Evidence on the Decision Usefulness of Fair Values in Business Combinations

Abstract

In 2001, SFAS 141 (ASC 805) required that identifiable assets and liabilities acquired in a business combination be initially recorded at fair value rather than pre-acquisition book value. The FASB argued that fair value measurement would provide more decision-useful information about future cash flows following business combinations. However, opponents argued that fair values are often difficult to estimate and may be too noisy to be useful. In this study, we examine whether fair value measurement for identifiable assets and liabilities provides incremental decision-useful information about post-acquisition cash flows and offer two main findings. First, we find that fair values have incremental predictive ability for post-deal cash flows (beyond pooled book values), but only in limited circumstances: (i) horizontal (i.e., same-industry) deals, (ii) deals that do not involve R&D-intensive targets, and (iii) deals in which managers have less incentive to over-allocate purchase price to goodwill. This suggests that fair value measurement in business combinations only enhances decision usefulness in transactions when fair values are more reliably estimable and/or less subject to manager incentives. Second, we find that analysts update their cash flow forecasts to reflect the information provided by fair value disclosures, but only in transactions where we find that fair values are decision useful. Overall, our results suggest that there are limits in the extent to which fair value measurement for acquired identifiable assets and liabilities provides decision-useful information about future cash flows, and that capital market participants appear to recognize those limits as reflected in their decision making.