goodwill characteristics and impairment

Goodwill: Characteristics and Impairment Abstract The Financial Accounting Standards Board FASB issued two statements in June 2001 related to goodwill: Statement of Financial Accounting

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GOODWILL: CHARACTERISTICS AND IMPAIRMENT

by

Natalie Tatiana Churyk

Bachelor of Science California State University, Long Beach, 1993

Master of Business Administration

California State University, Long Beach, 1997

Submitted in Partial Fulfillment of the Requirements for the Degree of Doctor of Philosophy in

Moore School of Business University of South Carolina

UMI Number: 3036190

Copyright’2001 by

Churyk, Natalie Tatiana

Ali rights reserved

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© Copyright by Natalie Tatiana Churyk, 2001

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ii

To my family

Acknowledgements [ would like to thank Gene Chewning, Maribeth Coller, LeRoy Brooks, McKinley Blackburn, Earl Spiller, and all the other faculty and staff at the University of South Carolina for making this possible

I would like to thank John Lacey for leading me in the direction of a Ph.D I

would like to thank Dr G, Patricia Lynch, and Khosrow Moshirvaziri for keeping my

spirits up throughout the program

I would like to thank Lisa Benaise for being a wonderful friend for the past twelve

years [ would like to thank my classmates Karen Epermanis, Larry Seese, Sue Swanger, Julia Higgs, and Tong Yu for giving their guidance Lastly, I would like to thank everyone at CBC including Doris, Tracey, Paul, Joyce, Jane, and Ruby

Goodwill: Characteristics and Impairment

Abstract

The Financial Accounting Standards Board (FASB) issued two

statements in June 2001 related to goodwill: Statement of Financial Accounting

Standards (SFAS) No 141, Business Combinations and SFAS No 142, Goodwill and

Other Intangible Assets SFAS No 142 requires an annual review for goodwill impairment This review should be conducted more frequently in certain circumstances The circumstances described in SFAS No 142 include a subset of the circumstances

discussed in the Exposure Draft (ED), Business Combinations and Intangible Assets (FASB, 1999) I structure my analysis around the ED discussion in order to provide a

more comprehensive analysis of the items the FASB initially considered to be important This analysis also sheds light on whether the final statement includes relevant concerns and on how it may be implemented in practice

Goodwill has been the subject of research since the early 1900’s, but the focus of

this research has been on how to define, record, and subsequently treat goodwill rather than on the economic determinants of goodwill or how it might become impaired This study will examine these latter two issues pertaining to goodwill

First, | examine the characteristics comprising goodwill by regressing goodwill on

a number of acquired-firm characteristics proposed by the FASB and researchers as

determinants of goodwill This analysis provides evidence on which characteristics are

related to higher premiums paid by purchasing firms Findings indicate that both

statutory-based assets and corporate organizational and financial assets are significantly

positively related to goodwill

Second, I examine the initial overpayment for goodwill due to agency conflict and/or hubris where these are identified by calculating cumulative abnormal returns around the announcement of the merger/acquisition for both the parent and the target Findings indicate that synergy is predominant in the total sample, but that hubris is also present in a subsample To examine the effect that hubris may have on the initial valuation of goodwill, I regress goodwill on its characteristics and a variable representing agency conflict/hubris It is important to determine if goodwill is initially overvalued rather than subsequently impaired, in order to have representationally faithful financial

goodwill is not initially impaired The second model regresses the market value of equity

on the book value of equity, the book value of goodwill, an impairment variable along with interactions, and an abnormal earnings variable Results indicate that neither

goodwill nor future firm earnings are impaired at acquisition Subsequent impairment of

goodwill arises when the parent’s book value of equity is greater than its market value of equity and when the parent’s stock prices decline significantly following the purchase

This is the first study, to my knowledge, that examines events that impair goodwill Balance sheets are not representationally faithful if impaired goodwill is not appropriately written down The failure to write-down impaired goodwill violates

conservative accounting practices Firms can address this problem by implementing impairment evaluation measures

1: Introduction to Characteristics of Goodwill and its Impairment

Table of Contents

Chapter:

Ld Introduction on HH nh nh nh

1.2 Characteristics Comprising GoodwHl

1.3 Impairment of GoodwIll cv " 1.4 Contribution of the Study cu sa 2: Literature Review and Hypotheses Development

2.1 GoodwHll Measurement

2.2 Characteristics Comprising Goodwlll

2.2a Customer-based/market-based assets

2.2b Contract-based assets

2.2c Technology-based assetS -

2.2d Statutory-based assets

2.2e Workforce-based assets

2.2f Corporate organizational and financial assets

2.3 Initial Overpayment for Goodwill and Subsequent Impairment of Recorded Goodwill c su 2.3a Value-relevance of goodwill

2.3b Initial overpayment for goodwil

TA

Page

xi

xIH

10

10

11

15

18

18

20

20

22

24

24 27

Table of Contents — continued

3.1 Sample Selection-Total Sample

3.2 Existence of Synergy, Agency Conflict and/or Hubris

3.2a SampÌe SH n1 nh x

3.2b Model cuc

SVHCFBYV — ˆ QQQQQQQ TQ,

3.3 Characteristics Comprising Goodwill

3.1a SampÌe chu nu nh ng ke

3.4 Initial Overpayment for and Initial Impairment of

Recorded GoodwllÌ co

3.4a SampÌe -Q.Q HH k Agency Conflict/Hubris Sample _

Initial Impairment Sample

Table of Contents -continued

Chapter

Agency Conflict/Hubris Measure to be Included

In the Model

The FASB’s (1999) Impairment Guidelines

3.5 Subsequent Impairment of Goodwill

3.5a Samp̩ HH re

3.5b Model cu

4: Results For Characteristics Comprising Goodwill and Initial Overpayment

for and Subsequent Impairment of Recorded Goodwill —

4.1 Descriptive Statistics and Multicollinearity Diagnostics

4.1a Descriptive Statistics for AlI Models

4.1b Descriptive Statistics Comparing the Parent Sample

to the Population

4.1c Multicollinearity Diagnostics

4.2 Regression Results for Synergy, Agency Conflict and/

Or HubriS HH HH nung 4.3 Regression Results for Characteristics Comprising

GOOdWIÌÏ Q Qua 4.4 Initial Overpayment for and Subsequent Impairment of

Table of Contents -continued Chapter

4.4d Regression results for subsequent impairment using

a levels modelÌ con sec

5: Implications and Conclusions HH vi HH HS KH Hi tin

List of Tables Table

1 Identifiable Intangible Assets as Listed by the FASB in its Exposure Draft

2 Characteristics, Agency Conflict/Hubris and Impairment Potential Samples

3 Characteristics of Goodwill Variables, Compustat Mnemonic, Expected

Sign, and the Hypothesis to Which the Variable Relates

4 Agency/Hubris Hypothesis and Testable FASB Impairment Guidelines

Measures, and Related Hypotheses

5 Descriptive Statistics - Characteristics, Agency Conflict/Hubris,

Initial Inpairment, and Subsecquent Ímpairment

6 Descriptive Statistics Comparing the Sample to the Population

Over the Sample Years 1996 — 1998

7 Pearson (Spearman) Correlations Above (Below) the Diagonal for

Characteristics Comprising GoodwHl

8 Pearson (Spearman) Correlations Above (Below) the Diagonal for

Initial Impairment of GoodwH ”

9 Pearson (Spearman) Correlations Above (Below) the Diagonal for

Subsequent [mpairment of GoodwlÌÏ

10 Agency Conflict/Hubris Regressions of Target Gain on Total Gain

and Target Gain on Parent Gain as a Whole and as Positive and

Negative Subsamples

11 Regression Results for All Characteristics Comprising Goodwill

and Various Subsets of Characteristics Comprising Goodwill

12 Regression Results for All Characteristics Model With Overpayment

for Goodwill and Initial Impairment of Goodwill — 06-

13 Regression Results for Initial Impairment of Goodwill Using a

14 Regression Results Subsequent Impairment Events

Abnormal earnings Abnormal return Total assets Ratio of parent borrowing rate to target borrowing rate Book value of equity

Book value of equity less purchased goodwill

Cash and equivalents

Cash and equivalents Parent carrying value is greater than parent market value

Debt-total Total debt/total equity

Number of employees Goodwill

Geographical location

Goodwill is significant compared to the purchase price Horizontal integration

Intangible assets Intangible assets less goodwill Impairment event in general

Labor expense per employee compared to the industry Ratio of parent debt-to-equity to target debt-to-equity Multiple bidders

Managerial talent — ratio of target sales to industry sales Market value of equity

Parent cumulative abnormal return around purchase is negative Parent gain

Premium paid over target market value before acquisition discussions

Parent used significant amount of parent shares for purchase payment Return

Long-term credit rating compared with parent Research & development

Net sales Stock price decline since purchase of target

S&P senior debt rating Total assets

Target gain Total gain Tax loss carryforward Tax loss carryforward

List of Abbreviations - continued

Chapter |: Introduction to Characteristics of Goodwill and its Impairment

1.1 Introduction

A major focus of prior goodwill research has been on what goodwill represents

For instance, goodwill has been interpreted as representing the value of expected excess

future earnings discounted over a number of years (Walker, 1938; Emery, 1951; Nelson, 1953; Gynther, 1969; Ma and Hopkins, 1988) It also has been interpreted as a measure representing the difference between the fair values of the identifiable assets and the price paid for the firm as a whole (Emery; 1951; Miller, 1973; Colley and Volkan, 1988; Ma

and Hopkins, 1988) Another interpretation views goodwill as representing a momentum

or an initial push comprised of unrecorded characteristics/components such as managerial

skill, economies of scale, and customer relations (Emery, 1951; Nelson, 1953; Barlev,

1973)

Regardless of what goodwill is interpreted as representing, the Financial Accounting Standards Board (FASB) requires goodwill to be measured and recorded as the difference between the payment made for a firm and the fair value of its net

identifiable assets The recorded amount does not explicitly reflect the characteristics comprising goodwill or take into account possible overpayment issues or subsequent

impairment which may render the measurement of goodwill inaccurate This study investigates three issues related to goodwill: (1) characteristics comprising recorded

goodwill, (2) initial overpayment for goodwill, and (3) subsequent impairment of recorded goodwill

Examination of the characteristics comprising goodwill and the initial overpayment for and subsequent impairment of recorded goodwill has several important implications Examining characteristics comprising goodwill will provide insight as to which characteristics compel purchasing firms to pay a premium Producing conservative and repesentationally faithful financial statements are among the many goals

of financial reporting as described by the FASB An understanding of goodwill and its

characteristics can aid in achieving these goals This study provides evidence on the

initial value of goodwill and on firm characteristics or events that signal goodwill

impairment initially and subsequently

1.2 Characteristics Comprising Goodwill

The FASB provided a comprehensive list of intangibles in its Exposure Draft, Business Combinations and Intangible Assets (1999) (hereafter referred to as the ED) More recently, the FASB has updated this list in their Statement of Financial Accounting Standards No 141, Business Combinations (2001) (hereafter referred to SFAS No 141) Both the ED and SFAS No 141 require that individual intangible assets continue to be identified and amortized over their useful lives However, the FASB states that if any

particular intangible asset cannot be measured reliably, it should be included as goodwill

It is possible that these items appear in goodwill because of measurement difficulty or expediency The intangible items listed by the FASB in the ED, and discussed in detail

later, are grouped into six asset-based categories: customer/market-based assets,

contract-based assets, technological-contract-based assets, statutory-contract-based assets, workforce-contract-based assets,

and corporate organizational and financial assets

The accounting literature on goodwill provides a foundation for viewing goodwill

as a composition of certain characteristics, many of which are related to merger motives

The four dominant merger motives cited in the literature are synergy, taxes/leverage, agency, and hubris

In The Momentum Theory of Goodwill, Nelson (1953) describes goodwill as a

momentum — a marketing or promotional push comprised of characteristics such as

customer lists, organization costs, copyrights, trademarks, patents, and franchises

Empirical support for Nelson’s (1953) view of goodwill’s association with certain

characteristics is provided by Chauvin and Hirschey (1994) In addition to finding that goodwill is value relevant, they find that advertising, research and development, and intangible assets are positive and significantly associated with goodwill

Rather than viewing goodwill as being comprised of only certain characteristics

possessed by a firm, Barlev (1973) proposes that mergers provide economic gains (synergy) justifying the premium over market value paid for goodwill by the acquirer The sources of gain are linked with type of merger: horizontal, vertical, or conglomerate

Falk and Gordon (1977) hypothesize and find evidence to support that the synergy

created from mergers, along with several characteristics identified by Nelson (1953) are associated with goodwill Others, including Jensen and Ruback (1983), Weston and Halpern (1983), Bradley, Desai, and Kim (1988), Berkovitch and Narayanan (1993), Maquieira, Megginson, and Nail (1998), and Zhang (1998), also empirically support synergy motives in their studies

Haw, Pastena, and Lilien (1987) find that higher premiums are paid for troubled firms with tax loss carryforwards than for similar firms without carryforwards Similarly, Hayn (1989) examines tax attributes in corporate acquisitions and finds that higher premiums compensate target firm’s shareholders who are faced with an immediate capital gains tax Debt, through interest deductions, results in tax advantages Evidence supports the hypothesis that the tax shields gained through increased leverage are a motive for mergers (Lewellen, 1971; Lintner, 1971; Melnik and Pollatschek, 1973; Scott, 1977; Amihud and Lev, 1981; Walkling and Edmister, 1985; Crawford and Lechner, 1996; Raad, Ryan, and Sinkey, 1999)

To date, empirical studies have examined recorded goodwill in conjunction with the purchaser 's net assets (Chauvin and Hirschey, 1994; McCarthy and Schneider, 1995; Jennings, Robinson, Thompson, and Duvall, 1996; and Vincent, 1997), not the acquired firm’s net assets All find the coefficient on goodwill in levels models to be positive and significantly related to equity market values Chauvin and Hirschey (1994) also empirically examine characteristics comprising goodwill, although they examine the purchasing firm’s characteristics, not the acquired firm’s characteristics [ examine characteristics comprising goodwill by regressing goodwill on characteristics related to the acquired firms

The characteristics | examine are organized around the ED’s categories I

examine vertical integration, horizontal integration, and geographic areas of major lines

of business as representing customer-based/market-based assets Research and

development expenditures are used to proxy for technology-based assets Intangibles other than goodwill represent statutory-based assets Managerial talent proxies for

workforce-based assets Cash reserves, tax loss carryforward benefits, borrowing rates,

and debt-to-equity ratios proxy for corporate organizational and financial assets

My results indicate that both statutory-based assets and corporate organizational and financial assets are significantly positively related to goodwill when all characteristics are included in the model Other assets become significantly positively

related to goodwill when subsets of the characteristics are examined This result could be due to the larger sample sizes in the subsets of characteristics or because the variable is picking up the effects of the variables not included More data are needed to determine which of these explains this result

1.3 Impairment of Goodwill

Under current accounting standards, initial goodwill is recorded when purchased

Goodwill may not be highly correlated with the characteristics cited above if the purchase

is the result of agency conflict, hubris, and/or other causes resulting in overpayment The agency motive for mergers states that managers act in their self-interest to the detriment

of stockholders For example, managers may purchase targets to diversify their holdings (Amihud and Lev, 1981), to create attractive promotion opportunities for junior managers (Donaldson, 1984), or to contribute to long-term growth of the firm (Morck, Shleifer, and Vishny, 1990) The desire by managers to pursue personal gain can result in overpayment for a target

Having a similar effect as the agency conflict but without the intent, Roll’s (1986) hubris hypothesis, supported by Morck et al (1990), Berkovitch and Narayanan (1993),

and Zhang (1998), implies that managers make mistakes in initially valuing a target

resulting in overpayment for that target Additional events contributing to initial overpayment can result from the desire to gain control of the target (Weston and Halpern, 1983) or by paying for the target with the acquirer’s stock (as pointed out by Myers and Majluf, 1984) Meyers and Majluf argue that managers use their own stock to pay for targets when they believe their firms are overvalued

Because hubris is found to exist in my sample, I examine initial overpayment for goodwill by including a measure (using cumulative abnormal returns) capturing agency

conflict/hubris directly in the model regressing goodwill on its characteristics I expect

the agency/hubris variable to be positively related to goodwill if the acquisitions were, on

average, the result of agency conflict/hubris Findings do not support this However, this could be due to the small sample size

To address the initial overpayment and subsequent impairment issues, the FASB

requires an annual review for overstatement of purchased goodwill or more frequently when certain events are present Unlike SFAS No 142, Goodwill and Other Intangible

Assets (FASB, 2001) (hereafter referred to as SFAS No 142), the ED lists events that potentially signal a review for initial overpayment of goodwill These events include: 1)

the purchaser paid a significant premium over the market value of the acquired firm

where market value is measured prior to the start of acquisition discussions, 2) the acquisition involved a bidding or auction process, 3) the amount of recorded goodwill is

significant compared to the total acquisition price, and/or 4) most of the consideration paid is in the form of shares of the acquiring firm

In the absence of such initial events, the ED events requiring impairment review

in subsequent years include: 1) the carrying amount of net assets is greater than the