Evidence on the Effects of Unverifiable Fair-Value Accounting

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Evidence on the Effects of Unverifiable Fair-Value Accounting*

Karthik Ramanna Harvard Business School kramanna@hbs.edu and Ross L. Watts MIT Sloan School of Management rwatts@mit.edu

This draft: August 17, 2007

Abstract SFAS 142 requires firms to use fair-value estimates to determine goodwill impairments. Watts (2003) and Ramanna (2007) argue the unverifiable nature of those fair-value estimates gives firms discretion to manage impairments. We test this in a sample of firms with market indications of impairment (firms with book goodwill and market-to-book ratio below one). We find that the frequency of non-impairment is this sample is about 71%, and that non-impairment is increasing in financial characteristics predicted to be associated with greater unverifiable fair-value-based discretion. To investigate whether non-impairment is associated with managers producing on average better estimates of goodwill than the market, we test whether non-impairment increases in industries with higher average information asymmetries. We fail to find evidence consistent with this proposition.


We thank William Hetzler for research assistance.

1. Introduction Fair-value accounting values assets and liabilities at estimates of their current values. When those estimates are based on observable prices from active markets, they are verifiable and less susceptible to opportunistic use. However, some recent FASB standards require managers to estimate the values of assets and liabilities that have no or thinly traded markets. Since these estimates are not disciplined by arms-length transactions, they are unverifiable. Agency theory predicts managers will use this unverifiability to opportunistically manage financial reports. Thus, we expect recent FASB standards relying on unverifiable fair-value estimates to either increase the management of financial statements or increase the agency costs of monitoring managers. In this paper, we investigate managers’ implementation of a recent and prominent fair-value-based accounting standard: SFAS 142, accounting for acquired goodwill (FASB 2001). Watts (2003) and Ramanna (2007) argue that SFAS 142’s use of subjective estimates in calculating goodwill impairment gives firms discretion to manage financial statements. Ramanna (2007) identifies firm financial characteristics associated with this discretion. In this paper, we find evidence that firms with these financial characteristics are more likely to avoid goodwill impairment in situations where market prices imply goodwill is impaired.1 We identify situations with market indications of goodwill impairment by using the time-series of firms’ market-to-book ratios (MTB): firms with book goodwill that experience MTB declines from above one to below one are considered likely to have

Throughout the paper, we assume that managers are responsible for firm decisions: if managers’ incentives are not perfectly aligned with those of shareholders, firm decisions will reflect managers’ interests. 1


impaired goodwill (MTB is calculated before the effect of any impairment and negative book-value firms are excluded). When a firm’s market value falls below its book value (MTB < 1), there is an overstatement in book value. If the firm has goodwill on its books, it is reasonable to assume that at least some of the book-value overstatement is in goodwill. The sample in this paper begins in 2003. SFAS 142 was issued in late 2001, but for most firms, 2002 was a year for transitioning to the new goodwill accounting rules. A firm enters our sample if it meets our above definition of having market indications of goodwill impairment. If the firm records goodwill impairment in this year, the impairment is considered “timely.” If, in the following year, the firm’s MTB continues to remain below one, the firm is retained in the sample, and impairments in this subsequent year, if any, are considered “untimely.” In our sample of firms with market...
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