise of the Ball and Brown study was to see whether the magnitude of unexpected earnings (as opposed to merely the sign of unexpected earnings) was related to the magnitude of the stock price response. Beaver, Clarke and Wright (1979) addressed the issue and discovered that the magnitude of unexpected earnings was related to the magnitude of the stock price response. Again, they focused on market-adjusted stock returns to facilitate across-firm comparisons and to control for market-wide movements in stock prices.

Ball and Brown (1968) and Beaver, Clarke and Wright (1979) show that despite the deficiencies of historical cost accounting, accounting earnings are potentially useful to investors. They also ushered in the so-called information perspective on the...

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