Discretionary behavior with respect to the adoption of SFAS no. 142 and the behavior of security prices

Abstract

PurposeThis study aims to examine whether managers use discretion in determining transitional goodwill impairment loss (initial impairment loss or IIL) upon the adoption of SFAS no. 142, Goodwill and Other Intangible Assets, and whether and how the market reacts to the impairment loss and to the absence of goodwill amortization.Design/methodology/approachVarious empirical models are applied to a sample of 870 firms that completed the IIL test.FindingsIt is found that more highly leveraged firms (firms that have undergone a recent management change) report lower (greater) goodwill impairment. Stock return is not associated with a boost in earnings caused by elimination of goodwill amortization, but it is negatively associated with an unexpected IIL, with the association being stronger for highly leveraged firms. Subsequently, analysts revise earnings forecasts for upcoming quarters downward in response to the unexpected IIL.Research limitations/implicationsPossibility of measurement errors in proxies is a caveat.Practical implicationsThe findings are consistent with the strategic reduction of the goodwill impairment by management to avoid the violation of debt covenants and with the notion that new managers take a big bath so they can report higher earnings in the future. The market tests imply that unexpected IIL provides value‐relevant information about a negative view of the future profit‐making potential of the firm or an adverse impact on its debt contracts. No association with elimination of goodwill amortization can be interpreted as the market's anticipation or the lack of information content in goodwill amortization.Originality/valueThis research helps better understand the importance of managers' incentives in determining IIL as well as the stock market effect of the announcement of the IIL and the exclusion of goodwill amortization.