Fair Value Accounting: Consequences of Booking Market-Driven Goodwill Impairment

Abstract

We examine whether fair value accounting applied to goodwill impairment leads to unintended negative consequences. Under the fair-value-based goodwill impairment test, a firm’s market value is often used as an important reference point for determining whether goodwill is impaired. A below-one market-to-book ratio, generally used by external auditors and security lawyers, is a reasonable indicator of impairment; however, it could be misleading when prices deviate from fundamentals. In fact, strict reliance on this indicator can result in firms being pressured into recording goodwill impairment upon a temporary market value decline even when such decline is unsubstantiated by economic fundamentals. From a sample of goodwill impairments recorded during the period 2002-2009, we identify about a sixth of our sample firms reporting impairment charges that are most likely market-driven and not backed by fundamentals. This number triples during the financial crisis when price deviations from fundamentals are likely more prevalent. Validating our identification of market-driven impairments, we find that the impairment loss of these firms is associated with a return reversal in the subsequent year. It appears from our results that investors do not differentiate between market-driven and other impairments and react equally negatively upon the initial announcement of the loss. This results in a further price decline for firms with market-driven impairments analogous to the downward price spiral observed during the crisis. In addition, we find that, until the return reversal occurs, firms with market-driven impairment experience an increase in information asymmetry associated with the impairment loss. Finally, our results suggest that these firms "time" share repurchases to benefit from the delay in the market's reversal of the temporary undervaluation. Overall, our findings shed light on potential negative consequences associated with the imperfect implementation of fair value accounting.