Recent change in goodwill accounting: Elimination of amortization of goodwill (Refer to Case, SFAS No. 142, and what you studied in ACCT 800 (or ACCT

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Goodwill Accounting Paper

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⚫ Each team will need to address all points based on reading the SFAS

No. 142, the case, 4 articles in Canvas, what was covered in ACCT 800

and 801, reading and researching additional information and/or

materials, and team discussions.

⚫ The case needs to be purchased.

⚫ For tasks where opinions are asked and/or discussions are needed,

there is NO right or wrong answer. However, each team should clearly

and logically provide team’s arguments and/or opinions based on

reading, research and analyses (NOT simply based one’s thoughts)

⚫ Goodwill Accounting Paper is an opportunity to study effects of

change in accounting rules on financial statements

– Focus only on Goodwill, not Trademark and Other Intangible Assets

General

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⚫ Goodwill arises when “Purchase price exceeds fair value of identifiable net assets

of acquired company”

⚫ (Address using case) Purchase price – Fair value of identifiable net assets = Goodwill.

Hence,

Fair value of identifiable net assets

= Purchase price (i.e., Total consideration) – Goodwill

* For “Total consideration” and “Goodwill”, refer to Exhibit 1

⚫ (Address using case) Why was Talbots, Inc. willing to pay more than the fair market

value of the identifiable net assets acquired from J. Jill? – General reasons are provided in case and also ACCT 800 and ACCT 801 textbook

– In addition, think about (or research) reasons specific to Talbot

⚫ Based on SFAS No. 142 and your team’s own research, summarize recent elimination

of amortization of goodwill including (but not limited to) rationale behind elimination of

amortization of goodwill. – Elimination of amortization of goodwill

– Impairment test

– SFAS No. 142 provides background of new goodwill accounting

Recent Change in Goodwill Accounting

B/S

Assets

Liabilities

Net assets ≈

Shareholders' equity

Identifiable

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⚫ At the bottom of page of case, there is section “Using an impairment

test to recognize changes in goodwill”

– Goodwill accounting changed once again after the case had been

written

– Ignore that section in case but recall what you learned in ACCT 800

– Now, impairment test for Goodwill is one-step process as covered in

ACCT 800

Correction for Bottom of Page 2 of Case

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⚫ (Address using case) For Fiscal Year 2008 (ending February 2, 2008), make an estimate of the

amortization of goodwill if SFAS No. 142 had not changed accounting for goodwill in 2001 and Talbots,

Inc. had chosen to amortize goodwill recognized in the purchase of J. Jill over the allowed period of 40

years based on the straight-line method with zero salvage value. Then, compare the amortization of

goodwill with the impairment of goodwill actually reported in income statement for Fiscal Year 2008

(ending February 2, 2008).

⚫ As learned in ACCT 800 and stated in SFAS No. 142, goodwill still needs to be tested annually for

impairment, although it is not subject to amortization any more. Discuss effects of elimination of

amortization of goodwill on impairment of goodwill.

– Address based on team’s research and discussion, focusing on “Amount” and “Frequency” of

impairment loss when goodwill is NOT amortized relative to when goodwill is amortized.

Consequences of Elimination of Goodwill Amortization

Amortization No Amortization

Fiscal year 2007

(ending Feb 3, 2007)

Amortization expense of approximately $3,975,000

(= $211,977,000 / 40 years x (9 months / 12 months)) * 9 months: May 3, 2006 – Feb 3, 2007

NONE

Fiscal year 2008

(ending Feb 2, 2008)

Amortization expense of approximately $5,300,000

(= $211,977,000 / 40 years)

Impairment loss of $134,000,000

(as reported in Exhibit 3)

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⚫ (Address using the case) Estimate Talbots, Inc,’s net income for Fiscal Year 2008

(ending February 2, 2008) if goodwill had been amortized as in 3 above without the

impairment test. Then, compare re-calculated net income or net loss to the net loss

actually reported after the impairment of goodwill of $134 millions for Fiscal Year 2008

(ending February 2, 2008).

⚫ (Continue from previous bullet point) Then, discuss effects of addition of impairment

test after elimination of amortization of goodwill on income statements by comparing

income statements between before and after SFAS No. 142 (i.e., addition of impairment

test after elimination of amortization of Goodwill).

– Address based on research, analyses, discussion, and observation from above comparison of net income, focusing

on “amount”, “frequency” and “location” of Amortization expense and Impairment loss on “income statement”.

– Also, address trend of net income across different periods based on the discussion of “amount”, “frequency” and

“location” of Amortization expense and Impairment loss on “income statement”.

Elimination of Goodwill Amortization and Financial Reporting (1/2)

Amortization No Amortization

Net Income for Fiscal

year 2007 (ending

Feb 3, 2007)

$27,601,000

(= $31,576,000 (from Exhibit 3)

– $3,975,000 (from calculated amortization expense))

$31,576,000

(as reported in Exhibit 3)

Net Income for Fiscal

year 2008 (ending

Feb 2, 2008)

($60,141,000)

(= ($188,841,000) (from Exhibit 3)

+ 134,000,000 (Add back impairment loss from

Exhibit 3)

– $5,300,000 (from calculated amortization expense))

($188,841,000)

(as reported in Exhibit 3)

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⚫ ACCT 800 and ACCT 801 textbook defines earnings quality as “ability to predict future

earnings and cash flows based on current earnings”. Discuss how addition of impairment

test after elimination of amortization of goodwill would affect earnings quality.

– Answer based on previous answers, and team’s research and discussion, focusing on whether

earnings including impairment loss would improve predictability of future earnings (or not)

– Note that there are different definitions of earnings quality and we focus on one of those

(i.e., ability to predict future earnings and cash flows based on current earnings) in this

paper so please adhere to the earnings quality definition in the textbook

⚫ Discuss whether elimination of amortization of goodwill has made financial statements

more useful or less useful. (In addition to the reference papers in Canvas, your team

should conduct own research)

– Reference papers posted in Canvas provide conflicting views on SFAS No. 142

– Hence, each team should conduct more research and discuss in own words whether elimination of

goodwill amortization and addition of impairment test (based on SFAS No. 142) have made

financial statements more or less useful

– MUST use reference papers posted in Canvas in the paper

– Your team is supposed to take one side (i.e., more useful vs. less useful) based on

compelling argument, examples, and/or evidence

– Writing MUST be based on compelling argument based on supporting research and

analyses, NOT simply based on one’s thoughts

Elimination of Goodwill Amortization and Financial Reporting (2/2)

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Assume readers are people with basic knowledge about accounting

1st draft should be near completion since there will be ONLY 1 week until final draft submission after meeting with instructor

J. Account. Public Policy 30 (2011) 236–255

Contents lists available at ScienceDirect

J. Account. Public Policy

journal homepage: www.elsevier .com/locate/ jaccpubpol

The effect of SFAS 142 on the ability of goodwill to predict future cash flows

Cheol Lee ⇑ Department of Accounting, School of Business Administration, Wayne State University, 207 Rands House, United States

a r t i c l e i n f o

0278-4254/$ – see front matter � 2010 Elsevier In doi:10.1016/j.jaccpubpol.2010.11.001

⇑ Tel.: +1 313 577 2242; fax: +1 313 577 2000. E-mail address: [email protected]

a b s t r a c t

This study examines the effect of Statement of Financial Account- ing Standards No. 142 (SFAS 142) on the ability of goodwill to pre- dict future cash flows. SFAS 142 allows substantial managerial discretion and leads to a significant magnitude of economic impact on financial statements, resulting in critical debates over the con- sequence of its adoption. I find that the ability of goodwill to pre- dict future cash flows has improved since the Financial Accounting Standards Board (FASB) adopted SFAS 142. Furthermore, sub-sample analyses fail to reveal compelling evidence that reporting discre- tion induced by SFAS 142 is used opportunistically or informa- tively, contrasting with the pervasive view based on the opportunistic reporting hypothesis. Overall, contrary to the posi- tion of critics of SFAS 142, the results support the view taken by the FASB and proponents of SFAS 142: eliminating systematic amortization and adopting fair value estimates improve represen- tational faithfulness of goodwill reporting.

� 2010 Elsevier Inc. All rights reserved.

1. Introduction

A wake of recent corporate accounting scandals has raised concerns about the role of financial re- ports in accounting failure and warranted a restoration of the financial reporting system. Responding to a request to reform the US financial reporting framework (i.e. Sarbanes–Oxley Act, 2002), the Securities and Exchange Commission (SEC) conducted a study of ‘principles-based’ accounting

c. All rights reserved.

C. Lee / J. Account. Public Policy 30 (2011) 236–255 237

standards and produced a report (2003) proposing that financial reporting move from a so-called ‘rules-based’ accounting system to a more ‘principles-based’ accounting regime.1 The SEC’s Report (2003) and the Financial Accounting Standards Board (FASB)’s response (2004) both emphasize that this movement is driven by a need for better and expanded use of professional judgment to capture a faithful presentation of the economic reality of assets or liabilities, and this can be solidified by increasingly adopting fair value accounting standards. This attempt to change the financial reporting system has been reflected in the standard settings with an emphasis on representational faithfulness and the downplay- ing of verifiability as a key conceptual element.

In keeping with the trend toward using fair value accounting to enhance the presentation of assets or liabilities, the FASB issued the Statement of Financial Accounting Standards 142 (SFAS 142), Good- will and Other Intangible Assets (2001b). The objective of SFAS 142 is to improve a faithful representa- tion of intangible assets with indefinite lives by eliminating the systematic amortization and applying reinforced fair value impairment tests. The results of the enactment of SFAS 142 have had a significant economic impact on financial reports. For example, Heufner and Largay (2004) analyze the 100 public companies with the largest goodwill balances. They estimate the possible net income effect for those firms to be $20 billion to $25 billion due to elimination of amortization and report that firms recognize a total of $135 billion of goodwill impairment in the adoption year.

Furthermore, the core of the controversy introduced by SFAS 142 is the role of managerial discre- tion embedded in the statement. For example, Watts (2003a) criticized the provisions of SFAS 142, cit- ing a lack of reliability in the fair value estimates. He argued that unverified managerial discretion resulting from fair value estimates leads to distortions in financial reports – an assertion antithetical to the FASB’s position that SFAS 142 was intended to enhance the reliability and relevance of financial reporting. Given the large economic impact of SFAS 142 and inherent managerial discretion in fair va- lue estimates, most prior studies (e.g. Ramanna and Watts, 2009; Bens et al., forthcoming; Li et al., forthcoming) examine the effect of SFAS 142 by primarily aiming at goodwill impairment. However, there was little documentation of the evidence of the fundamental efficacy of SFAS 142 because the primary goal of the statement is to represent a better valuation of goodwill and intangible assets with indefinite lives by not only implementing the fair value impairment test but also by eliminating sys- tematic amortization of those intangible assets.

In this study, I investigate two issues derived from the enactment of SFAS 142. First, I test whether SFAS 142’s treatment for goodwill enhances or dampens the ability of goodwill to predict future cash flows from operations across the pre- and the post-SFAS 142 regimes, which, according to the FASB, is the primary objective of the standard.2 Despite the FASB’s intention to improve the quality of financial reporting by issuing SFAS 142, a stream of accounting research indicates the possible costs of the change in accounting standards for goodwill and other intangible assets. This study attempts to resolve the ongoing debate by providing empirical evidence of the efficacy of SFAS 142.

Second, I examine the effect of managerial reporting discretion on goodwill’s ability to predict fu- ture cash flows because the implementation of SFAS 142 explicitly relies on managerial judgment or estimation. If SFAS 142 serves as a new source for managers to use their reporting discretion, the ex- panded discretion may be used opportunistically to achieve desired earnings targets or to signal pri- vate information through goodwill accounting. Following prior literature, I identify firms that have different economic incentives to exercise discretion as those with different degrees of absolute value of discretionary accruals and those meeting (or beating) earnings benchmarks, such as avoiding loss

1 The SEC’s Report (2003) characterizes principles-based accounting standards as an approach requiring professional judgment by eschewing bright-line tests and articulating the objective of conceptual framework with a primary emphasis on faithful representation of assets or liabilities. In addition, the report describes rules-based accounting as standards containing the following three attributes: (1) numerous bright-line tests, (2) numerous exceptions, and (3) voluminously detailed implementation guidance. The SEC’s Report indentifies SFAS 142 as an example of application of principles-based accounting standards.

2 The passage of SFAS 142 is equally applied to valuation of purchased goodwill and other intangible assets with indefinite lives. I focus on the treatment of goodwill because of an economic materiality of goodwill balance (e.g. a goodwill balance counts for approximately 85% of total intangible assets in Compustat Annual files) and a difficulty in distinguishing intangible assets with definite lives and intangible assets with indefinite lives. This approach may not incorporate the total effect of SFAS 142, but dominance of goodwill over other intangible assets is likely to provide sufficient evidence about the main effect of SFAS 142 on the quality of financial reports.

238 C. Lee / J. Account. Public Policy 30 (2011) 236–255

and avoiding a decrease in earnings, before goodwill charges with expected goodwill impairment. I use a market-to-book ratio below one (MTB < 1) as an expected indicator of goodwill impairment.

The results of empirical tests show that the enactment of SFAS 142 has substantially changed the ability of goodwill and goodwill charges to predict cash flows, and the mapping of goodwill and good- will charges into future cash flows has improved from the pre-SFAS 142 period to the post-SFAS 142 period. These findings generally support the position of the FASB and proponents of SFAS 142, suggest- ing that goodwill balance under the post-SFAS 142 regime can better represent the underlying economic value of assets than that mainly applied by the systematic amortization method in the pre-SFAS 142 regime. Also, the enhancement in the predictive ability of goodwill charges may reflect an overall advantage of fair value adoption. While these results are consistent even after controlling for the effects of macro-economics across the pre- and the post-SFAS 142 periods, these findings should be interpreted with caution because of the difficulty of disentangling the financial reporting effect from the influence of macro-economics on the mapping of goodwill into future cash flows.

Further results from cross-sectional sub-sample analyses in the post-SFAS 142 regime generally do not support the opportunistic reporting hypothesis nor the signaling hypothesis. Specifically, I find that firms predisposed to manipulate (i.e., high level of abnormal accruals and avoiding a de- crease in earnings before goodwill charges with MTB less than one) show a greater positive asso- ciation between goodwill balance or goodwill charge and future cash flows compared to those not predisposed to manipulate after adoption of SFAS 142; however, the difference is marginally insig- nificant. These results are inconsistent with prior pervasive views based on the opportunistic reporting hypothesis. While my finding does not completely rule out the possible opportunistic reporting behaviors indicated by prior literature (e.g. Beatty and Weber, 2006; Ramanna, 2008), the results suggest that the potential informative value of expanded discretion might offset the ef- fect of opportunistic reporting.

This study contributes to prior research in two ways. First, it provides evidence that is relevant to the debate on the effectiveness of the move to a more principles-based accounting standard (SEC, 2003) with an emphasis on the balance sheet model. While prior studies conclude that the efficacy of SFAS 142 was only based on a small sample of firms reporting an impairment loss of goodwill, the inference from the small sample analysis and non-balance sheet item may not represent the effi- cacy of the standard. My research illustrates more comprehensive evaluation of the informativeness of the goodwill balance under the new goodwill accounting standards. These results may be interesting to standard setters or regulators with a shift to a new paradigm of financial reporting.

Second, this study adds insight to the ongoing debate over ‘uniformity versus flexibility’ in financial reporting standards (e.g. Dye and Verrecchia, 1995). The issue of accounting flexibility rises to the sur- face with a convergence between International Financial Reporting Standards (IFRS) and the US accounting standard. While a number of prior studies claim that managerial discretion is used oppor- tunistically and then impairs the quality of financial reporting, the signaling hypothesis (Beaver, 1997) argues that managerial discretion favorably affects reporting quality by allowing management to com- municate private information about the firm. This study provides additional insights to the conse- quence of managerial discretion in financial reporting.

The remainder of this paper is organized as follows: Section 2 summarizes the background of SFAS 142 and reviews prior literature. Section 3 provides information about the research design and devel- ops the testing of hypotheses. Sections 4 and 5 present data, descriptive statistics and the results of the empirical analyses. Section 6 offers the summary and conclusion.

2. Background and literature review

2.1. SFAS 142

After long deliberation on business combinations and intangible assets, in 2001 the FASB issued SFAS 141, Business Combinations, and SFAS 142, Goodwill and Other Intangible Assets (FASB, 2001a,b), which unified the treatment of business combinations under the purchase method and required all new and existing goodwill and other intangibles with indefinite lives to be written down only when

C. Lee / J. Account. Public Policy 30 (2011) 236–255 239

impaired. The promulgation of SFAS 142 significantly changed the financial reporting of those assets. Specifically, the elimination of systematic amortization of goodwill and other intangible assets with indefinite lives resulted in a boost to net income on average and mandatory impairment test of good- will amplified income volatility.

The goodwill impairment under SFAS 142 differs considerably from the previous asset write-down accounting standard, SFAS 121, Accounting for the Impairment of Long-Lived Assets and for Long-Lived Assets to Be Disposed of (FASB, 1995), by reinforcing fair value approach.3 First, the threshold for the impairment indicator is different. Under SFAS 142, managers compare carrying value to fair value to determine the possible impairment of assets, rather than an undiscounted cash flow as specified under SFAS 121. If fair value of reporting units and goodwill are not available, the statement suggests fair value estimation by several valuation techniques, including the discounted cash flows method. Second, SFAS 142 requires reporting unit analysis for testing goodwill impairment rather than the asset groupings used by SFAS 121.4 Finally, SFAS 142 requires an evaluation of impairment losses at least annually, which is more timely than the SFAS 121 requirement of an impairment test based on managers’ judgment using impairment indicators.

Moreover, the most critical change in the statement eliminates the amortization process of intan- gible assets with indefinite lives. The FASB states that mechanical amortization of goodwill and other intangible assets is economically meaningless because the economic value of those assets does not de- cay over the finite time horizon, such as a maximum 40 years.5 By issuing this standard, the FASB antic- ipates that SFAS 142 will better report the goodwill asset balance by improving both the relevance and reliability of financial reporting.

Opponents of SFAS 142, however, question the effectiveness of this standard in two regards. First, Watts (2003a) points out that fair value estimates for impairment tests require cash flow assumptions, which are unverifiable, because the market price for reporting units is usually unavailable. Second, the allocation of joint benefits or costs into reporting units is inherently subjective (e.g. Watts, 2003a; Beatty and Weber, 2006). Critics argue that such additional subjectivity and unverifiability allowed under SFAS 142 do not guarantee improvement of representational faithfulness. Instead, they claim that the issuance of SFAS 142 results in an overall reduction of reliability in financial reporting by using managerial discretion opportunistically, and then the quality of financial reports would be declined.

2.2. Principles-based accounting standards and SFAS 142

There are divergent views on the assessment of accounting standards as principles-based account- ing. I define principles-based accounting standards as ‘objectives-oriented’ standards following the definition in the recent SEC Report (2003, hereinafter ‘‘the Report’’). In the Report, SEC specifies that principles-based accounting standards should allow preparers to use professional judgment for imple- menting standards, resulting in enhancement of representational faithfulness of financial reporting, and provide a certain level of implementation guidelines for an adequate degree of comparability. The Report also regards the asset/liability (i.e. balance sheet) model, which views the representational faithfulness of assets or liabilities as the primary objective of financial reporting, as a fundamental unit of principles-based accounting standards.6

3 SFAS 144, Accounting for the Impairment or Disposal of Long-Lived Assets, FASB (2001C) superseded SFAS 121 in 2001. This statement retained the general provisions of SFAS 121, with the exception