Do Firms Manage Fair Value Estimates An Examination of SFAS 142 Goodwill Impairments

Journal of Business Finance & Accounting
Journal of Business Finance & Accounting, 36(9) & (10), 1059–1086, November/December 2009, 0306-686X
doi: 10.1111/j.1468-5957.2009.02169.x
Do Firms Manage Fair Value Estimates?

An Examination of SFAS 142
Goodwill Impairments
Henry Jarva*
Abstract: I find that goodwill write-offs under Statement of Financial Accounting Standards
No. 142 (SFAS 142) are associated with future expected cash flows as mandated by the standard.
However, there are indications that goodwill write-offs lag behind the economic impairment of
goodwill. Additional analysis reveals that the association between goodwill write-offs and future
cash flows is insignificant for firms with contemporaneous restructuring. I hypothesize that this
finding is due to agency-based motives. Finally, I examine a sample of non-impairment firms in
which there are indications that goodwill is impaired. I fail to find convincing evidence that these
firms are opportunistically avoiding impairments.
Keywords: accounting conservatism, fair value accounting, write-offs
1. INTRODUCTION
The Financial Accounting Standards Board (FASB) has sought to improve the relevance
of financial reporting by moving towards the broad-based adoption of fair value
accounting. When assets’ book values exceed their recoverable amounts, accounting
rules focus on correcting the balance sheet, and assets are written down at their
fair values. 1 However, fair value standards allow the reporting entity to use its own
data to develop unobservable inputs, if observable prices from an active market are
not available. Holthausen and Watts (2001) point out that if there are management
incentives to bias and introduce measurement error, then the lack of verifiability
will tend to affect the reliability and the value relevance of the accounting numbers.
*The author is from the Department of Accounting and Finance, University of Oulu, Finland. He is grateful
for helpful comments and suggestions from Andrew Stark (editor), an anonymous referee, Juha-Pekka
Kallunki, Mikko Zerni, and workshop participants at the University of Oulu. The author acknowledges
financial support from the Academy of Finland, the Finnish Cultural Foundation, the Savings Banks Research
Foundation, and Suomen Arvopaperimarkkinoiden Edistämissäätiö. (Paper received June 2008, revised
version accepted July 2009, Online publication September 2009)
Address for correspondence: Henry Jarva, University of Oulu, Department of Accounting and Finance, P.O.
Box 4600, FIN-90014 Oulu, Finland.
e-mail: henry.jarva@oulu.fi
1 I note that current accounting standards are asymmetric, in the sense that they generally require timely
loss recognition but prohibit timely gain recognition.

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Consequently, there is a continuing debate about whether fair value measurements in

financial statements are appropriate. Opponents of fair value accounting argue that
allowing unverifiable estimates into accounting numbers can seriously compromise
their usefulness and increase the likelihood of opportunistic disclosures. 2 Proponents
of fair value accounting believe that asset and liability measures that reflect current
economic conditions and up-to-date expectations of the future will result in more
useful information for making economic decisions. 3
The Statement of Financial Accounting Standards 142 – Goodwill and Other Intangible
Assets (SFAS 142) eliminated goodwill amortization, requiring instead that firms use
fair value estimates to determine goodwill impairments. Under SFAS 142, goodwill
is impaired if the reporting unit’s total fair value is less than its book value. Thus,
SFAS 142 is consistent with the FASB’s decision to measure assets and liabilities in fair
values. The FASB believe that SFAS 142 will improve the ability of users of financial
statements to assess future profitability and cash flows. However, there may be a trade-
off between reliability and relevance in moving toward fair value accounting. Agency
theory predicts that managers will use the discretion permitted them by SFAS 142 in
circumstances where they have agency-based motives to do so (Watts, 2003). Whether
the attempt to increase the relevance of asset measures comes at the expense of reduced
reliability of accounting numbers is an open empirical question.
This paper examines whether SFAS 142 goodwill write-offs are associated with future
expected cash flows as mandated by the standard. 4 I investigate a sample of firms
reporting goodwill impairments between 2002 and 2005. As asserted by the FASB, I find
that SFAS 142 goodwill impairments have significant predictive ability for expected one-
and two-year-ahead cash flows. The positive association between goodwill write-offs and
future cash flows is robust to various controls. Thus, the evidence is consistent with the
notion that goodwill write-offs are, on average, more closely related to economic factors
than opportunistic behavior. However, there are indications that SFAS 142 goodwill
write-offs lag behind the economic impairment of goodwill. Additional analysis reveals
that the association between goodwill write-offs and future cash flows is insignificant
for firms with contemporaneous restructuring. I hypothesize that this finding is due to
an agency-based motive. However, my tests cannot determine whether these write-offs
are untimely or whether the numbers are biased (as part of a ‘big bath’). I also find
evidence that small firms are able to conduct sophisticated impairment tests. Finally, I
examine a sample of non-impairment firms in which there are indications that goodwill
is impaired. I fail to find convincing evidence that these firms are opportunistically
avoiding impairments.
There is a long stream of research, dating back to Strong and Meyer (1987) and Elliot
and Shaw (1988), that documents the relation between write-offs and stock returns. The
recent adoption of SFAS 142 has evoked considerable new research on write-offs. 5 Li
et al. (2004) find that investors as well as analysts revise their expectations downward on
the announcement of an impairment loss and this downward revision is significantly
2 Watts (2003) argues that the assessment of the value of a firm and its implied goodwill is extremely
subjective. Ramanna and Watts (2009) posit that recent FASB standards that rely on unverifiable fair value
estimates either increase the management of financial statements or increase the agency costs of monitoring
managers.
3 For example, FASB (2001) and Barth (2006).
4 I use the term ‘write-off’ to refer to both complete and partial downward goodwill revaluations.
5 See Alciatore et al. (1998) for a thorough review of the earlier studies on write-downs of long-lived assets.

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DO FIRMS MANAGE FAIR VALUE ESTIMATES? 1061
related to the magnitude of the loss. Ahmed and Guler (2007) provide evidence that
goodwill write-offs and goodwill are more strongly associated with stock returns and
stock prices after SFAS 142 than before SFAS 142. Chen et al. (2008) find evidence
that adoption impairments under SFAS 142 represent timelier information than prior
goodwill impairments although there is still room for improvement in their timeliness.
Muller et al. (2009) provide evidence that insiders of goodwill impairment firms engage
in abnormal selling of their shares quarters prior to the announcement of such losses.
An exception to the above association studies is Ramanna (2008), who examines the
evolution of SFAS 142 and finds evidence consistent with the idea that FASB issued SFAS
142 in response to political pressure over its proposal to abolish pooling accounting.
In related research, Ramanna and Watts (2009) provide evidence that non-impairment
is increasing in financial characteristics that serve as proxies for greater unverifiable
fair value based discretion. 6 They fail to find evidence that non-impairment is due
to managers’ possession of favorable private information. Finally, evidence in Frankel
et al. (2008) suggest that recorded goodwill provides a useful input to the firm’s lending
contract. They find some evidence that the promulgation of SFAS 141 and 142 have
reduced the net contracting benefits of goodwill.
This study differs from studies that base their conclusions on the association between
SFAS 142 impairments and equity market values. Barth et al. (2001) point out that value
relevance tests generally jointly test relevance and reliability. Market-based tests provide
only indirect evidence about the information contained in goodwill impairments
because these tests rely on share prices as proxies for expected future cash flows.
The present study attempts to provide more direct evidence on the reliability of SFAS
142 goodwill write-offs. Specifically, I study how goodwill impairment charges relate
to firms’ realized future cash flows with an attempt to control deviations from initial
expectations.
Findings in this paper provide insights for standard-setters on the reliability of
unverifiable fair value estimates. In 2004, the International Accounting Standards
Board (IASB) revised International Accounting Standard (IAS) 36, Impairment of Assets,
which is nearly identical to SFAS 142. Like SFAS 142, IAS 36 relies on estimates of
future cash flows. Hence, many firms around the world have the opportunity to use
unverifiable estimates in their financial reports. Since the firm’s value is the present
value of its expected future net cash flows, the evidence in this paper is potentially
useful for the analysis of financial statements containing asset impairments that are
based on management forecasts.
The results should be interpreted cautiously. First, I assess the reliability of
unverifiable estimates by examining the relation between goodwill write-offs and future
cash flows using firm-level data. Since impairment testing is done at the reporting
unit level, the use of firm-level data introduces an errors-in-variables problem, or a
bias against finding significant results. Second, the 2002–2005 period examined is
relatively short. Third, the extent to which the observed regression results are affected
by correlated omitted variables is unknown. Finally, although I examine firms both
recording and avoiding impairments it is difficult to make conclusions on the ‘net
benefits’ of SFAS 142.
6 These two firm characteristics are: (1) number and size of reporting units and (2) unverifiable net assets
in reporting units.

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The paper is organized as follows. The next section provides the background and
hypotheses for the study. Section 3 describes the research design. Section 4 presents
the sample selection and descriptive statistics. Section 5 shows the empirical results and
the sensitivity analyses. Section 6 provides concluding remarks.
2. BACKGROUND AND HYPOTHESES
(i) Accounting for Goodwill under SFAS 142

SFAS 141 (Business Combinations) requires all business combinations initiated after
June 30, 2001, to be accounted for using the purchase method of accounting. Under
SFAS 141, the excess of the cost over the fair value of the acquired net assets (goodwill)
is recorded at the date of the business combination. The FASB adopted SFAS 142
in June 2001 to address financial accounting for goodwill. 7 The main changes for
goodwill accounting are: (i) goodwill will be assigned to reporting units; (ii) goodwill
will no longer be amortized; (iii) there will be specific guidance for testing goodwill for
impairment; and (iv) there will be enhanced disclosures about goodwill in the years
subsequent to its acquisition.
Under SFAS 142, firms are required to test goodwill for impairment at the reporting
unit level. A reporting unit is an operating segment or one level below an operating
segment. If the firm does not disclose segment information, then SFAS 131 is used to
determine its operating segments for the purposes of determining the firm’s reporting
units. SFAS 142 provides a framework for testing goodwill for impairment using a two-
step process. The first step is a screen for potential impairment that begins with an
estimation of the fair value of a reporting unit. If the carrying amount exceeds the
estimated fair value then the second step measures the amount of impairment. The
impaired amount is the difference between the carrying amount of reporting unit
goodwill and its implied fair value. The standard prohibits the loss recognized from
exceeding the carrying amount of goodwill. Also, the subsequent reversal of a previously
recognized impairment loss is prohibited. Under SFAS 142, goodwill write-offs should
be presented in line items on the income statement, within continuing operations.
(ii) Hypotheses
Both standard-setters and practitioners are interested in whether firms distort fair
value based impairment write-offs. On the other hand, SFAS 142 gives management
considerable latitude to exercise accounting judgment to convey their private infor-
mation credibly to stakeholders through financial statements. In turn, this latitude
leaves more room for earnings management. For example, Watts (2003) argues that
SFAS 142’s use of future cash flow estimates when assessing impairment gives firms
the opportunity to manipulate earnings, because those estimates are unlikely to be
verifiable and contractible.
By definition, assets embody expected future inflows of economic benefits. If
the reporting unit’s book value of goodwill exceeds its implied fair value, current
accounting rules focus on correcting the goodwill balance. Thus, management’s
7 See Ramanna (2008) for the evolution of SFAS 142 and information about the two FASB Exposure Drafts.

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balance sheet adjustments should be associated with expected future cash flows.
However, agency theory predicts that managers will use the discretion in SFAS 142
to manage their earnings opportunistically. As Ramanna (2008) points out, managers
can use two earnings management techniques to manage reported earnings under
SFAS 142. First, they may avoid timely goodwill write-offs, overstating current earnings
and net assets. Second, they may overstate goodwill impairment losses, understating
current earnings and net assets. Note that both scenarios predict a lower association
between goodwill write-offs and expected future cash flows. However, it is an empirical
question whether goodwill charges contain information about expected future cash
flows. My first hypothesis is:
H 1 : Goodwill write-offs are positively associated with expected future cash flows.
Management determines the timing, magnitude and presentation of goodwill write-
offs. Prior studies suggest that there are cross-sectional differences in the information
content of goodwill write-offs. I examine two factors that have been proposed to explain
the information content of goodwill impairments: firm size and big bath earnings
management.
First, size has been used as a proxy for many factors, including implementation
efficiency of the impairment test and information asymmetry. The FASB acknowledged
that an annual impairment test entails costs for preparers (see, paragraphs B143–
B144 in SFAS 142). The Board noted that the most labor-intensive part of the process
relates to assigning goodwill and net assets to reporting units and establishing the
model and key assumptions to be used to measure the fair value of each reporting
unit. Bens et al. (2007) find that the market reaction to goodwill write-offs is less
significant for small firms. They argue that small firms face the greatest difficulty in
conducting sophisticated impairment tests due to their limited resources. The existence
of an estimation error in goodwill write-offs lowers its association with future cash
flows. Accordingly, I hypothesize that limited resources of small firms increase the
measurement error in goodwill write-offs:
H 2 : The association between goodwill impairments and expected future cash flows
is lower for small firms.
Agency theory suggests that managers will use unverifiable discretion opportunis-
tically. 8 I test this prediction by examining firms that have agency-based motives to
do so. A well-known incentive for a big bath may occur when a firm is reorganizing
its operations. 9 The reorganization creates an opportunity to ‘clean the books’ and
this write-off creates a loss reserve for future years (Ramanna and Watts, 2009). SFAS
142 (par. 36) allows a firm to reassign its goodwill when it reorganizes its reporting
structure in a manner that changes the composition of one or more of its reporting
units. A big bath scenario predicts that the economic reasons for a goodwill write-off
are lower for these firms. If a firm overstates impairment losses, this behavior reduces
the association between goodwill write-offs and future cash flows, because excess write-
offs dilute their association with future cash flows. It is also possible that these firms
8 Monitoring and reputational costs can mitigate opportunism. However, Ramanna (2008) points out that
contracts are unlikely to prevent opportunism, since unverifiable estimates are difficult to challenge ex post.
9 For example, former SEC Chairman Arthur Levitt expressed his concern over big bath restructuring
charges (Levitt, 1998).

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have been avoiding timely goodwill write-offs because of unresolved agency problems.
Untimeliness of write-offs also reduces the association between current write-offs and
future cash flows. These considerations lead to my third hypothesis:
H 3 : The association between goodwill impairments and expected future cash flows
is lower for firms with contemporaneous restructuring.
3. RESEARCH DESIGN
The reliability of unverifiable estimates is assessed by examining the relation between
goodwill write-offs and expected future cash flows. As in prior research, I use realized
cash flows as a proxy for managers’ expectations, since managers’ cash flow expectations
are unobservable. Unfortunately, this is a noisy proxy for two reasons. First, since
goodwill is tested for impairments at the reporting unit level, firm-level cash flow is
inherently a noisy measure for firms with diverse operations. However, Watts (2003,
p. 218) notes that there is no meaningful way to allocate goodwill among the units
if there exist synergies ( joint costs and benefits) among the units. This implies that
it is likely that the impairment of goodwill in one unit could result in impairment in
another unit. Second, the dependent variable should only contain the cash flow that is
expected in period t. However, as I discuss further below, realized cash flows are subject
to measurement error since they contain both expected and unexpected components.
Dechow and Ge (2006) conclude that the recording of special items (e.g., asset
impairments) indicates that management is taking action to turn the firm around. Their
results show that low accrual firms with special items have higher future stock returns
than other low accrual firms. If goodwill write-offs lead to improved performance,
then the estimated coefficient on goodwill write-offs will be biased towards zero. For
this reason, it is important to control for stock returns when testing hypotheses H 1 –
H 3 . The severity of the errors-in-variables problem depends on the extent to which
the realized cash flows (CF t+j ) deviate from the expectations in period t. This errors-
in-variables problem can be mitigated by using a model that includes a proxy for the
measurement error. My proxy for measurement error is the future returns (R t+j ). 10
Barth et al. (2001) show that each major accrual reflects different information about
future cash flows. In contrast, aggregating earnings masks information that is relevant
to predicting future cash flows. To facilitate comparison, I disaggregate accruals into
major components, as in Barth et al. (2001). To test the hypothesized relation between
goodwill write-offs and expected future cash flows, I estimate the following pooled cross-
sectional time series model (the firm subscripts are omitted here and in subsequent
equations): 11
CFt+ j = α0 + α1 CFt + α2 WOt + α3 ARt + α4 INVt + α5 APt + α6 DEPRt

3
+ α7 OTHERt + α8 Rt+ j + α9 YearControls t + εt+ j (1)
j =1
10 Basu (1997) also uses returns as a proxy for good and bad news.
11 Expanding Model (1) to include the future returns is econometrically equivalent to the following two-
stage procedure. First, regress the future operating cash flow on future returns. The residuals from the
first-stage regressions represent the expected operating cash flow in period t. In the second stage, regress
the residuals from the first-stage regressions on the variables of interest.

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where t denotes the year, and j ranges from 1 to 3. CF t is the operating cash flow,
WO t is the goodwill write-off, AR t is the change in accounts receivable, INV t
is the change in inventory, AP t is the change in accounts payable, DEPR t is the
depreciation, depletion, and amortization expenses, and OTHER t is all other net
accruals, calculated as E t − (CFt + WOt + ARt + INVt + APt + DEPRt ). R t is the
12-month stock return ending three months after the fiscal year-end. Year indicators
control for year fixed effects. All accounting variables are deflated by the market value
of equity at three months after the fiscal year-end t−1. 12
Since I model goodwill impairments as negative values, a positive association would
imply that more negative write-offs lead to more negative expected future cash flows.
Evidence that goodwill write-offs are positively associated with expected future cash
flows is inconsistent with the claims that firms manage unverifiable fair value estimates.
If firms manage goodwill write-offs and/or disclosures do not reflect underlying
economics, I expect to see an insignificant coefficient on goodwill impairments (α2 ).
If the cash flows are greater (smaller) than expected, future returns will also be higher
(smaller). Therefore, the coefficient on future returns, α8 , is expected to be positive.
To test the hypotheses H 2 and H 3 , I add new control variables one at a time to the
primary model, and refer to them as Z t in the Model (2). The variable of interest is
the interaction Z t × WO t . The variable Z t is included to make the interpretation of the
coefficient on Z t × WO t more natural in the following equation:
CFt+1 = α0 + α1 CFt + α2 WOt + α3 ARt + α4 INVt + α5 APt + α6 DEPRt

+ α7 OTHERt + α8 Rt+1 + α9 YearControls t + α10Z t + α11Z t × WOt + εt+1 .
(2)
As discussed earlier, this paper examines two factors that have been proposed to
explain the discretion of goodwill impairments: size and big bath incentive. I use the
SEC’s reporting requirements to categorize firms into a small subsample. 13 The variable
LowSize t is dichotomously coded 1 when the size of the firm’s market value of equity at
three months after the fiscal year-end t−1 is less than $75 million, and 0 otherwise. I
use a dummy variable to capture the big bath incentive. RES t is a dummy variable that
takes value of 1 if the firm reports restructuring charges during the fiscal year, and 0
otherwise.
4. SAMPLE SELECTION AND DESCRIPTIVE STATISTICS

The sample comprises all firms listed on the New York (NYSE), American (AMEX), and
NASDAQ markets, for which requisite financial and return data are available over the
period 2002–2006. The data used in the empirical tests are drawn from three sources.
Financial statement data are obtained from the Worldscope database, and stock return
data are obtained from the Datastream daily stock return files. 10-K filings are retrieved
from the SEC’s Electronic Data Gathering, Analysis, and Retrieval system (EDGAR)
archives.
12 Kraft et al. (2006) point out that one potential concern with scaling by average assets is that beginning
total assets are increasing in past accruals, past accruals are negatively correlated with current accruals, and
ending total assets are increasing in current accruals. Scaling by average assets can introduce complications,
because write-offs directly lower ending total assets.
13 Companies with a public float less than $75 million are considered as non-accelerated filers by the SEC.

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As shown in Table 1, a total of 16,770 firm-year observations are available on

Worldscope and Datastream with non-missing market value of equity (MV t −1 ), earnings
(E t ) and annual returns (R t ) over the period 2002–2006. As in prior research, financial
institutions (SIC 6000–6999) are excluded since accruals for these firms are difficult
to interpret. This sample selection criterion reduces the sample size to 15,334. Firm-
years with negative book value of equity are excluded (520 firm-years). 14 The empirical
tests require the following variables for year t: cash flows (CF t ), change in accounts
receivable (AR t ), change in inventory (INV t ), change in accounts payable (AP t ),
depreciation (DEPR t ), and book-to-market ratio (BTM t ). This selection process yields
14,526 firm-year observations. The data from the year 2006, and 3,211 additional firm-
year observations, are lost by requiring future cash flows (CFt+1 ) and future returns
(Rt+1 ) for year t+1. Finally, to control for the effects of extreme values, observations
that are in the top and bottom one-half percent of either (deflated) earnings or return
variables are removed (323 firm-years). 15 These procedures result in 10,992 firm-
year observations. The empirical analysis is performed on firms that report material
Table 1
Sample Selection Criteria for Goodwill Impairments During the Years 2002–2005
Total
Observations of MV t −1 , E t , and R t 16,770

1. Less: financial institutions (SIC 6000–6999) 1,436
15,334
2. Less: negative book value of equity 520
14,814
3. Less: CF t , AR t , INV t , AP t , DEPR t , and BTM t unavailable 288
14,526
4. Less: CF t +1 , and R t +1 unavailable 3,211
11,315
5. Less: the top and bottom one-half percent of E t , and R t variables 323
10,992
6. Less: zero or immaterial goodwill write-offa 10,644
348
7. Less: manual check for data errors 21
Goodwill write-off sample 327
Notes:
MV is market value of equity, E is earnings, R is the return from nine months before fiscal year-end
to three months after fiscal year-end, CF is operating cash flow, AR is change in accounts receivable, INV
is change in inventory, AP is change in accounts payable, DEPR is depreciation expense, and BTM is
book-to-market ratio. Details on the construction of these variables are provided in the Appendix.
a Material goodwill write-offs are defined as goodwill write-off/lagged total assets >1% or goodwill write-off
larger than $10 million.
14 Twenty-six (5%) of these firm-year observations have contemporaneous goodwill impairment. The largest
goodwill impairment is $8.483 billion, reported by Qwest in 2002. Curiously, a transition impairment test
of goodwill for Qwest incurred a charge for the cumulative effect of adopting SFAS 142 of $22.8 billion on
January 1, 2002.
15 Note that firm-year t+1 observations are also excluded if they are identified as outliers in year t.

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goodwill write-offs during the fiscal years 2002–2005. To increase the power of my tests,
I operationally define goodwill write-off to be material that represents more than 1% of
the beginning-of-the-year total assets or is larger than $10 million. The latter threshold
is included to avoid sample selection bias. 16 This sample selection criterion reduces
the sample size to 348, a reduction of slightly less than 97%. For these firms, I retrieve
10-K filings from the SEC’s EDGAR database and exclude all observations where the
goodwill write-off relates to the adoption of SFAS 142. 17 I manually check Worldscope’s
impairment of a goodwill variable for data errors. 18 Most data errors are due to write-
offs based on other standards (SFAS 121; SFAS 146) or because the goodwill write-off
amount includes SFAS 142’s other intangible assets write-offs. After this screening, the
final goodwill write-off sample consists of 327 firm-year observations.
5. EMPIRICAL RESULTS
(i) Goodwill Impairments

The distribution of goodwill write-offs over time by industry and by firm is shown in
Table 2. Note that the sample does not comprise initial transition charges, because firms
were permitted to ascribe goodwill write-offs as an SFAS 142 below-the-line cumulative
effect (see Beatty and Weber, 2006). Despite the exclusion of initial transition charges,
it is not surprising that in the year 2002 firms reported the most write-offs, because the
US stock market began to recover from the early 2000s recession in 2003. However,
goodwill write-offs do not appear to be clustered in any particular year. Panel B reports
the distribution of material impairments by Standard Industrial Classification (SIC)
code. The sample firms are in 48 different two-digit SIC industries. Noticeably, 21.1%
of the observations are clustered in the Business services industry (SIC 73). The second
largest industry, Electronic and other electrical equipment (SIC 36), comprises 15.0% of the
observations. Finally, Panel C of Table 2 lists the number of annual goodwill write-offs
reported by each of the sample firms between 2002 and 2005. In the sample, 83% of the
firms reported only one goodwill write-off. Six firms reported three goodwill write-offs
during the sample period. 19
Table 3 presents descriptive statistics for goodwill write-off firms and a control
sample. The control sample consists of firms that are not included in the goodwill
write-off sample. The results in Panel A show that reporting a goodwill write-off is not
a random event. A comparison of the goodwill write-off sample to the control sample
16 For very large firms 1% threshold is too restrictive. For example, in 2004 Motorola Inc. took a $125
million impairment charge related to goodwill that was, however, less than 1% of its beginning-of-period
total assets.
17 Beatty and Weber (2006) examine an accounting choice that managers made upon adoption of SFAS 142.
Their focus is on the trade-off that managers faced between recording certain goodwill impairment charges
below the line and uncertain future impairment charges included in income from continuing operations.
The authors find that firms’ equity market concerns affected their preference for above-the-line vs. below-the-
line accounting treatment, and firms’ debt contracting, bonus, turnover, and exchange delisting incentives
affected their decisions to accelerate or delay expense recognition.
18 According to Worldscope Database Datatype Definitions Guide (issue 6, April 2007), this item should
exclude impairment losses for goodwill arising from the initial application of SFAS 142 and resulting from
a transitional impairment test, which is reported as a change in accounting principles.
19 These firms are Brooks Automation Inc, Ciena Corporation, Masco Corporation, Newell Rubbermaid
Inc, Tenet Healthcare Corporation, and United Rentals Inc.

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Table 2
Distribution of Goodwill Write-Offs Over Time by Industry and by Firm
Panel A: Distribution of Goodwill Write-Offs by Fiscal Year
Year 2002 2003 2004 2005 Total
Number of goodwill write-offs 91 78 70 88 327

Panel B: Distribution of Goodwill Write-Offs Across Two-Digit SIC Codes
Industry SIC % of Obs.
Business services 73 21.1

Electronic and other electrical equipment 36 15.0
Electric, gas, and sanity services 49 6.1
Industrial machinery and equipment 35 5.5
Chemicals and allied products 28 5.2
Instruments and related products 38 5.2
Communication 48 4.9
Engineering and management services 87 4.0
Health services 80 3.1
Otherc 30.0
Total 100.0
Panel C: Number of Goodwill Write-Offs Reported per Firm
Goodwill Write-Offs per Firm 1 2 3 Total
Number of firms 227 41 6 274

Notes:
c The industries represented in this group include the two-digit SIC codes 1, 10, 13, 15, 17, 20, 22, 23, 25,
26, 27, 30, 31, 32, 33, 34, 37, 39, 42, 45, 47, 50, 51, 52, 53, 54, 55, 56, 57, 58, 59, 70, 72, 75, 76, 78, 79, 82, and 83.
reveals that goodwill write-off firms performed poorly in the year that the goodwill write-
off is reported. Both accounting earnings (E) and stock returns (R) are significantly
lower in the goodwill write-off sample than in the control sample. The mean value
of goodwill write-offs (WO) in the goodwill write-off sample indicates that goodwill
write-offs tend to be large in magnitude, 13.5% of the lagged market value of equity.
Moreover, the distribution of goodwill write-offs is negatively skewed. In both samples,
current accruals (AR, INV and AP) are smaller in magnitude than DEPR, which is
a long-term accrual. The negative mean and median for OTHER imply that the write-off
firms are downsizing and may be recording other write-offs or restructuring charges.
The future cash flow performance continues to be poorer for the goodwill write-off
sample. Finally, the goodwill write-off sample firms have a higher future stock return
than the control sample firms (mean 0.484 vs. 0.330). This finding is consistent with
Dechow and Ge (2006), and it also emphasizes the need to control for firm performance
when testing hypotheses H 1 –H 3 .
Panel B of Table 3 reports both the Pearson and Spearman correlations among the
variables for the goodwill write-offs sample. To facilitate the discussion, I focus on the
Spearman correlations. Earnings are positively correlated with current returns (0.205)
and negatively correlated with future returns (−0.163). This indicates that reported
earnings reflect at least a portion of the information reflected in the returns, and at
least some firms are successful in turning themselves around. WO exhibits a significantly
positive correlation with DEPR (0.370) which indicates that goodwill write-off firms are

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Table 3
Descriptive Statistics and Correlations for Firm-Year Observations for the Years 2002–2005
Panel A: Descriptive Statistics
Impairment Sample (N = 327) Control Sample (N = 9,960)
†
Variable Mean Median Std. Dev. Mean Median Std. Dev.

Et −0.240∗∗∗ −0.134∗∗∗ 0.320 0.001 0.041 0.172
CF t 0.058∗∗ 0.050∗∗∗ 0.235 0.084 0.075 0.209
WO t −0.135∗∗∗ −0.077∗∗∗ 0.177 0.000 0.000 0.001
AR t −0.017∗∗∗ 0.000∗∗∗ 0.152 0.014 0.005 0.148
INV t 0.001 0.000∗∗∗ 0.068 0.006 0.000 0.078
AP t −0.010∗ −0.001∗∗∗ 0.176 0.007 0.003 0.114
DEPR t −0.102∗∗∗ −0.053∗∗∗ 0.187 −0.067 −0.037 0.109
OTHER t −0.035 −0.021 0.349 −0.042 −0.023 0.272
Rt −0.006∗∗∗ −0.145∗∗∗ 0.708 0.307 0.136 0.810
CF t +1 0.067∗∗ 0.056∗∗∗ 0.208 0.097 0.084 0.248
DO FIRMS MANAGE FAIR VALUE ESTIMATES?
R t +1 0.484∗∗∗ 0.213 1.033 0.330 0.170 0.747

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Table 3 (Continued)
Panel B: Pearson (Top) and Spearman (Bottom) Correlations for Impairment Sample Firms (N = 327)
Et CF t WO t AR t INV t AP t DEPR t OTHER t Rt CF t +1 R t +1
Et 0.205 0.682 0.216 0.125c 0.084a 0.316 0.102b 0.021a 0.134b −0.250
CF t 0.427 −0.132c −0.353 0.134c −0.095b −0.475 0.012a 0.235 0.590 −0.065a
WO t 0.746 0.082a 0.112c 0.017a 0.067a 0.276 −0.028a −0.042a 0.003a −0.100b
AR t 0.206 −0.062a 0.124c 0.134c 0.777 0.251 −0.610 −0.047a −0.043a −0.094b
INV t 0.213 0.053a 0.079a 0.225 0.362 −0.054a −0.391 0.129c 0.032a −0.103b
AP t 0.180 0.220 0.170 0.356 0.302 0.115c −0.869 0.005a 0.032a −0.023a
DEPR t 0.324 −0.279 0.370 −0.015a 0.055a −0.010a −0.223 −0.147 −0.529 −0.088a
OTHER t 0.219 −0.099b 0.067a −0.222 −0.108b −0.515 0.039a −0.046a 0.004a −0.015a
Rt 0.205 0.265 0.075a 0.189 0.038a 0.112c −0.243 −0.068a 0.130c −0.310
JARVA
CF t +1 0.319 0.601 0.116c 0.048a 0.063a 0.033a −0.355 0.062a 0.305 0.089a
R t +1 −0.163 0.013a −0.121c −0.301 −0.059a −0.099b −0.090a 0.029a −0.348 0.165
Notes:
The table reports summary statistics for two samples of firms drawn from the time period 2002–2006. E is earnings, CF is operating cash flow, WO is goodwill write-off,
AR is change in accounts receivable, INV is change in inventory, AP is change in accounts payable, DEPR is depreciation expense, OTHER is net of all other
accruals, and R is the return from nine months before fiscal year-end to three months after fiscal year-end. Details on the construction of these variables are provided
in the Appendix.
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∗∗∗ , ∗∗ and ∗ indicate statistical significance at the 1%, 5% and 10% levels (two-tailed).
† t-test of the null hypothesis that means are equal for goodwill write-off sample and other firms sample.
Mann-Whitney U test.
In Panel B all correlations are significant at p < 0.01, except as follows: a not significant, b significant at p < 0.10, and c significant at p < 0.05.

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reducing assets. As expected, current cash flows and future cash flows are correlated,
with a correlation coefficient of 0.601.
Table 4 presents the estimates of future expected cash flows predicted by the primary
model. Each pooled regression tests whether goodwill write-offs are associated with
future expected cash flows. The results reveal that the estimated coefficients on WO
are statistically significant and positive for one- and two-year-ahead cash flows. This
finding is consistent with H 1 . The parameter on goodwill write-offs for one-year-ahead
and two-year-ahead cash flows is 0.206 and 0.188, respectively. For three-year-ahead
Table 4
Future Cash Flows on Earnings Components and Control Variables
Dependent Variable
Variable Prediction CF t+1 CF t+2 CF t+3
Intercept ? 0.020 −0.017 0.053

(1.27) (−0.94) (1.66)
CF t + 0.512∗∗∗ 0.637∗∗∗ 0.753∗∗∗
(5.48) (4.58) (3.67)
WO t + 0.206∗∗∗ 0.188∗∗ 0.049
(2.65) (2.51) (0.52)
AR t + 0.496∗∗ 0.364∗∗ 0.613∗∗
(2.22) (2.20) (2.17)
INV t + −0.155 −0.222 0.756
(−0.59) (−0.76) (0.94)
AP t − −0.137 0.129 −0.212
(−0.89) (0.67) (−0.74)
DEPR t − −0.395∗∗∗ −0.464∗∗∗ −0.457∗∗∗
(−6.20) (−3.60) (−3.53)
OTHER t ? 0.009 0.059 −0.085
(0.10) (0.87) (−0.74)
R t +1 + 0.040∗∗∗ −0.003 −0.017
(3.51) (−0.15) (−0.69)
R t +2 + 0.042∗∗∗ 0.032
(3.05) (1.03)
R t +3 + 0.052∗
(1.91)
Year Controls included included included
N 327 234 164
Adj. R 2 (%) 53.1 61.5 56.0
Notes:
This table reports results from the following OLS regression (firm subscripts omitted):
CFt+ j = α0 + α1 CFt + α2 WOt + α3 ARt + α4 INVt + α5 APt + α6 DEPRt + α7 OTHERt

3
+ α8 Rt+ j + α9 YearControlst + εt+ j .
j =1
CF is operating cash flow, WO is goodwill write-off, AR is change in accounts receivable, INV is
change in inventory, AP is change in accounts payable, DEPR is depreciation expense, OTHER is net of
all other accruals, and R is the return from nine months before fiscal year-end to three months after fiscal
year-end. Details on the construction of these variables are provided in the Appendix. j ranges from 1 to 3.
Year indicators are included in the regressions but not reported. White (1980) corrected t-statistics are in
parentheses.
∗∗∗ , ∗∗ and ∗ indicate statistical significance at the 1%, 5% and 10% levels (two-tailed).

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1072 JARVA
cash flows the estimated coefficients on WO is positive but statistically insignificant.

The insignificant coefficient on three-year-ahead cash flow is consistent with the view
that goodwill write-offs lag behind the economic impairment of goodwill. However,
the three-year-ahead cash flow variable is likely to contain significant measurement
error. The statistically insignificant coefficient is just as likely to be due to power or
measurement issues as to untimely write-offs. Thus, this result should be interpreted
cautiously. The sum of the estimated coefficients suggests that approximately 40% of the
goodwill write-offs are related to future cash flows. This result should be interpreted
with caution, however, because the amount of impairment loss is assessed by using
present value techniques (not undiscounted cash flows).
The predicted signs of the other earnings components are based on Barth et al.
(2001). All of the coefficients have the predicted signs, except for the coefficient on
change in inventory (INV). However, this finding is not surprising since change
in inventories may signal unanticipated changes in a firm’s future prospects. The
coefficient on cash flow (CF) increases from 0.512 in year t+1 to 0.753 in year t+3. This
relative high increase may simply be due to increased cash flow performance and/or
survivorship bias. The significance of the DEPR coefficients indicates that depreciation
predicts future cash flows. Note that the sign of depreciation is opposite to that of
goodwill write-offs. Depreciation ameliorates transitory variation in free cash flows,
while goodwill impairment charges are timely loss recognition accruals. The OTHER
component is insignificant for each of the three future cash flows. For the measurement
error proxy, future returns (R), the coefficient is positive and significant in three
of six cases. This is consistent with stock returns incorporating information about
unexpected components of cash flows. In addition, the magnitudes of the significant
coefficients on R increase as the forecast period (and hence the set of estimation errors)
grows.
Collectively, the evidence presented in Table 4 suggests that SFAS 142 goodwill write-
offs are associated with expected one- and two-year-ahead cash flows. Next, I conduct
a number of robustness tests.
(ii) Sensitivity Analyses
(a) Correlation with Shocks to Current Cash Flows

In my first sensitivity test, I consider the effect of shocks to current cash flows. Goodwill
write-offs that contain information about expected future cash flows are consistent with
SFAS 142. It is important to note that goodwill write-offs that are positively correlated
with shocks to current cash flows are also within SFAS 142. It is possible that only
about 40% of the goodwill write-offs are related to future cash flows, because the major
portion of the impairment relates to current period economic loss. The following
two-stage procedure should provide a cleaner measure of this portion. In the first
stage, I attempt to remove the correlation between the goodwill write-offs and the
current-period cash flow shock. In the second stage, I use the residuals from the first
stage to estimate the effects of goodwill write-offs on expected future cash flows. As in
Model (2), the sum of the estimated coefficients is used to assess the extent to which
goodwill write-offs are related to future cash flows.
Changes in cash flow are likely to be correlated with shocks to current-period cash
flows. However, cash flow changes may not capture all revisions in expected future

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cash flows in a timely manner. Market returns measure economic losses with error
but are likely to capture some information that is not reflected in cash flow changes.
Following Basu (1997), I allow the slopes to vary for negative and positive returns.
Consistent with conditional conservatism, I expect that only negative returns contain
information about write-offs. I include both the current and past year’s returns because
stock prices lead reported accounting performance. I lose some observations because
of data unavailability for past stock returns. Allowing for asymmetry with respect to
contemporaneous and prior period shocks is consistent with Pope and Walker (1999).
Each proxy has strengths and weaknesses, so I explore them in combination. The
regression is performed with no intercept because the sum of the residuals is not
necessarily equal to zero. To assess the extent to which goodwill write-offs reflect the
shock to current cash flows, I estimate the following model:
WOt = β0 CFt + β1 Rt + β2 DRt × Rt + β3 Rt−1 + β4 DRt−1 × Rt−1 + εt (3)
where t denotes the year. WOt is a goodwill write-off, CFt is the change in cash
flows, Rt is the 12-month stock return ending three months after the fiscal year-
end, and DR t is a dummy variable that takes the value of 1 if Rt is negative, and 0
otherwise. The residual (εt ) from the OLS regression represented in Model (3) is the
portion of goodwill write-off that is not related to current period (WOt ). In the second
stage, I use the residuals from the first-stage to replace the original goodwill write-off
variable:

3
+ α7 OTHERt + α8 Rt+ j + α9 YearControls t + εt+ j . (4)
j =1
Panel A of Table 5 shows the results from the first-stage regression. All the coefficients
are consistent with what would be expected. The change in cash flow is significant at
the 5% level. For positive current and past stock returns, the coefficients on R t and
R t −1 are insignificant. For negative past and current stock returns, the coefficients
on DRt × Rt and DRt−1 × Rt−1 are positive and significant at the 1% level (0.134 and
0.363, respectively). The larger coefficient on past negative stock returns is evidence
that market returns lead goodwill write-offs. Further, the result that goodwill write-
offs incorporate information only about negative economic income is consistent with
accounting conservatism.
Panel B of Table 5 shows the results from the second-stage regression. My inferences
are not affected by using the two-stage procedure. Specifically, the sum of the estimated
coefficients suggests that only about one third of the goodwill write-offs are related
to future cash flows after controlling for the shock to current cash flows. Since the
estimated coefficients are almost identical to those of the more parsimonious model, I
find little benefit from using the two-stage procedure. For the sake of brevity, I do not
report the coefficient estimates for the other variables.
(b) Additional Robustness Tests for H 1

In this subsection, I conduct additional robustness tests for the Model (1). I show
that the results are robust with respect to outliers, industry fixed-effects, concurrent

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Table 5
The Two-Stage Procedure
Panel A: The First-Stage Regression of the Goodwill Write-Offs on Economic Losses
CF t Rt DR t × Rt R t−1 DR t−1 × Rt−1
0.079∗∗ −0.014 0.134∗∗∗ −0.038 0.363∗∗∗

(2.00) (−0.71) (3.36) (−1.82) (8.19)
Panel B: The Second-Stage Regression of the Future Cash Flows on the First-Stage Residual
Dependent Variable
Variable CF t+1 CF t+2 CF t+3
Intercept 0.004 −0.023 0.058∗

(0.28) (−1.29) (1.95)
CF t 0.533∗∗∗ 0.662∗∗∗ 0.796∗∗∗
(5.68) (4.76) (3.83)
WOt 0.174∗∗ 0.159∗ 0.051
(2.35) (1.95) (0.58)
Other earnings components included included included
Measurement error controls included included included
Year Controls included included included
N 323 232 162
Adj. R 2 (%) 51.9 60.5 56.3
Notes:
Panel A reports results from the following OLS regression (firm subscripts omitted):
WOt = β0 CFt + β1 Rt + β2 DRt × Rt + β3 Rt−1 + β4 DRt−1 × Rt−1 + εt .
Panel B reports results from the following OLS regression (firm subscripts omitted):

3
+α7 OTHERt + α8 Rt+ j + α9 YearControls t + εt+ j .
j =1
WO is goodwill write-off, CF is change in operating cash flows, R is the return from nine months before
fiscal year-end to three months after fiscal year-end, DR is an indicator variable equal to 1 if R is negative
and zero otherwise, CF is operating cash flow, AR is change in accounts receivable, INV is change in
inventory, AP is change in accounts payable, DEPR is depreciation expense, and OTHER is net of all
other accruals. Details on the construction of these variables are provided in the Appendix except: WO is
the residual from the first-stage regression (Model 3). Other earnings components, measurement error
controls, and year indicators are included but not reported for brevity. In Panel B White (1980) corrected
t-statistics are in parentheses.
∗∗∗ ,∗∗ and ∗ indicate statistical significance at the 1%, 5% and 10% levels (two-tailed).
write-offs, residual correlation, another proxy for the measurement error, and various
firm characteristics. For the sake of simplicity, I do not present the results, but they are
available upon request from the author.
Outliers: The sensitivity of the estimated coefficients to influential observations is

examined using procedures outlined in Belsley et al. (1980) and Rousseeuw and LeRoy
(1987). In the first robustness test, I delete the observations that have studentized
residuals with an absolute value greater than 3 and re-estimate the Model (1) regressions
in Table 4. The coefficient on goodwill write-offs remains significantly positive for

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one- and two-year-ahead cash flows. 20 The second robustness test is based on the least
trimmed squares (see Kraft et al. 2006). I drop the 2% of the observations with the
largest squared residual and re-estimate Model (1) with the remaining 98% of the sample.
The inferences are unaffected by estimating a specification that controls for influential
observations. 21 Since both procedures yield similar results, this adds confidence to the
inferences I draw.
Industry Fixed-Effects: Panel B of Table 2 shows that the sample firms are concentrated
in the computer and high-technology industries (SIC codes 36 and 73). These two
industries make up 36.1% of the total sample. Because of the limited number of
observations, the model is not estimated separately for different industry groups.
However, I use an industry fixed-effects specification to rule out the possibility that
the results are driven by cross-industry differences in goodwill write-offs and cash flows.
Industries are identified as in Barth et al. (1998). I find results consistent with Table 4.
The results show that the coefficient on WO for one-year-ahead cash flows is 0.210 and
significant (p = 0.007). The coefficients for years +2 and +3 are 0.221 (p = 0.007)
and 0.005 (p = 0.952) respectively. The results continue to hold after controlling for
industry fixed-effects.
Concurrent Write-Offs: As noted earlier, firms may also take other concurrent write-offs,
and these items could exaggerate the estimated WO coefficients. Panel A of Table 3
indicates that the OTHER component has a mean (median) value of −0.035 (−0.021).
Surprisingly, as shown in Panel B of Table 3, WO does not exhibit significant
correlation with OTHER. An analysis of variance inflation factors (VIFs) indicates that
multicollinearity is not a serious problem. However, I further address this issue by
deleting observations where the OTHER component is less than the tenth percentile
value, and then re-estimating the Model (1). Nonetheless, the inferences are unaffected
after controlling for other concurrent negative accruals.
Residual Correlation: The findings are based on pooling observations over time and
across firms. This raises the possibility that residual correlation could result in biased test
statistics (see Petersen, 2009). There are 47 firms that report more than one goodwill
write-off. The results remain robust when I correct for residual correlation within the
firms.
Another Proxy for the Measurement Error : As noted earlier, the dependent variable should
only contain the cash flow that is expected in period t. To control for the unexpected
component in realized future cash flows, I use realized future (raw) returns. By
definition, a firm’s stock returns are driven by shocks to expected cash flows and/or
shocks to discount rates. Thus, raw returns are potentially a noisy proxy for cash-flow
news. No inferences are affected when I use size-adjusted returns.
Controlling for Firm-Specific Factors: Finally, I control for various firm-specific factors. I
include the firm size, book-to-market ratio (BTM), number of business segments, and
sales growth as controls for other missing factors that might affect the analysis. I include
20 The coefficient on WO for +1 year cash flows is 0.119 (0.211 and 0.101 for event years +2 and +3
respectively).
21 The coefficient on WO for +1 year cash flows is 0.206 (0.197 and 0.078 for event years +2 and +3
respectively).

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firm size, measured as the log of the firms’ market value of equity at three months after
the fiscal year-end t, because prior work has found that firm size relates to disclosure
practices. I include BTM because while it is easy for market participants to observe
a firm’s book-to-market ratio, the reporting units’ fair-value-to-book-value ratios are
unobservable. The BTM simply measures the extent to which book value overstates
(understates) equity value. BTM is defined as the book value of equity divided by its
market value at the fiscal year-end t. An impairment test is performed at the reporting
unit level, but empirical data on the number of reporting units is not available. I use the
number of business segments as a proxy for the number of reporting units. 22 I include
the percentage change in sales to control for any differences in the growth. Including
these controls does not change the regression results.
(iii) Cross-Sectional Variation in Predictive Ability of Goodwill Write-Offs
(a) Tests of H 2 and H 3

Characteristics of the sample firms may explain the cross-sectional variation in the
predictive ability of goodwill write-offs. In this section, I examine whether small firms are
able to conduct sophisticated impairment tests. I also examine whether restructuring
introduce agency-based motives to overstate goodwill impairment losses (as part of a
big bath).
Table 6 reports the results of estimating Model (2). The explanatory variables of
interest are the interactions between dummy variables and goodwill write-offs (Z t ×
WOt ). The sum of the coefficients on WO t and Z t × WOt measures the predictive ability
of goodwill write-offs when the dummy variable Z t takes the value of one. The coefficient
on the interaction term between LowSize t and WO t is positive but insignificant, which is
inconsistent with H 2 . This calls into question the claim of Bens et al. (2007) that small
firms face the greatest difficulty in conducting sophisticated impairment tests. On the
contrary, the sum of the estimated coefficients on WO t and LowSi ze t × WOt (0.365)
suggests that shocks to small firms are more severe than to larger firms. Although I
cannot rule out that there are incremental costs associated with impairment testing
for small firms, the results show that small size per se is not a critical determinant of
impairment testing efficiency.
Next, I examine whether big bath incentives affect the predictive ability of goodwill
write-offs. I attempt to capture the big bath incentive with a dummy variable RES t .
The RES t variable takes the value of 1 for firm-years where a firm reports restructuring
charges. The estimated coefficient on the interaction term is significantly negative.
As shown in column 4 of Table 6, the reported coefficient on RESt × WOt is −0.285,
while the coefficient on WO t is 0.321. Consistent with H 3 , the sum of the coefficients
is not significantly different from zero. This result suggests that goodwill write-offs of
restructuring firms contain very little or no information about their future cash flows.
There are a number of potential explanations for this finding. First, the recognition
of impairment might be less timely for these firms. 23 This explanation is consistent
22 I use Worldscope’s product segment data (items 19501, 19511, 19521, 19531, 19541, 19551, 19561, 19571,
19581 and 19591) to calculate the number of business segments.
23 An unlikely explanation is that firms are so timely in recording the impairment that it has no effect on
one-year-ahead cash flows. In an untabulated analysis, I find that this is not the case.

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Table 6
Additional Analysis: Adding a Single New Control Variable Z
Control Variable Z t
Variable Prediction LowSize t RES t
Intercept ? 0.017 0.025

(1.26) (1.44)
CF t + 0.503∗∗∗ 0.534∗∗∗
(5.66) (5.90)
WO t + 0.127∗∗ 0.321∗∗∗
(2.53) (3.03)
AR t + 0.502∗∗ 0.523∗∗
(2.43) (2.43)
INV t + −0.130 −0.154
(−0.50) (−0.58)
AP t − −0.113 −0.134
(−0.71) (−0.86)
DEPR t − −0.423∗∗∗ −0.402∗∗∗
(−6.38) (−6.35)
OTHER t ? 0.020 0.022
(0.27) (0.29)
R t +1 + 0.042∗∗∗ 0.036∗∗∗
(3.57) (3.10)
Zt ? −0.003 −0.027
(−0.11) (−1.63)
Z t × WO t − 0.237 −0.285∗∗
(1.26) (−2.56)
Year Controls included included
N where Z t = 1 75 119
N 327 327
Adj. R 2 (%) 54.4 54.3
Notes:
+ α7 OTHERt + α8 Rt+1 + α9 YearControls t + α10 Z t + α11 Z t × WOt + εt+1 .
CF is operating cash flow, WO is goodwill write-off, AR is change in accounts receivable, INV is change
in inventory, AP is change in accounts payable, DEPR is depreciation expense, OTHER is net of all other
accruals, R is the return from nine months before fiscal year-end to three months after fiscal year-end, Z
is LowSize or RES, LowSize is an indicator variable equal to 1 if firm size is less than $75 million and zero
otherwise, and RES is an indicator variable equal to 1 if the firm reports restructuring charges during the
fiscal year t and zero otherwise. Details on the construction of these variables are provided in the Appendix.
Year indicators are included in the regressions but not reported. White (1980) corrected t-statistics are in
parentheses.
with the argument that impairment rules allow managers to delay write-offs. Second,
estimation errors might be larger in these firms because of financial distress. Finally,
the managers of these firms are managing earnings by overstating impaired goodwill
(e.g., cleaning the books for future profits). All these explanations introduce a
bias against finding a significant coefficient on goodwill write-offs for restructuring
firms.

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(b) Endogeneity of Restructuring Dummy

Restructuring is an endogenous decision based on a number of factors, including
the firm’s past performance, investment opportunity set, and expected future perfor-
mance. To control any bias resulting from self-selection of the decision to restructure, I
use the method used by Ball and Shivakumar (2005), when the group dummy variable
(RES t in this study) is endogenous and is used interactively in the regression. The
model is estimated using the two-stage approach of Heckman (1979). In the first stage,
I use ‘instruments’ to estimate the inverse Mills ratio for all firms. In the second stage,
regression model (2) is estimated, including the inverse Mills ratio as a control variable
and allowing its coefficient to vary between restructuring and non-restructuring firms.
The restructuring choice equation is estimated as a probit model. I include stock
returns, book-to-market ratio, size (log of market value of equity), log of total assets,
leverage (ratio of total debt to total assets), and fixed industry and year effects. All
variables are measured in year t−1. In untabulated results, stock return, log of total
assets, and leverage are significant at less than the 5% level.
In the second stage, the coefficients on the inverse Mills ratios are insignificant,
implying that the endogeneity is not a serious problem. The two-stage approach has
little effect on the estimated coefficients. The untabulated coefficient on RESt × WOt
is −0.293, while the coefficient on WO t is 0.330. Again, the sum of the coefficients is
not significantly different from zero. I conjecture that controlling for endogeneity does
not change the results.
(iv) Firms Avoiding Impairments

In this section I investigate non-impairment in firms where there are reasons to expect
that economic impairment of goodwill has occurred. Ramanna (2008) points out that
without an investigation of the extent and causes of impairment avoidance, it is difficult
to draw conclusions on the net benefits of SFAS 142. It is possible that an economic
impairment has occurred but firms fail to recognize the impairment loss in their
financial statements. I call this the ‘dog that didn’t bark’ scenario. 24 In the following
sections, I first discuss various motives for impairment avoidance, and then present my
design for analyzing non-impairment firms.
(a) Motivations for Impairment Avoidance

Based on previous research, Ramanna and Watts (2009) identify the following five
factors that are expected to increase impairment management. (1) Debt contracts.
Debt contracts are written over reported accounting numbers, and covenant violations
are costly to the borrower. (2) Compensation contracts. The impairment decision may
affect managers’ wealth, because compensation contracts are usually written based
on net income. (3) Reputation. Reputational concerns are valid if the incumbent
CEO made the original acquisition decision because then the impairment may suggest
that the acquisition price was too high. (4) Exchange delisting. Exchange delisting
incentives may affect managers’ incentives to delay expense recognition. (5) Equity
24 I thank the anonymous referee for proposing this metaphor (from The Adventure of Silver Blaze by Arthur
Conan Doyle).

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valuation. Managers consider the potential equity valuation effects when making
accounting choices. Given these motivations, it is reasonable to expect that some firms
are avoiding write-offs. Below, I discuss how I attempt to deal with this issue.
(b) Impairment Avoidance Analysis

One way to shed light on the ‘dog that didn’t bark’ scenario is to examine non-
impairment firms in which there are indications that goodwill is impaired. For these
non-impairment firms I generate artificial impairment to assess whether this amount is
associated with expected future cash flows. I have shown that if goodwill impairment is
reported then impairment has occurred. For this reason properties of impairment firms
can be used to assess whether economic impairment has occurred in non-impairment
firms (excluding restructuring firms). One major advantage of this approach is that it is
only necessary to include variables that relate to economic impairment in the analysis.
Arguably, it would be very difficult to capture the full complexity of the accounting
choice decision empirically.
Proxies for Economic Impairment: The variables used as proxies for economic impairment
are based on intuition and evidence from prior literature. Earnings before goodwill
impairment (preE t ) measure general performance of the firm. To proxy for financial
distress, I create a dichotomous variable (Loss t ) that is one if preE t is less than zero. I
argue that the probability of goodwill impairment is higher for firms that have large
amounts of capitalized goodwill. Thus, I create a variable that is the beginning-of-
period goodwill scaled by the beginning-of-period total assets. I use the book-to-market
ratio (BTM t −1 ) as a proxy for growth options. Goodwill impairment is expected if the
book-to-market ratio is above one (Ramanna and Watts, 2009). To capture this effect, I
create a variable (DBTM t −1 ), which is a dichotomous variable equal to one if the firm’s
beginning book value of equity exceeds the beginning market value of equity. I use the
logarithm of beginning market value of equity (Size t −1 ) to control for effect of size. I
include the firms’ annual stock returns (R t ) to measure news. A dichotomous variable
(DR t ) is equal to one if R t is negative. As previously noted, current (DRt × Rt ) and
past year (DRt−1 × Rt−1 ) negative returns should contain information about write-offs.
Finally, I include year and industry indicators to control for year and industry fixed
effects.
In order to calculate the probability of goodwill impairment, I construct the following
logistic model:
Impair t = β0 + β1 pr e E t + β2 Loss t + β3 GW%t−1 + β4 BTMt−1 + β5 DBTMt−1 + β6 Size t−1

+ β7 DRt + β8 Rt + β9 DRt × Rt + β10 DRt−1 + β11 Rt−1 + β12 DRt−1 × Rt−1

+ β13 YearControls t + β14 IndustryControls i + εt (5)
where Impair t variable is dichotomously coded 1 if a firm reported material impairment

in year t (defined earlier) and 0 otherwise.
To investigate impairment avoidance, I construct a sub-sample from the goodwill
write-off and control samples as follows. First, 5,488 firm-years having less than
$10 million goodwill balance at the beginning of that fiscal year are excluded. Second,
1,204 firm-years that report restructuring charges are dropped from the sample
because they have incentives to manage goodwill impairments. Third, 103 firm-years

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are excluded after imposing additional data requirements. The sub-sample consists of
3,492 firm-year observations.
Results for Impairment Avoidance: Table 7 provides estimates from a logistic regression.
I find that earnings before goodwill impairment (preE t ) and the presence of a loss
(Loss t ) are positively associated with the probability of reporting a goodwill write-off.
This result is consistent with a correlation between recorded goodwill write-offs and firm
performance. The positive coefficient on GW% t suggests that the level of capitalized
goodwill is positively associated with the probability of taking a goodwill write-off. I find
a statistically significant coefficient on BTM t . In addition, I also find that the probability
of making an SFAS 142 goodwill write-off is higher for firms that have book-to-market
ratios above one. Consistent with conditional conservatism, I find that only the firm-
years with negative returns contain significant information about impairment. This
result is consistent with the results in Table 5, Panel A.
Table 7
Logistic Regression of Goodwill Write-Off Decision on Economic Determinants
Variable Coefficient Estimate Chi-square p-Value
Intercept −5.782 88.785 0.000

preE t 1.202 2.910 0.088
Loss t 1.149 18.490 0.000
GW% t −1 1.407 10.614 0.000
BTM t −1 0.245 3.074 0.080
DBTM t −1 1.174 17.271 0.000
Size t −1 0.218 13.159 0.000
DR t 0.443 2.482 0.115
Rt −0.125 0.308 0.579
DR t × R t −2.174 9.855 0.002
DR t −1 −0.479 2.390 0.122
R t −1 −0.109 0.266 0.606
DRt−1 × Rt−1 −2.645 15.048 0.000
Year Controls included
Industry Controls included
N 3,492
N where Impair = 1 152
Likelihood ratio statistics 235.86 0.000
Max-rescaled R 2 0.217
Notes:
This table reports the results of the following logistic regression (firm subscripts omitted):
Impair t = β0 + β1 preE t + β2 Los s t + β3 GW%t−1 + β4 BTMt−1 + β5 DBTMt−1 + β6 Size t−1
+ β7 DRt + β8 Rt + β9 DRt × Rt + β10 DRt−1 + β11 Rt−1 + β12 DRt−1 × Rt−1

+ β13 YearControls t + β14 IndustryControls i + εt .
Impair is an indicator variable equal to 1 if a firm reported material goodwill write-off and zero otherwise,
preE is earnings before goodwill write-off, Loss is an indicator variable equal to 1 if preE is negative and zero
otherwise, GW% is proportion of goodwill to total assets, BTM is book-to-market ratio, DBTM is an indicator
variable equal to 1 if BTM is greater than one and zero otherwise, Size is the natural logarithm of market
value of equity at fiscal year-end, DR is an indicator variable equal to 1 if is negative and zero otherwise, and
R is the return from nine months before fiscal year-end to three months after fiscal year-end. Details on the
construction of these variables are provided in the Appendix. Year and industry indicators are included in
the model but not reported.

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For my non-impairment tests, suspect firms are non-impairment firms in which

there is a high probability of goodwill impairment. To construct the final sample, I
retain only observations that have a probability of making an impairment write-off
decision higher than 0.20. 25 This criterion leaves 136 observations on 118 firms. Of
these observations, 29% record goodwill impairments (impairment sample) and 71%
do not (non-impairment sample). I use information from the impairment sample firms
to generate artificial impairment for the non-impairment sample firms. Specifically, I
first compute the mean and standard deviation of the following ratio in the impairment
sample: goodwill write-offs divided by beginning-of-period goodwill balance. Then
I generate a random variable for the non-impairment sample with the same mean
and standard deviation as previously computed for the impairment sample (bounded
between zero and one). Finally, I create an artificial goodwill write-off for every firm
in the non-impairment sample as follows: the random variable is multiplied by the
beginning-of-period goodwill balance, and then deflated by the market value of equity
three months after the fiscal year-end t−1. Table 8 provides descriptive statistics for
both samples.
Table 8
Descriptive Statistics for Two Samples
Impairment Sample (N = 40) Non-Impairment Sample (N = 96)
Variable Mean † Median Std. Dev. Mean Median Std. Dev.
Size t −1 5.450 5.058 1.756 5.265 5.182 1.992

BTM t 2.191 1.914 1.461 1.917 1.494 1.513
GW% t −1 0.321 0.286 0.187 0.313 0.229 0.348
preE t −0.192 −0.113 0.248 −0.179 −0.082 0.258
WO t a −0.258 −0.187 0.267 −0.284 −0.123 0.505
CF t 0.098 0.052 0.318 0.074 0.062 0.298
CF t −0.025 −0.022 0.332 −0.022 −0.004 0.385
Rt −0.131 −0.380 0.675 −0.199 −0.305 0.558
CF t +1 0.076 0.066 0.197 0.088 0.059 0.301
CF t +1 −0.022 0.004 0.296 0.014 0.012 0.347
R t +1 0.491 0.276 0.828 0.559 0.369 0.865
Notes:
The table reports summary statistics for two samples of firms that have the largest probability (>0.20) to
make a goodwill write-off. See Table 7 for details of how this probability is estimated. Size is the natural
logarithm of market value of equity at fiscal year-end, BTM is book-to-market ratio, GW% is proportion of
goodwill to total assets, preE is earnings before goodwill write-off, WO is goodwill write-off, CF t is operating
cash flows, CF is change in operating cash flows, and R is the return from nine months before fiscal
year-end to three months after fiscal year-end. Details on the construction of these variables are provided in
the Appendix.
† t-test of the null hypothesis that means are equal for impairment sample and non-impairment sample.
Mann-Whitney U test.
a For non-impairment sample firms the variable is created as follows: a random variable (with mean 0.327
and variance 0.2522 ) is multiplied by the beginning goodwill balance in year t and then divided by the
market value of equity three months after the fiscal year-end t−1.
25 The results remain unchanged with the threshold value 0.25.

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A comparison of the impairment and non-impairment samples reveals that

contemporaneous performance is similar between the groups, suggesting that the
matching based on the probability of impairment was adequate. Inspection of the WO
variables also suggests that the ‘artificial impairment’ procedure was able to create
comparable write-offs. Future year performance variables are higher for the non-
impairment sample, but these differences are not statistically significant. Thus, both of
the following explanations receive support: (1) some managers avoid goodwill write-
offs opportunistically; (2) some managers avoid goodwill write-offs because they have
private information on positive future cash flows. It is likely that the two explanations
coexist. To address this issue further, I estimate the model (1) for both sets of samples.
Table 9 reports the results from regressing the explanatory variables on one-
year-ahead cash flows. The results show that the CF coefficient is lower in the
Table 9
Impairment Avoidance Analysis
Dependent Variable CF t+1
Variable Prediction Impairment Sample Non-Impairment Sample
Intercept ? −0.025 0.001

(−0.81) (0.04)
CF t + 0.233∗∗ 0.434∗∗
(2.34) (2.38)
WO t a + 0.249∗∗∗ 0.065
(3.26) (1.25)
AR t + 0.900∗∗∗ 0.545∗∗
(3.36) (2.37)
INV t + 0.167 0.195
(0.44) (0.69)
AP t − −0.686∗ −1.263∗∗∗
(−2.05) (−3.38)
DEPR t − −0.612∗∗ −0.037
(−2.67) (−0.19)
OTHER t ? −0.108 −0.089
(−0.96) (−0.41)
R t +1 + 0.079∗∗∗ 0.108∗∗∗
(3.00) (2.94)
Year Controls included included
N 40 96
Adj. R 2 (%) 61.4 47.8
Notes:
+ α7 OTHERt + α8 Rt+1 + α9 YearControls t + εt+1
CF is operating cash flow, WO is goodwill write-off, AR is change in accounts receivable, INV is change
in inventory, AP is change in accounts payable, DEPR is depreciation expense, OTHER is net of all other
accruals, and R is the return from nine months before fiscal year-end t to three months after fiscal year-end
t. Details on the construction of these variables are provided in the Appendix. Year indicators are included
in the regressions but not reported. White (1980) corrected t-statistics are in parentheses.
a For non-impairment sample firms the variable is created as follows: a random variable (with mean 0.327
and variance 0.2522 ) is multiplied by the beginning goodwill balance in year t and then divided by the
market value of equity three months after the fiscal year-end t−1.

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impairment sample than in the non-impairment sample (0.233 vs. 0.434). However,
the most interesting difference is found on the goodwill impairment variable, WO.
The coefficient on WO is significantly positive in the impairment sample, but it is
insignificant in the non-impairment sample. This result is consistent with the view that
managers avoid opportunism and use their discretion to make financial statements
more informative.
Inferences from the artificial impairment test should be drawn cautiously. My im-
pairment avoidance test is a joint test of impairment avoidance and the appropriateness
of the research design used. While there is some evidence that impairment avoidance
is not a general phenomenon, I leave this question for future research.
6. CONCLUSIONS
This paper examines whether goodwill write-offs of SFAS 142 are associated with future
expected cash flows as mandated by the standard. Opponents of fair value accounting
assert that unverifiable impairment estimates allow earnings management (e.g., big
bath accounting). I investigate a sample of firms reporting goodwill impairments in
2002–2005, and find that SFAS 142 goodwill write-offs have significant predictive ability
for one- and two-year-ahead cash flows. Thus, the evidence is consistent with the notion
that goodwill write-offs are, on average, more closely related to economic factors than
opportunistic behavior. However, there are indications that SFAS 142 goodwill write-offs
lag behind the economic impairment of goodwill. Additional analysis reveals that the
association between goodwill write-offs and future cash flows is insignificant for firms
with contemporaneous restructuring. I hypothesize that this finding is due to agency-
based motives. I also find evidence that small firms are able to conduct sophisticated
impairment tests. Finally, I examine a sample of non-impairment firms in which there
are indications that goodwill is impaired. I fail to find convincing evidence that these
firms are opportunistically avoiding impairments.
The analysis and results in this paper are subject to a number of caveats. First,
firm-level cash flow is a noisy measure to assess whether goodwill write-offs are
associated with expected future cash flows. Information about a reporting unit’s cash
flows would reduce the measurement error inherent in firm-level data. Also, detailed
information about the valuation estimates a firm used would be helpful to assess the
reliability of its goodwill write-offs. Second, the time period studied is relatively short.
Third, the extent to which the observed regression results are affected by correlated
omitted variables is unknown. Finally, although I examine both firms recording and
avoiding impairments, it is difficult to draw definite conclusions on the net benefits of
SFAS 142.
The results raise additional issues for future research. I find evidence that agency-
based incentives lower the association between goodwill write-offs and expected future
cash flows. Since preparers’ various incentives can adversely affect their judgments and
decisions, future research can investigate whether independent appraisers’ impairment
valuations are more reliable. The methodology employed in this paper to measure the
association between goodwill write-offs and expected future cash flows may be used
to measure audit quality. For example, is an auditor’s industry expertise associated
with more reliable impairment valuations? It is well known that accounting amounts
result from the interactions among various features of the financial reporting system
(e.g., accounting standards, enforcement, and litigation). Another interesting avenue

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for future research would be to examine cross-country differences in the reliability of

goodwill and other asset write-offs. Finally, a possible avenue for future research may
be to develop better models to measure accounting conservatism. It can be argued that
timely loss recognition is mostly implemented through impairment write-offs (e.g.,
SFAS 142 and 144).
APPENDIX
Variable Definitions
Variable Definition of Variable
MV t −1 Market value of equity (Datastream item MV), measured three months after the
fiscal year-end t−1.
Et Earnings (Worldscope item #04001) in year t, scaled by MV t −1 .
Rt The twelve month buy-and-hold return for the accumulation period beginning
three months after the previous fiscal year-end (e.g., March 31, 2005 to March 31,
2006 for a firm with a December 31, 2005 fiscal year-end). Returns are calculated
from changes in the Thomson Datastream return index.
CF t Cash from operations (#04860) taken from the statement of cash flows in year t,
scaled by MV t −1 .
AR t Change in accounts receivable (−#04825), from the statement of cash flows in year
t, scaled by MV t −1 . If #04825 is missing, then AR t is calculated from balance
sheet data (#02051).
INV t Change in inventory (−#04826), from the statement of cash flows in year t, scaled by
MV t −1 . If #04826 is missing, then INV t is calculated from balance sheet data
(#02101).
AP t Change in accounts payable (#04827), from the statement of cash flows in year t,
scaled by MV t −1 . If #04827 is missing, then AP t is calculated from balance sheet
data (#03040).
DEPR t Depreciation (− #04051), from the statement of cash flows in year t, scaled by
MV t −1 . If #04051 is missing, then DEPR t is (−#01151).
BTM t Book-to-market ratio (#03995/DS MV) in year t.
CF t +1 Cash from operations (#04860) in year t+1, scaled by MV t −1 .
R t+1 Twelve month buy-and-hold return for the accumulation period beginning three
months after the fiscal year-end (e.g., March 31, 2006 to March 30, 2007 for a firm
with a December 31, 2005 fiscal year-end).
WO t SFAS 142 goodwill impairment write-offs (− #18225, manually checked for data
errors) in year t, scaled by MV t −1 .
OTHER t All other net accruals in year t, calculated as E t − (CFt + WOt + ARt + INVt +
APt + DEPRt ).
CF t Change in operating cash flows (#04860 – lag #04860) in year t, scaled by MV t −1 .
LowSize t Dummy variable, coded as 1 if market value of equity at three months after the fiscal
year-end t−1 is less than $75 million dollars, and 0 otherwise.
RES t Dummy variable, coded as 1 if firm is under restructuring during the fiscal year t
(non-zero #18227), and 0 otherwise.
DR t Dummy variable, coded as 1 if R t is negative, and 0 otherwise.
preE t Earnings before goodwill write-off (E t − WOt ).
Loss t −1 Dummy variable, coded as 1 if preE t is negative, and 0 otherwise.
GW% t −1 Beginning-of-period goodwill (#18280) scaled by beginning-of-period total assets
(#02999).
DBTM t −1 Dummy variable, coded as 1 if BTM t −1 is greater than 1, and 0 otherwise.
Size t −1 Natural logarithm of market value of equity at fiscal year-end t−1.

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Do Firms Manage Fair Value Estimates An Examination of SFAS 142 Goodwill Impairments

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Do Firms Manage Fair Value Estimates?

Consequently, there is a continuing debate about whether fair value measurements in

2. BACKGROUND AND HYPOTHESES

(i) Accounting for Goodwill under SFAS 142

CFt+ j = α0 + α1 CFt + α2 WOt + α3 ARt + α4 INVt + α5 APt + α6 DEPRt

CFt+1 = α0 + α1 CFt + α2 WOt + α3 ARt + α4 INVt + α5 APt + α6 DEPRt

4. SAMPLE SELECTION AND DESCRIPTIVE STATISTICS

As shown in Table 1, a total of 16,770 firm-year observations are available on

Observations of MV t −1 , E t , and R t 16,770

(i) Goodwill Impairments

Number of goodwill write-offs 91 78 70 88 327

Business services 73 21.1

Number of firms 227 41 6 274

C Blackwell Publishing Ltd. 2009

R t +1 0.484∗∗∗ 0.213 1.033 0.330 0.170 0.747

Intercept ? 0.020 −0.017 0.053

cash flows the estimated coefficients on WO is positive but statistically insignificant.

(ii) Sensitivity Analyses

(a) Correlation with Shocks to Current Cash Flows

WOt = β0 CFt + β1 Rt + β2 DRt × Rt + β3 Rt−1 + β4 DRt−1 × Rt−1 + εt (3)

(b) Additional Robustness Tests for H 1

0.079∗∗ −0.014 0.134∗∗∗ −0.038 0.363∗∗∗

Intercept 0.004 −0.023 0.058∗

Outliers: The sensitivity of the estimated coefficients to influential observations is

(iii) Cross-Sectional Variation in Predictive Ability of Goodwill Write-Offs

(a) Tests of H 2 and H 3

Intercept ? 0.017 0.025

(b) Endogeneity of Restructuring Dummy

(iv) Firms Avoiding Impairments

(a) Motivations for Impairment Avoidance

(b) Impairment Avoidance Analysis

Impair t = β0 + β1 pr e E t + β2 Loss t + β3 GW%t−1 + β4 BTMt−1 + β5 DBTMt−1 + β6 Size t−1

where Impair t variable is dichotomously coded 1 if a firm reported material impairment

Intercept −5.782 88.785 0.000

For my non-impairment tests, suspect firms are non-impairment firms in which

Size t −1 5.450 5.058 1.756 5.265 5.182 1.992

25 The results remain unchanged with the threshold value 0.25.

A comparison of the impairment and non-impairment samples reveals that

Intercept ? −0.025 0.001

for future research would be to examine cross-country differences in the reliability of

Variable Definition of Variable

Pope, P. F. and M. Walker (1999), ‘International Differences in the Timeliness, Conservatism,

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