SFAS 142 provides one exception to the annual testing rule: According to SFAS 142.27, the determination of reporting unit fair value can be carried forward from the previous goodwill impairment test under certain circumstances: First, the assets and liabilities that comprise the reporting unit "have not changed significantly" since reporting unit fair value was last determined. 950 Recent significant acquisitions or reorganizations of the segment reporting structure are given as examples of events that might lead to such a significant change. However, since only these two examples are given, management will possibly be justified in arguing that this first criterion is met whenever major acquisitions or reorganizations have not recently occurred. Further, the Board let it suffice to state that these events "might" significantly change a reporting unit's composition. This implies that there is elbowroom for management to argue that, under specific circumstances, a reporting unit has remained unchanged although a major acquisition and/or reorganiza-

947 See SFAS 142.58.

948 It could be argued that, given an infinite forecasting period, the date at which reporting unit fair vale is measured does not make a difference. However, in practice forecasting periods are usually shorter and terminal value is not necessarily defined as a perpetuity. Also, where reporting unit fair value is not measured as the present value of future cash flows, the timing of the measurement is likely to be relevant.

949 Refer to section <IP_ADDRESS> above.

*950*See SF AS 142.27 lit a.

tion has recently taken place. Aided by such reasoning, management might be able to sidestep the testing requirement altogether in some years.

Second, when reporting unit fair value was determined in detail last time, it exceeded the reporting unit's carrying amount (including the carrying amount of the reporting unit's goodwill) "by a substantial margin".951 It is not at all clear what constitutes a *substantial*  margin. Given the potential sensitivity of reporting unit fair value, determined based on either quoted market price or some valuation method,952 to changes in circumstances or valuation assumptions, it is likely that even a relatively large difference between reporting unit fair value and reporting unit carrying value may erode within a year's time.

Therefore, the third criterion requires that an analysis of events and changes in circumstances since the last determination of reporting unit fair value be conducted. Based on this analysis, the likelihood that the current reporting unit fair value is less than the carrying amount must be *remote.* According to SFAS 5, *Accounting for Contingencies,* the term "remote" implies that the "chance of the future event or events occurring is slight." 953 Application of this criterion inherently calls for management's subjective judgment regarding the occurrence probability of some event.954

In summary, SFAS 142.27 gives management the option to avoid the annual goodwill impairment test. The condition is that management successfully argues that there is no evidence to suggest that reporting unit fair value has declined below carrying amount since the last time both were determined and compared with each other. If so inclined, management can assert a certain minimum reporting unit fair value without actually measuring it, provided that three criteria are met. These criteria rely heavily on illspecified terms such as "significant", "substantial", and "remote". While *remote* is arguably the most clear-cut of these terms, a great deal of discretion remains when management is required to apply it to real-life circumstances in order to make a likelihood assessment. This is even truer for the other two expressions, as is discussed in more detail below.

951 SFAS 142.27 lit b.

952 Refer to section 4.5.1.

953 SFAS 5.3 lit. c. See also SFAS 90, *Regulated Enterprises-Accounting for Abandonments and Disal- /owances of Plant Costs-an amendment of F ASB Statement No.* 7 *I,* par. 9 lit. a, SF AS 114, *Accounting by Creditors/or Impairment of a Loan,* par. 10, and SFAS 133.464.

954 For a fundamental discussion of the use of probability assessments in financial reporting, albeit in an !AS context, refer to LUdenbach and Hoffmann (2003).

### 4.3.2 Unscheduled testing when circumstances warrant

Since a fixed test date each reporting period might preclude timely reporting when economic circumstances change, SF AS 142.28 provides a non-exhaustive list of impairment indicators:955 These events and changes in circumstances that would *more likely than not*  reduce reporting unit fair value below its carrying amount trigger additional impairment tests.956 As shown below, most of these indicators are inherently subjective, in effect providing management with the opportunity to either actively seek or avoid additional, unscheduled impairment tests, depending on the financial reporting strategy pursued.

The first indicator is a "significant adverse change in legal factors or in the business climate". 957 The term "significant" is not defined in the context of SF AS 142. Thus, various perceptions are likely to exist regarding exactly what constitutes that type of event.958 The term "significant", in contrast to the admittedly vague but well-understood financial accounting concept of materiality, *959* is used throughout the F ASB' s statements in a rather casual and not strictly defined manner. Two examples will demonstrate this: A reference to the term "significant" under U. S. GAAP is found in APB Opinion 18.17. The equity method of accounting is to be applied to an investment that gives the investor "the ability to exercise significant influence over operating and financial policies of an investee". The Board recognized that "determining the ability of an investor to exercise such influence is not always clear and applying judgment is necessary". Therefore, it established the rebuttable presumption that significant influence can be exercised when the investor controls between 20 and 50% of the investee's voting stock. Another reference to the term "significant" is found in SFAS 95, *Statement of Cash Flows,* where certain "significant noncash transactions" are to be omitted from the body of the statement and instead disclosed in the notes. 960 Existing does not provide sufficient guidance to strip the term "significant" of excessive subjectivity. 961

*955*See SFAS 142.B138.

956 Unscheduled impairment tests are also required in the period of initial application (SF AS 142.57).

957 SF AS 142.28 lit a.

958 Likewise, it is not clear how large a "portion of a reporting unit" or an "asset group within a reporting unit" must be in order to be deemed significant in the context of SF AS 142.28 lit. e and f, and by what criteria the size of a reporting unit is to be measured.

*959*Refer to SFAC 2.123-132. See also Pe liens (200 I, p. 142).

960See SFAS 95.32 and Kieso, Weygandt and Warfield (2001, pp. 1336-7).

961  It is not discussed whether the tenns "significant" and "material" are equivalent, which would imply that, in SF AS I 42.28 lit. a, an adverse change in legal factors or in the business climate is significant when "the judgment of a reasonable person" regarding the fair value of the reporting unit in question "would have been changed or influenced" by the knowledge of it (SF AC 2, Glossary).

According to SF AS 142.28 lit. e, a "more-likely-than-not expectation" that a (significant portion of a) reporting unit will be disposed of triggers an unscheduled impairment test. According to SFAS 109, *Accounting for Income Taxes,* the term *more likely than not*  implies "a likelihood of more than 50 percent". 962 Although this definition seems, at first sight, to imply a relatively fixed cut-off point, the criterion is very open to management preferences since the likelihood of disposal is primarily determined by management's intent. Furthermore, deciding whether some future event is more likely than not to occur is much vaguer than applying criteria such as "remote"963 that lean towards one end of the likelihood range. A clear judgment is only possible where the likelihood is either very small or very large, and a gray area exists in the center of the range.

Equally subjective are the following questions, to name but a few: When is competition "unexpected"?964 What constitutes "key" personnel?965 These questions cannot be answered without intimate knowledge of a company's business, and decisions based on them are therefore inherently difficult to verify. They demonstrate that management has the opportunity to exploit the information asymmetry that exists in its favor in judging whether or not an unscheduled impairment test is called for.

The two secondary criteria in SFAS 142.28 lit. f and g require an unscheduled impairment test under the condition that other financial reporting events have occurred elsewhere within the reporting entity. These criteria shift the discretion to the decision makers responsible for determining whether or not a significant asset group within a reporting unit is tested for impairment under SF AS 144966 or a goodwill impairment loss is recognized in the separate financial statements of a subsidiary that is a component of a reporting unit. SF AS 144 contains a high degree of management flexibility in its own right, which, by this mechanism, is perpetuated for the purpose of applying SF AS 142.28 lit. f.

An unscheduled impairment test is only required when it is *more likely than not* that reporting unit fair value is reduced below its carrying amount because of the presence of one or more impairment indicators. The wording in SFAS 142.28 is somewhat ambigu-

962 SFAS 109.17 lit. e, 97.

963 SFAS 5.3 lit. c: *"Remote.* The chance of the future event or events occurring is slight." (Emphasis **in**  original.)

964 SFAS 142.28 lit. c.

965 SFAS 142.28 lit. d.

966 SFAS 144 superseded SFAS 121 for fiscal years beginning **after** December 15, 2001.

ous,967 and allows different interpretations: First, one alternative is that the presence of any one of these indicators *in itself* is sufficient to assume that reporting unit fair value is more likely than not reduced below its carrying amount. Stated differently, under the first interpretation, the tenn "impainnent indicator" means an event or change in circumstances that more likely than not reduces reporting unit fair value below its carrying amount. In that case, discretion does not go beyond that already described above. Impairment indicators would trigger an unscheduled impairment test regardless of how high reporting unit fair value was *before* the impairment indicator occurred.

Second, another reading would imply that management is not only required to determine whether these indicators are present, but also to judge the extent to which their presence is likely to influence reporting unit fair value. This interpretation suggests that an "impairment indicator" is an event or change in circumstances that might or might not be more likely than not to reduce reporting unit fair value below its carrying amount. The discretion inherent in the "more-likely-than-not" condition, which is invoked again here, has been discussed above. Determining the likelihood of a reduction of reporting unit fair value below its carrying amount also requires some preconception regarding how high reporting unit fair value was before the event or change in circumstances occurred. The obligation to conduct unscheduled impairment tests would mainly hinge on management's estimate of reporting unit fair value *before* that value had actually been measured.968 This "second-guessing" about the likelihood of impairment has been a powerful argument against an "events-and-circumstances approach" to goodwill impairment testing, under which impairment tests would not have been required annually but only in the presence of impainnent indicators. 969

Since the list contained in SFAS 142.28 is non-exhaustive, management is free to find additional impairment indicators that it thinks are more likely than not to have reduced reporting unit fair value below its carrying amount. To the extent that timely/accelerated recognition of goodwill impairment losses is consistent with management's financial reporting strategy, management has incentive to adduce events and circumstances other than those listed as impairment indicators. Overall, while some discretion exists in the context of impairment indicators, the effect of this discretion on goodwill write-off be-

967 SFAS 142.28: "Goodwill ofa reporting unit shall be tested for impairment between annual tests ifan event occurs or circumstances change that would more likely than not reduce the fair value of a reporting unit below its carrying amount. Examples of *such* events or circumstances include ... " (emphasis added).

968 The problem is similar to that discussed in section 4.3.1 .2.

969 See SFAS 142.8140.

havior is not very severe since SFAS 142.26 ensures that impairment tests are conducted annually, regardless of the presence of impairment indicators. The discretion inherent in the frequency provisions can mainly be exploited to accelerate goodwill impairment losses, if desired. The notable exception is the provision in SFAS 142.27, which enables management to avoid the goodwill impairment test altogether when certain criteria are met.

### *4. 4 Level of aggregation*

The level of aggregation on which goodwill impairment tests are conducted allows management to influence the likelihood that any goodwill impairment will be detected in step one of the impairment test. According to SFAS 142.18, goodwill shall be tested for impairment at a level of reporting referred to as a *reporting unit.* As shown in Figure 12 and explained in more detail below, a reporting unit is either an operating segment according to par. IO of SF AS 131, *Disclosures about Segments of an Enterprise and Related Information,* or a component, i.e. one level below an operating segment.970

**Figure 12: Defining reporting units**

SF AS 131 .10 defines an operating segment as a component of an enterprise that engages in business activities from which it may earn revenues and incur expenses, whose operating results are regularly reviewed by the enterprise's chief operating decision maker to decide about resource allocation and performance assessment, and for which separate financial information is available. 971 Under this so-called "management approach", 972

970See SFAS 142.30. See also Hitz and Kuhner (2002, pp. 275-6), Kilting, Weber and Wirth (2001, p. 186), and LUdenbach and Frowein (2003, pp. 218-9).

971For an analysis of SF AS 131, refer to Williams (2002, ch. 43).

firms rely for external financial reporting purposes on data generated and used in the context of their internal control and reporting structures.973 A firm's organizational and financial reporting decisions are likely to be jointly determined and influenced by management's incentives as well as considerations of organizational efficiency. 974 Therefore, while the management approach to defining operating segments (and, therefore, reporting units) gives management considerable discretion, it is unlikely that earnings management incentives will be the only or even the most influential determinant of a firm's organizational set-up. Stated differently, management will establish and maintain an organizational set-up that maximizes the utility derived from earnings management, efficiency, and other incentives.

Under certain circumstances, firms are required to use *components,* i.e. organizational units below the operating segment level, as reporting units. "A component of an operating segment is a reporting unit if the component constitutes a *business* for which discrete financial information is available and segment management regularly reviews the operating results of that component. *"975* The definition of "business" is contained in EITF Issue 98-03, *Determining Whether a Nonmonetary Transaction Involves Receipt of Productive Assets or of a Business:* "A business is a self-sustaining integrated set of activities and assets conducted and managed for the purpose of providing a return to investors. A business consists of(a) inputs, (b) processes applied to those inputs, and (c) resulting outputs that are used to generate revenues. "976 As a result, whenever an operating segment consists of several distinct smaller units that amount to separate businesses and are reviewed on a regular basis by one or more segment managers,977 these components are to be used as reporting units for the purpose of applying SFS 142.

972 This term was coined by the FASB in SFAS 13 I. According to par. 4, the "management approach is based on the way that management organizes the segments within the enterprise for making operating decisions and assessing perfonnance." In contrast to prescribing the exact nature and extent of disclosures, the Board gives management what it intends to be a cost-effective and timely opportunity to disclose the "information that an enterprise's decision makers use to make decisions about the enterprise's operating matters" (SFAS 131.5).

973  For a discussion in the context of SF AS 142, see also Hitz and Kuhner (2002, **p.** 276), LUdenbach and Frowein (2003, pp. 218-9), and Nestler and Thuy (2002, pp. 170-1 ).

974 Refer to section 3.3 .2.3.6 above.

975 SFAS 142.30 (emphasis added).

976 EITF Issue 98-03 .6. Further guidance is provided on the definitions of inputs, processes, and outputs.

977 According to SF AS 131.14, a *segment manager* is "directly accountable to and maintains regular contact with the chief operating decision maker to discuss operating activities, financial results, forecasts, or plans for the segment. The term segment manager identifies a function, not necessarily a manager with a specific title."

This guidance is another example of a rigorous management approach, because it implies that firms are not required to allocate goodwill to components below the operating segment level when either no discrete financial information is available for them or their operating results are not reviewed on a regular basis by senior executives who fit the definition of "segment management". In other words, the guidance suggests that firms with inappropriate internal reporting systems and/or neglectful management are spared the potentially costly requirement of breaking down their operating segments into components. They are apparently not required to generate and review component data for application of SF AS 142 unless they are already doing so for internal control purposes.

SFAS 142.30 states an exception to the above rule: Two or more components are to be aggregated to a single reporting unit if they have *similar economic characteristics.* In detennining whether several components have similar economic characteristics, firms are referred to the "aggregation criteria" given in SF AS 131.17 for defining reportable segments. However, this guidance is rather unclear about what constitutes similar economic characteristics. The criteria listed in SF AS 131 .17978 cannot be meant as indicators of economic similarity since their presence is required *over and above* the similar economic characteristics of the reporting segments. 979 Also, similar performance and margin measures across segments are not necessarily indicators, but may or may not be *results* of several segments' similar economic characteristics.980 Overall, since the guidance on similar economic characteristics provided in SF AS 142.30 and, by reference, in SF AS 131.17, is rather vague, it is at management's discretion whether components of operating segments are aggregated to form a larger reporting unit.

This subjectivity has fundamental implications for the likelihood of impairment being found. The higher the level of aggregation at which reporting units are formed, the larger is the probability that a goodwill value decrease in one sub-set of a reporting unit is com-

978 The list includes criteria such as the nature of the products, services, and of the production process, customer types, and distribution methods.

979 SF AS 131.17: "Two or more operating segments may be aggregated into a single operating segment if aggregation is consistent with the objective and basic principles of this Statement, if the segments have similar economic characteristics, *and* if the segments are similar in each of the following areas: [ ... ]" ( emphasis added).

980 SF AS 131.17: "For example, similar long-term average gross margins for two operating segments would be expected if their economic characteristics were similar."

pensated by an increase in the value of (internally generated) goodwill in another.981 Therefore, the level at which an entity initially defines its reporting units detennines to a large extent the likelihood of goodwill write-offs occurring in later periods. 982 This conclusion is also reached by Henning, Shaw and Stock (2002), who state that "a narrower unit of analysis is likely to reduce managerial discretion, resulting in more impairment. "983 Depending on management's financial reporting strategy, incentives might exist to avoid/delay/understate any transitional SFAS 142 goodwill write-offs. In this case, management would have incentive to argue, for example, that any components existing below the reporting segment level either do not constitute businesses or have similar economic characteristics. Overall, the guidance on defining reporting units is very discretionary, owing in part to the rigorous implementation of the management approach.

### *4. 5 Existence*

The first step of the goodwill impainnent test is designed to detennine whether impairment is present *at all.* According to SFAS 142.19, the fair value of a reporting unit is compared with its carrying amount, including goodwill. It is only when the carrying amount exceeds the fair value that the second test step is to be perfonned because, in that event, impainnent is assumed to exist. Consequently, the main discretionary elements inherent in the testing procedure itself relate, first, to detennining reporting unit fair value and, second, to assigning the carrying amounts of assets, liabilities, and goodwill to reporting units.984

981 SFAS 142.B86 states that "the higher the level of review, the more difficult it would be to develop a robust impairment test". Osterland (2002) points out that "large companies with multiple business units and little existing (purchased] goodwill have an advantage over smaller companies in the acquisition market." The impact of aggregation on measuring impairment is also discussed in Braun, Rohan and Yospe's (1991) article on the FASB's standard-setting process preceding SFAS 121. See also Kahle (2002b, p. 902), Kilting, Weber and Wirth (2001, p. 192), Pfeil and Yater (2002c, p. 262), and Pfeil and Yater (2002a, p. 71).

982 SFAS 142.B84-7. For a numerical example, refer to Pellens and Sellhorn (2001a, pp. 1685-6). Braun, Rohan and Yospe ( 1991 , p. 68) conclude that "the manner in which assets are grouped can have a dramatic impact on the writeoffamount ofan asset impairment."

983 Henning, Shaw and Stock (2002, p. 7).

984 Special problems arise where portions of reporting units are disposed of and where reporting units include subsidiaries that are not wholly owned by the reporting entity. These latter problems of impairment testing in the presence of non-controlling (minority) interests are not discussed in detail. Instead, refer to SFAS 142.38, Pellens and Sellhorn (2003), Kilting, Weber and Wirth (2001 , p. 192), and Ltidenbach and Frowein (2003, pp. 221-2).

### 4.5.1 Reporting unit fair value

According to SFAS 142.19, the guidance in SFAS 142.23-25 is relevant in determining reporting unit fair value. 985 The concept of fair value is applied in SFAS 142.23 to reporting units using a quote from the glossary of SFAC 7, *Using Cash Flow Information and Present Value in Accounting Measurements,* which defines fair value of an asset or liability as the "amount at which that asset (or liability) could be bought (or incurred) or sold ( or settled) in a current transaction between willing parties, that is, other than in a forced or liquidation sale."986

SFAS 142.23-25 establish a fair value hierarchy applicable to reporting units:

Subjective elements inherent in these fair value measurements are discussed in the following sections.

985 As has been discussed at length in section <IP_ADDRESS> above, reporting unit fair value can be carried over from the previous goodwill impairment test when certain criteria are met (SF AS 142.27).

986 Stated differently, fair value can be characterized as a present value measurement that attempts to "capture the elements that taken together would comprise a market price if one existed" (SFAC 7.25). In German terms, the concept of fair value is closest to the measurement construct of "beizulegender Zeitwert". See, for example, German Accounting Standard (GAS) 4.7: "Betrag, zu dem im Bewertungszeitpunkt zwischen geschliftsbereiten und sachverstlindigen Geschliftspartnem ein VermOgenswert ausgetauscht oder eine Schuld beglichen werden kann."

987 SFAS 142.23 (emphasis added).

988 SFAS 142.24 (emphasis added).

989 SFAS 142.25 (emphasis added).

#### **<IP_ADDRESS> Quoted market prices**

Where equity securities of a reporting unit are publicly traded, quoted market prices are the preferable measure of reporting unit fair value.990 However, since in most cases only a relatively small portion of a given reporting unit's equity is publicly traded,991 proportionally extrapolating the reporting unit's market capitalization may not be a good indicator of the reporting unit's overall fair value.992 The Board acknowledges that this notion seems to contradict SF AS 115, *Accounting for Certain Investments in Debt and Equity Securities,* and SFAS 133, *Accounting for Derivative Instruments and Hedging Activities,*  according to which fair value is the product of the number of trading units times market price per trading unit. 993

However, the Board argues that due to the existence of a *control premium,994* the quoted market price of, for example, 30% of a reporting unit's stock may be significantly less than 30% of its fair value as a whole.995 An acquirer of a controlling 70% stake in a reporting unit may be willing to pay more than 70% of the reporting unit's overall fair value, since the ability to exercise control996 over the operations of the reporting unit may be of substantial value to the acquirer,997 for example because it could give rise to synergies between the acquirer's and the reporting unit's operations.998

By allowing finns to deviate from quoted market prices when detennining reporting unit fair value even where those prices are available, the FASB prefers (allegedly) relevant measures of fair value over reliable, verifiable ones.999 This decision results in consider-

990 For a discussion of the role of quoted market prices in company valuation, refer to Bocking and Nowak (2000).

991 A reporting unit, as defined in SFAS 142 (refer to section 4.4 above), does not necessarily constitute a separate legal entity.

992 See SFAS 142.23.

993 See SFAS 142.B154. Refer also to SFAS 133.540 (glossary), 534 lit j. (amendment of SFAS 115.137).

994 See, for example, KUting and Leinen (2002, p. 1203). For an empirical approach to estimating such premiums, refer to Henning, Lewis and Shaw (2000).

99s See also Hitz and Kuhner (2002, p. 278).

996 See SFAS 94, *Consolidation of All Majority-owned Subsidiaries,* par. 13.

997 See, for example, von Wysocki and Wohlgemuth (I 996, p. 124).

998 See SFAS 142.23 fn. 16.

999 See SFAC 7.17, 73 . Even where quoted market prices for reporting unit are available and deemed to be relevant, it is unclear whether valuation should be based on stock price at some *point* in time or on an average price measured over a certain *period.* See, for example, Nestler and Thuy (2002, p. 173) with further references.

able room for management judgment and argumentation. As will be discussed next, the following stages in the fair value hierarchy are increasingly subjective. 1000

#### **<IP_ADDRESS> Present value techniques**

#### *<IP_ADDRESS>.J Measuring/air value as the objective*

Where quoted market prices are either unavailable or deemed inappropriate for measuring reporting unit fair value, SFAS 142.24 requires firms to revert to valuation methods. 1001 Preference is given to present value techniques, as long as the cash flow estimates used are consistent with the objective of measuring fair value. 1002 SF AS 142.24 includes structural guidance from SF AC 7 for measuring present values. 1003 It is required that a present value measurement consistent with determining fair value incorporates the following elements:

In order to be consistent with the objective of measuring fair value and thereby achieve some degree of objectivity and verifiability, cash flow estimates are to include assump-

1000 This circumstance was deplored by some of the respondents to the FASB's revised exposure draft *Business Combinations and Intangible Assets* - *Accounting/or Goodwill.* See SF AS 142.B 151.

1001 The terms *measurement technique* and *valuation method* are considered to be synonymous. The application of methods of company valuation to the SFAS 142 impairment-only approach is discussed at length in AAA's Financial Accounting Standards Committee (2001), Frowein and LUdenbach (2003), L0denbach and Schulz (2002), Mard et al. (2002), Mercer Capital (2001), Nestler and Thuy (2002), Richter (2004, ch. 6) and Schultze (2003).

1002 See also SFAC 7.25.

1001 See, for example, Hitz and Kuhner (2000) and Starbatty (2001). Also, refer to the FASB's four-article "Understanding the Issues" series on SFAC 7, available at www.fasb.org. /articles&reports.

1004 See SFAC 7.23, 39. See also Hitz and Kuhner (2002, p. 278).

tions that *marketplace participants* would use in their estimates of fair value. 1005 This requirement to use third-party assumptions represents an attempt to limit management's financial reporting discretion by enhancing the degree of both reliability and relevance of the fair value measures generated. It has the effect that synergies among different reporting units are not part of the fair value measurements. 1006

However, where these assumptions are not available without undue cost and effort, management may use *its own* assumptions, as long as they are "reasonable and supportable" and "all available evidence" is considered. 1007 The conditions under which costs and efforts of obtaining information on market participants' assumptions can be regarded as "undue" are somewhat vague. In effect, managers may use their own estimates, as long as there is no information indicating that marketplace participants would use different assumptions. If such information exists, management must adjust its assumptions to incorporate that market information. 1008 According to SF AC 7 .38, the objective of measuring fair value is not violated under these circumstances. Interestingly, SFAC 7 24 lit. b indicates that a measurement based on management's own estimates, expectations and other assumptions, as opposed to those of market-place participants, is not strictly a fair value measurement. It is in fact referred to as a *value-in-use* or *entity-specific value.*

This discussion indicates that the borders between different types of measurements, each having different measurement objectives, 1009 are fairly indistinct. It is doubtful that the guidance given in SFAS 142.24 will ensure that market-based assumptions are consistently used in measuring reporting unit fair value and, thereby, that the resulting measures can be characterized as fair values in the sense of SFAC 7. In summary, whereas the F ASB, via SF AC 7, prescribes the elements and variables to be considered when using present value techniques for measuring fair value, it is left entirely up to management

1005SFAC 7.24 lit. a explicitly states that a fair value measurement captures all of the five elements listed in SFAC 7.23, using the estimates and expectations of marketplace participants rather than those of management.

1006See Hitz and Kuhner (2002, pp. 280-1), Hommel (2001 b, p. 1946), Kahle (2002a, p. 854), KUting, Weber and Wirth (2001, p. 189), and Nestler and Thuy (2002, p. 177).

1007SFAS 142.24 (both quotes).

1008See SFAS 142.B155.

1009As noted in SFAC 7.24 lit. b fn. 4, the "entity-specific value ... can be characterized as the amount at which independent willing parties that share the same information and ability to generate the entity's estimated cash flows would agree to a transaction that exchanges the estimated future cash flows for a current amount." This definition is quite different from that of fair value, which is given in the glossary to SFAC 7 (see quote above).

exactly what parameter values it chooses to assign to those variables. 1010 Projecting uncertain future cash flows, earnings, or other input data and choosing appropriate discount rates is a difficult task even for those attempting to generate unbiased results. In effect, management is safe in using business plans based almost entirely on its own assumption regarding the five elements listed above.

#### *<IP_ADDRESS>.2 Measurement techniques*

SFAS 142.24 gives firms considerable discretion regarding their choice of valuation method, as long as the approach used is consistent with the objective of measuring fair value. Two different approaches to computing present value are explicitly referred to in SF AC 7.40: When the preferred *expected cash flow approach* is used, the discount rate is intended to capture only the time value of money. Therefore, a risk-free interest rate is applied and cash flows are included at their expected values to incorporate uncertainty and risk. Under the *traditional approach,* the discount rate captures all uncertainty surrounding future cash flows, including a risk premium, whereas cash flows are not adjusted for any of these elements.'° 11 While the guidance in SF AS 142 implies that the equity variant of the discounted-cash-flow (DCF) method be used, 1012 it is argued that both the entity *and* equity approaches can accommodate the standard's requirements. 1013

However, applicable techniques are not limited to DCF methods. During the standardsetting deliberations, the Board also considered approaches based on market capitalization, residual income, and performance measures such as cash-flow return on investment

1010 See SFAS 142.Bl53 . A different approach is pursued in the British FRS 11, *Impairment of Fixed Assets and Goodwill,* which provides concrete guidance on estimating cash flows, e.g. growth rate assumptions. The F ASB decided against this approach based on the argument that such guidance could interfere with the objective of measuring fair value, since cash flows used to measure fair value should be estimated according to the management approach, i.e. based on "the most recent budgets and plans approved by management". However, the Board did indicate that "some consideration should be given to industry trends" (SFAS 142.Bl52 [both quotes]).

1011 Under German terminology, the first approach is referred to as the "Sicherheitsllquivalenzmethode", whereas the second method corresponds to the German "Risikozuschlagsmethode". For an introduction to these concepts, refer to Mandi and Rabel (1997, pp. 218-22, 226-35, respectively) and the cited literature. See also Starbatty (200 I, p. 545).

1012 The equity and entity variants of the DCF method are discussed in Hachmeister (2000, pp. 118-23), Hachmeister (1996) and Mandi and Rabel (1997, pp. 37-43). For a brief overview of valuation methods that are potentially consistent with the requirements of SF AS 142, refer to Nestler and Thuy (2002, pp. 172-9).

1013 See, for example, Lildenbach and Frowein (2003, p. 222).

(CFROI) and economic value added (EVA), 1014all of which were deemed to be consistent with the objective of measuring reporting unit fair value. According to the Board's credo, "entities should be permitted to use a valuation method with which they are familiar, providing that the result is consistent with the objective of fair value", 1015 and SFAS 142 was intended to "allow preparers latitude in applying that objective to their specific circumstances based on the guidance in Concepts Statement 7." 1016 It appears clear that encouraging firms to apply virtually any present value-based valuation technique imaginable to their own estimates, expectations, and assumptions, guided only by the sketchy catch-all reference in SF AC 7 to the objective of fair value measurement, is likely to make "reporting unit fair value" an extremely discretionary variable.

The AAA's Financial Accounting Standards Committee (2001) concludes that most techniques permitted under SFAS 142.24 are compromised by incorrect forecasts of future cash flows and are susceptible to other weaknesses like the inappropriate specification of discount rates and terminal values. Regardless of the concrete model used, the valuation process relies heavily on management's expectations about future developments and events. Detailed specification of acceptable methodology and abstract valuation model structure cannot constrain management from exercising substantial discretion when determining what values to assign to the prescribed parameters. Furthermore, even where management acts in all conscience, attempting to estimate reporting unit fair value to the best of its knowledge, the problems associated with estimating uncertain future cash flows and cost of capital are, in itself, severe. This abundance of subjectivity, combined with uncertainty, makes the resulting estimates open to criticism with regard to both relevance and reliability. The F ASB is aware of these caveats but deliberately decided against providing more guidance. 1017

It is doubtful that the requirement to incorporate marketplace participants' assumptions is sufficient eliminate much of the inherent judgment. For reporting unit fair value to represent "the amount at which the unit as a whole could be bought or sold in a current transaction between willing parties", 1018 the only relevant assumptions would be those of management and potential buyers. For reporting units whose disposal is not imminent,

1014 For a description of some of these methods and their appropriateness in the context of goodwill impairment testing, refer to AAA's Financial Accounting Standards Committee (2001) and Nestler and Thuy (2002, pp. 172-9).

1015 SFAS 142.8150.

1016 SFAS 142.8153.

*1011*See SFAS 142.8151.

1018 SFAS 142.23.

only management's assumptions will be readily available. Also, in a transaction between willing parties, synergies are likely to play a major role in the purchase price negotiations. Since the amount of synergies depends heavily on the identity of the potential buyer, incorporating the assumptions of marketplace participants will only be meaningful in the rare event that the potential buyer is known.

#### **<IP_ADDRESS> Multiples**

SF AS 142.25 permits the use of valuation techniques based on "multiples of earnings or revenue or a similar performance measure". Again, the methods applied must be consistent with the objective of measuring fair value. The F ASB restricts the use of these techniques to circumstances where "the fair value of an entity that has comparable operations and economic characteristics is observable and the relevant multiples of the comparable entity are known." 1019 However, SFAS 142.24 does not indicate whether these known multiples must in all cases be derived from stock price or other market data. For example, the popular PIE multiple is the ratio of stock price divided by earnings. This would strictly imply that the PIE multiple can only be used where stock price and earnings data of publicly traded comparable firms are observable.1020

A wide range of these valuation models is available and used in practice. 1021 All of these methods are based on the "law of one price", an economic rule which states that in an efficient market, a security must have a single price, no matter how that security is created. Applied to firm valuation, it implies that two identical or at least closely comparable firms cannot have widely different prices, or otherwise arbitrage opportunities would arise. 1022 Based on this assumption, it is argued that comparable firms are priced at fixed multiples of their earnings, cash flows or other performance measures.1023

1019 SFAS 142.25.

1020 As the common term "market multiples" suggests, valuation based on these methods usually relies on data derived from stock prices or other market transactions. See, for example, Coenenberg and Schultze (2002a, p. 697) and Mandi and Rabel (1997, p. 265).

1021 See, for example, Aders, Galli and Wiedemann (2000), Bausch (2000), Bocking and Nowak (1999), Hillebrandt (2001), Mandi and Rabel (1997, pp. 265-74), and Seppelfricke (1999). Also, refer to Damodaran (1996).

1022 See Coenenberg and Schultze (2002a, p. 697).

1023 Instead of a performance measure or similar flow figure, the book value of equity or other accountingbased stock figures are sometimes used. However, since SFAS 142.25 explicitly refers to multiples based on performance measures, these variants are not discussed here.

The multiple approach comprises three basic steps: 1024 First, a comparative company or transaction 1025 is identified. Several dimensions, along which comparability can be judged, are conceivable, e.g. same industry, size, or market position. Due to the multitude of attributes by which firms and transactions can be distinguished, finding a truly comparable finn or transaction is especially problematic. 1026 Second, the relevant perfonnance measure is ascertained and the multiple calculated. Perfonnance measures mainly used besides earnings include income statement sub-totals such as revenues, earnings before interest, taxes, depreciation, and amortization (EBITDA), and earnings before interest and taxes (EBIT), or cash flow figures such as free cash flow (FCF) and flow to equity (FTE). Frequently, several comparable companies or transactions are considered and averaged. Finally, the value figure is computed by applying the multiple to the perfonnance measure. 1027

Valuation techniques based on multiples might at first sight appear to generate relatively objective and verifiable results, since they resort to market-based measures such as stock prices or prices generated in other market transactions. However, the appropriateness of multiples for valuation purposes critically hinges not only on management's ability to identify comparable companies or transactions, but also on data availability. Where no data is available for the first-best comparison finn, management might be tempted to use sub-optimal benchmarks. Also, since the reporting unit to be valued and the comparable finn from which the multiple is observed are usually not equally sized, the accurateness of the valuation depends on whether the relation between the finn value measure and the perfonnance measure is proportional. 1028 Special problems arise when transaction prices are used. These may be distorted due to transaction-specific circumstances, such as control premiums paid in acquisitions or the value of synergies that is (partly) reimbursed in the purchase consideration, 1029 which might not be applicable to the reporting unit at is-

1024 See, for example, Hillebrandt (2001, p. 618).

1025 Transactions include recent mergers, acquisitions or (initial) public offerings.

1026 See Coenenberg and Schultze (2002a, p. 698). Nestler and Thuy (2002, pp. 174-5) note that unlisted reporting units should be valued at a discount compared with their publicly traded comparatives.

1027 It is important to assure that the value figure is consistent with the performance measure. For example, a performance measure to which only shareholders are entitled, e.g. net income, will generate a measure of the firm's equity value. Conversely, if a perfonnance measure such as FCF is used, the firm value generated will represent the market values of both equity and liabilities (so-called enterprise value).

1028 See Bausch (2000, p. 451).

1029 See Coenenberg and Schultze (2002a, p. 698).

sue. For these reasons, reporting unit fair values arrived at by using multiples will have a distinct discretionary component. 1030

#### **<IP_ADDRESS> Preliminary conclusion**

Since the majority of reporting units of SFAS 142 adopters are not publicly traded, 1031 firms will largely apply present value methods and/or market multiples to determine reporting unit fair value in the context of step one of the impairment test. The range of available methods is depicted in Figure 13. Having extensive control over the determinants of present value as well as over the parameters used in the market multiple approach, management will be able to justify a wide range of reporting unit fair values. 1032 This is especially true since the results are very sensitive to ( changes in) underlying assumptions regarding growth and other determinants of terminal value, interest rates, and inter-company comparability. 1033

**Figure 13: Hierarchy of reporting unit fair value measurements**

Reporting unit fair value determines to a large extent the outcome of the first test step, i.e. whether the second test step is "triggered" because a potential goodwill impairment loss is assumed to exist. For that reason, management has a strong incentive to influence reporting unit fair value to conform to its financial reporting strategy. If management's incentive is to avoid/delay/understate a goodwill impairment loss, it will use assumptions

1030 Due to the shortcomings of this concept, the use of market multiples in practice is usually limited to providing plausibility checks for values generated using more elaborate techniques, and making quick "back-of-the-envelope" calculations. See Coenenberg and Schultze (2002b, pp. 602-3), who are therefore critical of firms using multiples as the only measure in applying SFAS 142. Also, refer to L0denbach and Schulz (2002, pp. 494-5) and Nestler and Thuy (2002, p. 175).

1031 Even where a reporting unit is publicly traded, stock price need not be the relevant fair value measure. Refer to section <IP_ADDRESS> above.

1032 See also Busse von Colbe (2001a) and Hitz and Kuhner (2002, p. 283). In a more general context, Ordelheide (1997, p. 584) and Moxter (2001) arrive at the same conclusion.

1033 See also Kilting, Weber and Wirth (200 I, p. 189).

and data to maximize reporting unit fair value. Conversely, management will rely on pessimistic scenarios when it intends to recognize/accelerate/overstate a goodwill impairment loss.

### 4.5.2 Carrying value of reporting unit net assets

The second variable required to complete the first test step is the carrying value of the reporting unit's net assets, including goodwill. This value is derived from the carrying values of the reporting entity's assets, liabilities, and goodwill as a whole. The requirement of allocating these items to the reporting unit level creates significant elbowroom for management, as will be discussed below.

### **<IP_ADDRESS> Allocating assets and liabilities**

The guidance provided in SF AS 142.32-3 focuses on the case of assigning the assets acquired and liabilities assumed in a recent acquisition to the firm's reporting units. 1034 Two conditions must be met for an asset (liability) to be allocated to a reporting unit: 1035 First, the asset (liability) will be employed in (relates to) the operations of a reporting unit. Second, the asset or liability will be considered in determining the fair value of the reporting unit.

In some cases, it should be relatively clear to which reporting unit the assets and liabilities from a recent acquisition relate. For example, if an acquired entity is not integrated into the acquirer's operations but operated as a stand-alone reporting unit, the assets and liabilities originally acquired will naturally be assigned to that unit. The same is true when an acquired entity is grouped with a pre-existing reporting unit to form a part of it. However, if an acquired entity is integrated across several reporting units, complex allocation problems arise that are not likely to be solved by the criteria described above. For these instances, SFAS I 42.33 requires that assets (liabilities) that are employed in (relate to) the operations of multiple reporting units be assigned to those reporting units according to a methodology that is "reasonable and supportable" and consistently applied. This requirement is rather vague and gives management considerable discretion in determining a reporting unit's net asset base and, thereby, the outcome of the first test step. For example, if an acquired brand name is expected to benefit several of a firm's geographi-

1034 The allocation of the entity's pre-existing assets and liabilities to reporting units upon initial application of SFAS 142 is specifically governed by SFAS 142.54, which refers to the guidance in SFAS 142.32-3.

1035 See SFAS 142.32.

cally divided reporting units, allocation will be have to be based on some measure of future benefits that each of the reporting units is likely to derive from that brand name. Present value techniques are likely to be employed here, with all the discretionary components inherent in these procedures. 1036 In general, all assets that are expected to generate synergies for several reporting units are difficult to allocate. 1037 Likewise, liabilities are equally problematic to assign. 1038

In the special case of corporate items, i.e. assets or liabilities that are used at the reporting unit's top organizational level and are not easily broken down to the reporting unit level, SF AS 142.32 requires allocation to a reporting unit if both of the above criteria are met. Examples where the criteria are considered to be met are "environmental liabilities that relate to an existing operating facility of the reporting unit and a pension obligation that would be included in the detennination of the fair value of the reporting unit." 1039 However, due to the unique characteristics of corporate items, i.e. their inherent relation to the entity level and not to some lower level, it is doubtful whether the above criteria *ever*  apply to true corporate times or, stated differently, whether assets and liabilities that meet the above criteria are corporate items at all. 1040 Assigning corporate items to reporting units is by definition an extremely arbitrary process. 1041

The "management approach" plays an important role in the process of allocating assets and liabilities to reporting units. A finn' s allocation decisions are likely to be in part driven by its existing internal organization and reporting structure. The manner in which a finn allocates its assets and liabilities to reporting units is likely to be in part predetermined by its decisions relating to the reporting unit definition itself. 1042

1036 Refer to section <IP_ADDRESS>.

1037 Another possibility suggested in SFAS 142.33 is an allocation procedure based on the relative fair values of the different reporting units.

1038 SF AS 142.33 suggests that pension liabilities be allocated *pro rata* to multiple reporting units, based on relative payroll expense. For other liabilities, allocation formulas might not be so obvious.

1039 SFAS 142.32.

1040 See also Liidenbach and Frowein (2003, p. 218).

1041 Respondents to the FASB's 2001 exposure draft expressed the same concerns. See SFAS 142.B115. Furthermore, in some cases it can lead to results that are inconsistent with the requirements in Statement 131 since, for purposes of segment reporting, firms are required to allocate to reported segments only those assets that are included in the chief operating decision maker's measure of segment assets. Therefore, goodwill and other (corporate) assets and liabilities may not be included in reported segment assets. See SFAS 142.B121.

1042 Refer to section 4.4.

#### **<IP_ADDRESS> Allocating goodwill**

As with other assets and liabilities, the guidance provided in SF AS 142.34-5 on allocating goodwill to reporting units focuses on the case of a recent acquisition. 1043 However, in contrast to assets and liabilities, which are only to be allocated to reporting units when certain criteria are met, 1044 all of a firm's acquired goodwill must be assigned in its entirety.1045 The allocation procedure considers which reporting unit, or several reporting units, of the acquirer are expected to benefit from the synergies of the business combination.1046 Here again, the allocation method is required to be "reasonable and supportable and ... applied in a consistent manner." 1047 SFAS 142.35 provides additional guidance, depending on whether a reporting unit that goodwill is going to be allocated to has also been assigned assets and liabilities from the same acquisition.

"In concept, the amount of goodwill assigned to a reporting unit would be determined in a manner similar to how the amount of goodwill recognized in a business combination is determined."1048 For each reporting unit expected to benefit from the acquisition, a fair value as a surrogate for purchase price would be determined and allocated to the net assets of that unit as would be the case if the reporting unit had been acquired in a business combination. Consider the following simple example in which entity A is acquired and the acquirer's reporting units RU; are expected to benefit from the synergies of the acquisition of A: 1049

These arbitrary numbers show that only by coincidence is the sum of the reporting units' internally generated goodwills (here: 150 MU) equal to the acquired goodwill of A that is to be allocated (here: 40 MU). Therefore, the guidance in SFAS 142.35 does not represent a viable method of allocating A's goodwill. A "reasonable and supportable" method

1043 The allocation of the entity's pre-existing goodwill to reporting units upon initial application of SF AS 142 is governed by SFAS 142.54.

1044 Refer to section <IP_ADDRESS> .

1045See SFAS 142.34, 54. See also Hitz and Kuhner (2002, p. 276).

1046It is not necessary that goodwill be allocated solely to reporting units that have also been allocated assets and/or liabilities from the same business combination.

1047 SFAS 142.34.

1048SFAS 142.35.

1049All amounts are expressed in monetary units (MU). For a similar example, **refer** to Pellens, Crasselt and Schremper (2002).

could be to allocate A's goodwill based on the three reporting units' relative internally generated goodwills:

Alternatively, another "reasonable and supportable" method could be to distribute A's goodwill in proportion to the three reporting units' relative size as measured by net assets:1oso

It is doubtful whether these or other, similar procedures are consistent with the objective of assigning goodwill to reporting units proportionally to the benefits expected to arise from the acquisition, '°51 since all they achieve is an allocation of acquired goodwill proportional to some arbitrarily chosen apportionment formula.

The procedure described above is deemed to be inappropriate if goodwill is to a reporting unit to which none of the assets acquired or liabilities assumed in that specific acquisition were allocated. Goodwill might be allocated to such a reporting unit based on a "with and without" computation. "That is, the difference between the fair value of that reporting unit before the acquisition and its fair value after the acquisition represents the amount of goodwill to be assigned to that reporting unit."1052 This with and without computation is intended to capture the incremental increase, resulting from a recent business combination, in the reporting unit's internally generated goodwill. 1053 This increment will in most cases be due to synergies that are expected to arise from combining the acquired entity with the acquirer's operations, and from which benefits are expected to accrue to the reporting unit in question. For example, assume that entity A in the above example pro-

*1050*A third alternative would be an allocation based on reporting unit fair value; see SFAS 142.33. Also, refer to LUdenbach and Frowein (2003, p. 218).

1051 See SFAS 142.34.

1052 SFAS 142.35 (both quotes).

1053 See also KUting, Weber and Wirth (200 I, p. 188).

vides distribution channels to all three RUi, albeit being operated as a stand-alone reporting unit. It might be feasible to asswne that the future cash flows, and therefore the fair values, of RUi will increase to the extent that the distribution channels provided by A result in a reduction of distribution expenses and/or an increase in revenues, although no assets or liabilities are assigned to them:

However, as the example shows, the total amount of goodwill that, according to the "with and without" computation, can be potentially assigned to RUi (70 MU) will only by coincidence be equal to the amount that is to be distributed to these reporting units ( 40 MU).1054

While the guidance on allocating acquisition-specific goodwill, given in SFAS 142.34-5, already involves considerable discretion, this is even truer in the event that the firm's entire existing goodwill must be allocated to reporting units upon initial application of SF AS 142. 1055 As in SF AS 142.34, no more is required in SF AS 142.54 than that the method used to allocate goodwill to reporting units at transition be "reasonable and supportable". Firms are encouraged to consider the original sources of pre-existing goodwill and give special attention to those reporting units to which the related assets and liabilities were assigned. The guidance applicable to allocating acquisition-specific goodwill is also recommended for allocating pre-existing goodwill upon initial application of SF AS 142. However, for goodwill components resulting from business combinations that have been completed a relatively long time before, the allocation will tend to be even more subjective.

1054 Taken literally, the guidance in SFAS 142.35 suggests that the total amount of 70 MU ("the difference between the fair value of that reporting unit before the acquisition and its fair value after the acquisition") can be recognized in the acquirer's financial statements. This would imply that not only the purchased goodwill of 40 is recognized but, as the case might be, part of the internally generated goodwills of reporting units expected to benefit from the acquisition might end up being recognized as well. This result would be in contrast to SFAS 142.Fl, which defines goodwill as the "excess of the cost of an acquired entity over the net of the amounts assigned to assets acquired and liabilities assumed." In this example, not only this excess value of 40 MU, but an additional 30 MU, would be recognized.

*1055*SFAS 142.54 explicitly requires that all recognized goodwill be assigned to reporting units.

### 4.5.3 Disposal

When a *component* ( constituting a business) of a reporting unit is to be disposed of, management must determine how much of the reporting unit's goodwill to include in the carrying value of that component, in order to determine the gain or loss on disposal. 1056 According to SFAS 142.39, the portion ofreporting unit goodwill that enters into that calculation depends on whether or not the business to be disposed of was integrated into the reporting unit after its acquisition. If it was, the portion of the reporting unit's goodwill that relates to the business to be disposed of is not readily apparent. In that event, some allocation key must be devised. According to SFAS 142.39, that allocation is to be based on the relative fair values of, first, the business to be disposed of and, second, the portion of the reporting unit to be retained. The fair value of the business to be disposed of will usually be derived from the purchase price realized. The discretion inherent in determining the fair value of the retained portion is identical to that involved in valuing reporting units *per se.1057* Subsequent to the disposal, any goodwill remaining in the reporting unit must be tested for impairment. 1058

The guidance in SF AS 142.30 implies that a "business" as defined in EITF Issue No. 98- 03 is a separate reporting unit whenever it is situated directly below the operating segment level. 1059 In contrast, SF AS 142.39 suggests that businesses might exist even further down in the organizational hierarchy. Since reporting units are either segments or components immediately below the segment level, such businesses would not be viewed as reporting units. Conversely, if the reporting unit level is identical to the operating segment level, and no economically dissimilar businesses exist below that level, it will not be possible to allocate the goodwill portion to be disposed of in the manner required in SFAS 142.39. In that case, the disposed portion of the reporting unit would not have constituted a business, and no goodwill would have to be allocated to it. Therefore, management's argument that the disposed portion did not constitute a business would enable management to record a higher gain (or lower loss) on disposal. However, the FASB maintains that goodwill cannot relate to a group of assets that does not constitute a business. 1060

1056 The discretion related to detennining what constitutes a " business" is discussed in section 4.4.

1057 Refer to section 4 .5. I above.

1058 See SFAS 142.39.

1059 Refer to section 4.4 above.

1060See SFAS 142.B164.

### *4.6 Measurement*

The second test step compares the carrying value of reporting unit goodwill with its implied fair value. The implied fair value of goodwill is measured by comparing reporting unit fair value (representing a fictitious purchase price) to reporting unit net assets (without goodwill) at fair value. The F ASB coined the term ,,implied" fair value of goodwill because, conceptually, it is difficult to measure the fair value of this residual directly. 1061

### 4.6.1 Fair value of reporting unit net assets

#### **<IP_ADDRESS> Fictitious purchase price allocation**

Determining the fair value of reporting unit net assets requires management to measure reporting unit assets and liabilities "as if'' the reporting unit under scrutiny had been acquired as of the impairment test date. 1062 This fictitious "purchase price allocation" process1063 or "fair value adjustment"1064 is governed by the provisions in SF AS 142.21.1065 It involves discretionary parameters similar to those encountered during actual purchase price allocations subsequent to acquisitions. While it is beyond the scope of this chapter to discuss all the details and discretionary elements of the purchase price allocation process, 1066 it appears necessary to discuss the application of the relevant guidance in SF AS 141 to the second step of the goodwill impairment test and indicate the subjectivity involved in measuring the fair value of reporting unit net assets. 1067 Assets and liabilities are to be measured at "their estimated fair values at date of acquisition".1068 Most of the discretionary parameters involved in estimating fair value measurements for entire re-

1061 See SFAS 142.18 fu . 13.

1062 See SFAS 142.21.

1063 Ltidenbach and Frowein (2003, pp. 217-8) coin the term "Quasi-Kaufpreisallokation". See also Frowein and LUdenbach (2003, p. 65).

1064 See Kilting, Weber and Winh (2001, p. 187).

1065 SFAS 142.21 refers to SF AS I 41.35-8. SF AS I 41.35 in turn refers to SF AS 141.26-46 for guidance on the process of purchase price allocation.

1066For example, refer to Beams, Brozovsky and Shoulders (2000, pp. 76-82), Jeter and Chaney (200 I, ch. 5), Larsen (1997, pp. 189-91), and Pellens (2001, pp. 294-5).

1067 The extent to which the methods and procedures applied in the original purchase price allocation are binding for the "fictitious" purchase price allocation is an open issue. L0denbach and Frowein (2003, p. 218) maintain that consistency should be applied in this process in order to avoid distonion of the implied fair value of goodwill due to measurement anifacts. The authors also argue that, in order to correctly account for deferred taxes, the "fictitious" purchase price allocation must include an assumption about the legal form, which the "fictitious" purchase has taken.

1068 SFAS 141.35.

porting units, discussed in section 4.5.1, also apply to measuring the fair values of individual assets and liabilities for which fair values are not readily observable.

The FASB attempted to limit subjectivity by requiring in SFAS 141.35 that, first, the valuation of any non-cash purchase consideration be reviewed. By analogy, this translates into a requirement to review the detennination of reporting unit fair value when performing the second step of the goodwill impairment test according to SF AS 142.21. Second, all of the assets acquired and liabilities assumed must be identified. This requirement includes intangible assets that meet the recognition criteria in SF AS 141.39 (see discussion below) as well as all other assets and liabilities of the acquired entity, regardless of whether or not were previously recorded in the financial statements of the acquired entity. Applying this provision to the second step of the goodwill impainnent test implies that not only must the reporting unit's assets and liabilities be measured at fair value, but any assets or liabilities that do not qualify for recognition when generated internally must be recognized if they do meet the recognition criteria when acquired. The remainder of this section first discusses recognition issues, followed by measurement issues. 1069

#### **<IP_ADDRESS> Recognition**

Special recognition provisions exist for previously recorded goodwill (SF AS 141.38), deferred taxes (SFAS 141.38), intangible assets (SPAS 141.39), preacquisition contingencies (SFAS 141.40-1), and research and development assets (SFAS 141.42). According to SF AS 141.38, goodwill recognized by the acquired entity from its own previous acquisitions cannot be carried over to the consolidated balance sheet of the acquirer. In the context of the goodwill impairment test, this requirement implies that, as stated in SF AS 142.21, the carrying amounts of any goodwill recognized as part of reporting unit net assets must be excluded when calculating the implied fair value of reporting unit goodwill. Furthermore, no internally generated goodwill is included in the fair value of reporting unit net assets.

Likewise, deferred income taxes recorded by the acquiree cannot be carried over into the acquirer's books but must be reassessed. 107° Consistent with SFAS l 09.30, deferred tax liabilities (assets) are recognized based on any differences between the amounts assigned to assets acquired (liabilities assumed) in a business combination and the accordant tax

1069See also Lildenbach and Frowein (2003, pp. 219-22) and Frowein and Lildenbach (2003, pp. 67-72).

1070See SFAS 141.38 and Ltldenbach and Frowein (DB 2003, p. 221).

bases. No deferred taxes are recorded in association with goodwill for which amortization is not tax-deductible. 1071 The general rules for recognition and measurement of deferred taxes are contained in SFAS I 09.17. 1072 For the measurement of deferred tax assets, a valuation allowance must be established if "it is *more likely than not* ( a likelihood of more than 50 percent) that some portion or all of the deferred tax assets will not be realized." 1073 This term requires management's estimates of the likelihood of a future event occurring. To the extent that deferred tax assets are deemed to be more likely than not to be realized, the implied fair value of goodwill is reduced, and *vice versa.*

Subjectivity plays an especially pronounced role where intangible assets generated internally by the reporting unit must be identified. According to SFAS 141.39, intangible assets must be recognized separately from goodwill if they satisfy one of two recognition criteria: 1074 The *contractual-legal criterion* requires that the intangible asset arise from contractual or other legal rights. According to the *separability criterion,* the intangible asset in question must be capable of being sold, transferred, licensed, rented, or otherwise exchanged either separately or in combination with a related contract, asset, or liability . 1075 These renewed recognition criteria for acquired intangible assets were intended by the Board to take some of the subjectivity out of the process of purchase price allocation, since it observed that many firms chose not to recognize previously unrecognized intangible assets acquired in a business combination, but to include them within goodwill. 1076 Relying on contractual/legal rights and separate usability will tend to limit management's discretion in two ways: On the one hand, it will be more difficult for firms interested in avoiding/delaying/understating goodwill impairment losses to maximize the implied fair value of goodwill by recognizing as few previously unrecognized intangible assets as possible, because relatively objective criteria now exist that, if met, require an intangible asset to be recognized as part of the fair value of reporting unit net assets. On the other hand, firms that have incentive to recognize/accelerate/overstate a goodwill impairment loss will face difficulties in minimizing the implied fair value of goodwill by recognizing

1071 See also Pellens (2001, pp. 261-2).

1072 Refer to Pellens (2001, pp. 260-9).

1073 SFAS 109.17 lit. e (emphasis in original).

1074 See, for example, Alvarez and Biberacher (2002, pp. 347-8).

1075 An assembled workforce cannot be recognized as a separate intangible asset. Appendix A to SF AS 141 provides additional guidance, including a list of intangible assets that meet the recognition criteria.

1076 See SFAS 141.8148. Such behavior was usually explained by management's desire to minimize annual future amortization expense, considering that goodwill was usually amortized over longer periods (or, in some jurisdictions, deducted from equity) than were separately identifiable intangible assets. Refer to section 2.3 .2 above.

as many previously unrecognized intangible assets as possible, because such intangible assets cannot be recognized apart from goodwill unless relatively objective criteria are met.1011

Preacquisition contingencies, previously governed by SF AS 38, *Accounting for Preacquisition Contingencies of Purchased Enterprises,* are contingencies of an enterprise acquired in a purchase-method business combination that exist before the combination is consummated. 1078 Without regard to details of the sources of contingencies in general, 1079 it is important to note that preacquisition contingencies, usually measured at fair value determined during the allocation period, 1080 are recognized at reasonably estimated values when fair value cannot be determined by the end of the allocation period. 1081 Applying these provisions to the second step of the goodwill impairment test is not straightforward since preacquisition contingencies are an acquisition-specific accounting issue. In the context of SFAS 142, they would have to be recognized and measured at fair value when in existence before the impairment test date. 1082 In analogy to SFAS 142.22, it could be argued that reasonably estimated values must be used when fair value cannot be determined before the issuance of the financial statements. 1083 Under this condition, management would be able to use estimated values of preacquisition contingencies to either

1077 However, significant discretion still exists with regard to measurement issues. SFAS 141.37 lit. e requires intangible assets to be measured at estimated fair values. Where quoted market prices are unavailable or deemed inappropriate, valuation techniques will be applied. The discretion inherent in these methods is discussed extensively in section 4.5.1 above.

1078 This definition in SFAS 38.4 lit. a is carried forward unchanged in SFAS 141.FI. See SFAS 141.B175. Preacquisition contingencies can be contingent assets, contingent liabilities, or contingent impairments of assets.

1079 Refer to SFAS 5. See also Pellens (2001, pp. 227-35) and Kieso, Weygandt and Warfield (2001, pp. 670-9).

1080 According to SF AS 141.F I, the allocation period is the "period that is required to identify and measure the fair value of the assets acquired and the liabilities assumed in a business combination." It ends when the acquirer has incorporated all information known to be available or obtainable. The allocation period should usually not exceed one year from the consummation of a business combination (SFAS 38.4 lit. b).

1081 See SFAS 141.40 lit. a, b. Previous adjustments are recorded in earnings in the period in which the adjustment is determined. See SFAS 141.41.

1082 LUdenbach and Frowein (2003, p. 220) argue that, for the sake of consistency, such contingencies would be recognized or not recognized depending on whether or not their expected impact was also factored into the fair value of the reporting unit.

1083 This would also correspond with the general rules in SFAS 5.

over- or understate the implied fair value of goodwill when conducting the initial impainnent test. 1084

Finally, in-process research and development assets that would have to be written off to earnings when acquired in a business combination1085 are included in the allocation process for purposes of goodwill impairment testing. 1086

#### <IP_ADDRESS> **Measurement**

Regarding measurement issues, detailed guidance is given in SFAS 141.37 for the measurement of assets acquired and liabilities assumed, excluding goodwill. The recommendations include several variants of fair value measurements, most of which require estimates.

In a purchase price allocation that follows an actual acquisition, the sum of the amounts assigned to assets acquired and liabilities assumed is in effect limited to some extent by the cost of the acquired entity. According to SF AS 141.44, the amounts assigned to assets acquired and liabilities assumed are reduced *pro rata* when their sum exceeds the cost of the acquired entity. 1087 No such limit exists when the fair value of reporting unit net assets is detennined for purposes of the second test step. If management has incentive to overstate any goodwill impainnent loss, it will assess the fair value of reporting unit net assets at the highest possible amount, without being restricted by the cost of the acquired entity.

### 4.6.2 Inclusion of estimates

SF AS l 42.22 requires that the best estimate of a goodwill impainnent loss be recognized in the financial statements in those cases where the second test step is not completed before the financial statements are issued, a goodwill impainnent loss is probable, and can be reasonably estimated. This implies that "slow" finns can include or exclude an esti-

1084 However, it is not fully clear that preacquisition contingencies in the goodwill impairment test provide discretion over and above that already involved in accounting for contingencies under Sf AS *5.*

1085 According to FIN 4.5, the amounts assigned to tangible and intangible assets to be used in a particular research and development project that have no alternative future use shall be charged to expense at the acquisition date. This requirement is carried over unchanged in SFAS 141.42. However, the FASB recently announced its intention to revoke FIN 4 in order to achieve convergence with IFRS.

1086 See SFAS 142.21 fit. 14.

1087 Exempt from this rule are financial assets other than equity-method investments, assets to be disposed of by sale, deferred tax assets, prepaid assets relating to pension or other postretirement benefit plans, and any other current assets.

mated goodwill impainnent loss based on their financial reporting incentives. The criteria "probable" and "reasonably estimable", originally defined in SF AS 5, 1088 are sufficiently discretionary to allow management to argue either way. However, finns are required to disclose that the measurement of the impainnent loss is an estimate. 1089 After completion of the second test step, any necessary adjustments to the estimated losses are recognized. This provision will not play a major role in the transition period. SFAS 142.55 specifically states that the transitional goodwill impainnent test "must be completed ... no later than the end of the year of initial application." Therefore, a situation where a finn relies on estimated goodwill impainnent losses because the second test step has not been completed before issuance of the financial statements is not provided for under SFAS 142.

### *4. 7 Transition*

The provisions in SFAS 142 are written from the perspective of how goodwill arising from a recent acquisition is to be accounted for. For example, SFAS 142.32 requires that assets acquired and liabilities assumed "be assigned to a reporting unit as of the acquisition date". However, special problems arise when finns are required to apply SFAS 142 for the first time in the year of transition. For purposes of initial application, transition provisions are given in SF AS 142.48-6 l. This section discusses transition-specific issues and the effects of these issues on the degree of discretion available to management when making the goodwill write-off decision and detennining the amount, if any, to write off\_ 1090

#### 4. 7.1 Effective date and initial application

SFAS 142 takes effect in fiscal years beginning after December 15, 2001, with early application pennitted for finns that have fiscal years beginning after March 15, 2001. 1091 To ensure consistent application, early application is only pennitted if the first interim

1088SFAS 5.3 lit a: *"Probable.* The future event or events are likely to occur." (Emphasis in original.) See also SFAS 5.8 lit. b.

1089See SFAS 142.22, 47 lit. c.

1090Some of these issues **have already** been touched upon within the relevant sections of this chapter.

1091See SFAS 142.48 lit. a.

statements of the fiscal year have not been issued previously. 1092 Retroactive application is not permitted. 1093

Some of the rules in SFAS 142 become effective before initial application. Goodwill acquired in a business combination for which the acquisition date is between June 30, 2001, and the firm's initial application of SF AS 142, is no longer amortized but tested for impairment in accordance with APB Opinion 17 or SF AS 12 I. 1094 However, goodwill acquired in a business combination completed before July 1, 2001, continues to be amortized until initial application of SF AS 142. 1095 If firms were interested in avoiding goodwill amortization, they had incentive to consider postponing any pending acquisitions until after June 30, 2001 . Conversely, had firms preferred to amortize the greatest possible amount of their existing goodwill until amortization ceased upon initial application of SFAS 142, they would have tended to accelerate any pending acquisitions in order to complete them before the cut-off date on July 1, 2001. 1096

### 4.7.2 Transitional impairment test

The prescription in SFAS 142.55 was intended to ease the transition:!097 Firms were given six months' time to complete the first step of the goodwill impairment test in each reporting unit and another six months for the second step. 1098 Initial application took place as of the beginning of the fiscal year. 1099 Therefore, a calendar-year applied SF AS 142 as of January 1, 2002, completed the first test step by June 30, 2002, and carried out

1092 This implies that firms with a March 31 year-end can only apply SF AS 142 in their fiscal year ending on March 31, 2002, if no first-quarter interim reports, prepared under the SF AS 142 predecessor rules, were published. Since SFAS 142 was issued on June 29, 2001, firms only had one and a half months to change their reporting to SFAS 142. SEC filing requirements allow firms 45 days to issue their quarterly reports.

1093 See SFAS 142.48 lit. a.

1094 See SFAS 142.50-1.

1095 See SFAS 142.50.

1096 Such behavior would represent earnings management by "real" decisions ("Sachverhaltsgestaltungen") as discussed in section <IP_ADDRESS> above.

1097 See SFAS 142.B210-1.

1098 More precisely, "the second step of the transitional goodwill impairment test *must* be completed as soon as possible, but no later than the end of the year of initial application" (SF AS 142.55 [ emphasis added]).

1099 See SFAS 142.55.

the second test step by December 31 , 2002. 1100 As has been discussed briefly above, SFAS 142.58 required that firms conduct the first *annual* impairment tests in the transition year also. 1101 Besides, the existence of impairment indicators at some time during the transition year would have triggered additional impairment tests. 1102 Therefore, work on up to *three* parallel goodwill impairment tests was possibly carried out within each reporting unit during the transition year.

The transition provisions gave firms considerable flexibility regarding the timing of any goodwill impairment loss, enabling management to delay or accelerate it according to their financial reporting incentives, since the impairment test could be completed any time during the first twelve months. Likewise, a firm's announcement that no goodwill impairment loss has occurred can also be delayed or accelerated almost at will. Prior research has shown that management prefers to disclose "bad news" in later, rather than earlier quarters.1103 It must be stressed that the information used in the transitional goodwill impairment test was based on the situation at the beginning of the year of initial application. The Board intended that the initial impairment test capture any goodwill impairment losses that result from a change in methodology, 1104 rather than primarily from economic events. Consequently, these transitional goodwill impairment losses were reported as a change in accounting principle. 1105

In conclusion, while the transition provision did allow management discretion regarding the *timing* of disclosure of goodwill write-off behavior, it should not, in theory, have enabled management to exercise discretion with regard to the *substance* of that decision. However, in practice it is doubtful that management actually did use (possibly outdated) information and assumptions based on what it knew on January I, 2002, when conduct-

1100 SFAS 142.22 allowed firms to use the ,,best estimate" (as defined in SFAS 5) of any goodwill impairment loss when any required second test steps were not completed by fiscal year-end. As discussed briefly above, it is not entirely clear whether this rule applies to the transitional impairment test. At any rate, SFAS 142.55 does not refer to SFAS 142.22, which suggests that the twelve-month period is binding. So does the formulation in Sf AS 142.55 ("must"). See fn . I 098 above.

1101 Refer to section 4. 3. I. I above.

1102 See SFAS 142.57. For a discussion of impairment indicators that induce unscheduled impairment tests, refer to section 4.3 .2 above.

1103 See, for example, Elliott and Shaw (1988, p. 97) and Mendenhall and Nichols (1988).

1104 More precisely, the transitional SF AS 142 goodwill impairment test was meant to capture impairment not detected by the goodwill impairment test prescribed by the predecessor standard, SFAS 121 . For a brief description of that procedure, refer to section <IP_ADDRESS>.1 above.

1101 See SFAS 142.8209. Economic value declines that had occurred until the end of the previous year should have been captured by impairment tests carried out according to the predecessor standard(s), SF AS 121 and/or APB Opinion 17.

ing the second step of the goodwill impainnent test some time during, say, the fourth quarter of 2002.

### 4.7.3 Transitional presentation and disclosures

Presentation issues are argued here to be especially relevant for goodwill write-off behavior in the transition year. A goodwill impainnent loss resulting from the transitional goodwill impainnent test is reported as the effect of a change in accounting principle. 1106 It is presented in the income statement between the subtotals "extraordinary items" and "net income", along with any related income tax effects. 1107

Since the transitional goodwill impairment test is based on the situation as of the first of the transition year, any transitional goodwill impainnent loss is recognized in the first interim period, irrespective of when the test is completed. Consistent with SF AS 3, *Reporting Accounting Changes in Interim Financial Statements,* the first-quarter report and all other quarterly reports preceding the period in which the transitional goodwill impainnent loss is measured, are restated to reflect the accounting change. 1108 The effect is included in the first-quarter report as well as any cumulative year-to-date or last-twelvemonths-to-date financial reports that comprise that first quarter. For example, if the transitional goodwill impairment loss in a calendar-year firm is measured in November, the resulting effect is reported by restating net income in the first-quarter report and net income figures reported in the second-quarter report ("year-to-date June 30") and thirdquarter report ("year-to-date September 30"). In contrast, any "regular" goodwill impairment loss that does *not* result from the transitional test must be presented as a separate line item in the income statement, above "income from continuing operations" or a similar subtotal. 1109

Prior research suggests that not all components of net income are viewed equally by financial statement users, since some are judged to be more relevant to forecasting future cash flows than others. 1110 Therefore, it is reasonable to expect that financial statement users' perceptions of a goodwill impairment loss differed depending on whether this loss was reported as the effect of a change in accounting principle (and disclosed as a re-

1106If not stated explicitly otherwise, refer to SFAS 142.56 for the provisions discussed in this chapter.

1107Per-share information must also be presented for the accounting change.

1108See SFAS 142.56. Refer to SFAS 3.10.

1109 An exception applies to a goodwill impairment loss that is associated with a discontinued operation, which must be included within the results of discontinued operations. See SFAS 142.43.

1110Refer to section <IP_ADDRESS>.8 above.

statement of the first-quarter report) or as a component of the current period's income from continuing operations. Possibly, a transitional goodwill impairment loss was viewed as a relatively transitory and therefore less value-relevant earnings component, since it presumably reflects a change in accounting methodology rather than an economic value decline. Under that assumption, management might have had incentive to report the highest possible amount as a transitional goodwill impairment loss, thereby decreasing the likelihood of further, regular goodwill impairment losses in the near future. In order to achieve that goal, management might have chosen to diverge from the requirement to base the transitional impairment test on the first of the transition year. 1111 The date on which management based the transitional impairment test depends on whether a punishment was expected to result from deviating from the first of the fiscal year and on whether the situation that existed as of the first of the fiscal year was more or less suited to achieve management's financial reporting incentives.1112

Another required disclosure in the transition period relates to the results of the first test step. Upon completion of the first step of the initial goodwill impairment test, firms had to disclose in their interim financial information any reportable segment(s) in which a transitional goodwill impairment loss was expected. 1113 Depending on their financial reporting incentives, management might have used this disclosure obligation to "warn" financial statement users of an impending goodwill impairment loss in one or more of its reporting segments, before this loss was finally measured. Although not explicitly required, management might have had incentive to voluntarily disclose a numerical estimate of the anticipated loss in order to "guide" financial statement users' expectations.1114

### 4.7.4 Reclassification of goodwill and intangible assets

It has been discussed above that SF AS 141 defines new recognition criteria for intangible assets acquired in a business combination.1115 SFAS 142.49, parallel to SFAS 141.61, requires that these criteria be applied retroactively to intangibles assets and goodwill previously recognized in a business combination for which the acquisition date was before

1111See also the preceding section 4.7.2.

1112For example, if management intended to record the highest possible transitional goodwill impairment loss, it would have based the transitional test on a date at which the economic situation justified an exceptionally large goodwill impairment loss.

1113See SFAS 142.60.

1114For this type of"expectations management", **refer** to section <IP_ADDRESS>.5.1 above.

1113Refer to section 4.6.1.

July l, 200 l . 1116 Due to this requirement, the carrying amounts of previously acquired intangible assets that did not fulfill the recognition criteria now contained in SF AS 141.39 had to be reclassified as goodwill as of the date of initial application of SFAS 142. 1117Conversely, carrying amounts of items previously recognized within goodwill (or within similar balance sheet items such as goodwill and other intangible assets) had to be reclassified and recognized as separate intangible assets if these items met the above criteria. This would presume that accounting records had been maintained for all of these items. 1118

These reclassification provisions gave management the opportunity to use the inherent discretion to either increase or decrease the total carrying amount of goodwill, conditional on their financial reporting incentives. Reclassifying intangible assets to goodwill would have resulted in an increased carrying value of goodwill. Since intangible assets are frequently amortized under SFAS 142.12, unless they have indefinite useful lives, reducing the carrying amount of intangible assets in favor of the carrying amount of goodwill would have resulted in less amortization expense in future periods. However, the likelihood of goodwill impairment losses would have increased correspondingly. Therefore, it is not entirely clear which incentive dominated when management increased goodwill by reclassifying amounts previously recognized as separate intangible assets (or by avoiding to reclassify amounts previously recognized as goodwill in favor of separate intangible assets). 1119

#### *4.8 Intermediate results*

In this chapter, it is demonstrated by a detailed analysis of SFAS 142 that the goodwill impairment test in most of its facets is a highly discretionary procedure that allows management to coordinate goodwill write-off behavior with their financial reporting objec-

1116The acquisition date ordinarily is the date assets are received and other assets are given, liabilities are assumed or incurred, or equity interests are issued (SFAS 141 .48).

1117See SF AS 141.61 lit. a. This requirement includes any related deferred tax liabilities.

1118See SFAS 142.49 lit b. fn. 25.

1119Reclassifying goodwill to intangible assets would have had the reverse effect. Amortization expense was likely to increase, unless most of the reclassified intangible assets were determined to have indefinite useful lives. The likelihood of future goodwill impairment losses decreased correspondingly. Here again, a trade-off of different financial reporting incentives would have been involved.

tives. In this respect, SF AS 142 does not appear to differ to a great extent from the predecessor standard, SFAS 121. 1120

Management estimates and other subjective elements are required at all stages. 1121 The relevant rules refer to other vague terms and subjective provisions that are scattered throughout a wide range of GAAP pronouncements. Recognition rules that invoke vague terms such as "significant", "probable", or "substantial" provide extensive elbowroom for management. 1122 So do measurement provisions that call for estimated values or fair value measurements that, in the absence of quoted market prices, rely on valuation techniques. In addition to being subjective, the difficulties associated with estimating uncertain future cash flows contributes to the fact that these procedures generate potentially unreliable results. In other words, SF AS 142 creates verifiability problems due to both measurer bias and measurement bias. 1123

However, several factors restrict management's ability to use these discretionary elements in a short-sighted manner to influence goodwill write-off behavior in the year of transition. 1124 For example, Liidenbach and Frowein (2003) stress that the "fictitious" purchase price allocation in step two of the impairment test is largely guided by the procedures applied to prior actual purchase price allocations in acquisitions. 1125 Further, auditors are required to review management's assumptions and expectations,1126 and the threat of SEC enforcement and potential shareholder litigation might discipline management even further. 1127 With regard to the use of valuation techniques to measure reporting unit fair value, the use of marketplace participants' assumptions, where available, also limits subjectivity. Further, timing flexibility might be limited by the fact that annual

1120 See also Segal (2003, p. 29). According to Osterland (2002), "the new rules aren't likely to hold .. management any more accountable for the success or failure of [a] merger than the pooling method did."

1121 See also Hitz and Kuhner (2002, p. 283).

1122 For example, Aharony and Dotan (2001) show that different groups (financial analysts, managers, and external auditors) ascribe different interpretations to the SFAS *5* criteria "remote" and "probable". Analysts are found to be more conservative regarding numerical interpretations than are managers and auditors, who assign similar percentages to these verbal criteria. Further, they refer to earlier research that found the threshold "remote" and "reasonably possible" ranging from 15% to 25% and that between "reasonably possible" and "probable" at 67% to 70%. See Aharony and Dotan (2001, p. 5).

1123 See Holthausen and Watts (2001, p. 28).

1124 For a general discussion of constraints to earnings management, refer to section <IP_ADDRESS> above.

1125 See LUdenbach and Frowein (2003, p. 220).

1126 Hitz and Kuhner (2002, p. 285) are concerned about auditors' ability to fulfill this role in the context ofSFAS 142.

1127 See Kahle (2002b, p. 903) and Kilting, Weber and Wirth (2001, p. 198).

tests must be conducted at fixed dates every year. The discretion related to goodwill from future acquisitions will be limited by the fact that management must document its assumptions and expectations related to these transactions and is therefore likely to be held accountable by them. 1128

The above analysis indicates that, with the impairment-only approach set down in SF AS 142, the F ASB chose to prescribe a highly discretionary method of accounting for goodwill subsequent to its initial recognition and measurement. 1129 While it is difficult to ascertain if SFAS 142 is more or Jess discretionary than the predecessor rules, 1130 it probably did not fundamentally change the fact that accounting for goodwill remains one of the most subjective areas in financial reporting. 1131 According to Wilson (1996), "unrelated measurement experts would have a difficult time assessing changes in the value of goodwill, even if they were fully aware of management's private information about related economic activity". 1132 Especially with respect to the transitional SF AS 142 goodwill write-off, it is argued that it is almost completely at management's discretion whether, at what amount, and when such charges are recorded.1133

1128See SFAS 141.50-1. See also Hitz and Kuhner (2002, p. 276). However, this requirement does not apply to goodwill existing upon adoption.

1129Given this result, it is somewhat surprising to learn that the Board originally discussed a different approach, which it eventually rejected because it involved "numerous subjective judgments", afforded "opportunities for manipulation of reported amounts in financial statements" and led to "concerns about *its* operationality". See SFAS 142.873 (all quotes). Under this "discernible-elements approach" (SFAS 142.871-873), the reasons for paying a premium over the fair value of the acquired net assets would have been documented, and the recorded amount of goodwill would have been allocated to these discernible elements. All of these elements would then have been either amortized or carried forward without amortization, based on their respective useful lives. This approach would have resulted in part of goodwill being amortized over some weighted-average useful life, with the remaining portion being accounted for under an impairment-only approach. It could be argued that this accounting treatment could not logically have resulted in *more* accounting discretion than the procedure ultimately chosen: In the one extreme, all of goodwill would have been classified as indefinite-lived and not amortized. This would have corresponded with the current accounting treatment. In the other extreme, all of goodwill would have been classified as finite-lived and amortized over the weighted average of the useful lives of the discernible elements. The recorded goodwill amount would have been reduced by amortization charges annually, which tends to limit management's discretion over both the recorded goodwill amount and annual goodwill-related charges. A small annual charge can also be achieved under the current treatment, when firms use their discretion to generate moderate goodwill impairment losses each year. Possibly, reasons other than concerns over subjectivity and discretion influenced the FASB's decision in favor of the impairment-only approach ultimately codified.

1130  Segal (2003, p. 11) claims that "SFAS No. 142 may very well not enhance the reporting for goodwill impairment in either the short or the long run. The [inherent] discretion ... may lead to amounts that do not reflect the economic reality of the firm."

1131See, for example, Dunstan (1999, p. 2). From a German perspective, see Kilting (1997).

1*m* See also Henning, Shaw and Stock (2002), Jennings et al. (1996, p. 530),

11 n See also Elliott and Hanna (1996, p. 150 fu. 10).

### **5 Empirical investigation of write-off determinants**

### *5. I Chapter overview*

In this chapter, a cross-sectional research design is adopted to investigate the detenninants of publicly listed U.S. industrial finns' decision to write off (or not write-off) goodwill upon transition to SFAS 142 and of the amount written off, if any. The tenn "goodwill write-off' is used to refer collectively to these aspects. A cross-sectional approach mitigates the potential effects of changing macroeconomic circumstances and financial reporting rules on write-off activity. So far, Segal's (2003) and Henning, Shaw and Stock's (2002) analyses appear to be the only empirical studies on aspects of SFAS 142 goodwill write-offs. 1134

The analysis in this chapter proceeds as follows: In section 5.2, testable hypotheses about the detenninants of management's financial reporting behavior pertaining to transitional SFAS 142 goodwill write-offs are developed. Section 5.3 contains the definition of variables derived from the hypotheses, an outline of the sample selection procedure, as well as descriptive information and frequency analyses on sample firms. In section 5.4, applicable regression methodology is discussed, followed by Probit tests of the write-off decision and Tobit tests of the write-off amount. Model specification and robustness are investigated in both cases in order to assess the validity of inferences. In section 5.5, the empirical findings are summarized and potential limitations to the conclusions are discussed.

### *5.2 Hypothesis development*

### 5.2.1 Overview

In this section, explicit hypotheses about the determinants of the goodwill write-off in the year of initial application of SF AS 142 are derived. 1135 These hypotheses are based on the theory, presented in chapter 3, on possible determinants of (and market reactions to) discretionary asset write-offs in general. However, the specific motivations pertaining to the issue of goodwill accounting (discussed in section 2.4) and the unique discretionary parameters available to management upon adoption of SF AS 142 (subject of chapter 4) are

1134 However, Segal (2003) does not differentiate between transitional and regular write-offs, but focuses on a comparison of write-offs under SF AS 121 versus SF AS 142. The question addressed in Henning, Shaw and Stock's (2002) paper is whether certain valuation models can predict the amount and timing of transitional SFAS 142 goodwill write-offs.

1135 For calendar-year firms, this year was January 1 to December 31, 2002.

also considered in order to customize the predictions to the SF AS 142 setting analyzed here\_ 1136

Two general types of hypotheses are considered with respect to the transitional SF AS 142 goodwill write-off: First, predictions are made regarding the outcome of a firm's *write-off decision,* i.e. the likelihood that a write-off is expected at all, regardless of any concrete amount. These hypotheses are later tested using Probit regression methodology, in an attempt to discriminate between write-off and non-write-off firms. Second, to the extent that these or other determinants are expected to additionally influence the *write-off amount,* i.e. a "the more the larger" or comparable relation is predicted, this group of hypotheses is subjected to Tobit regression analysis. Viewed in conjunction with the two general types of write-off determinants introduced in section <IP_ADDRESS> above, Table 4 represents a matrix of hypothesis categories, which are elaborated upon below. All hypotheses are stated in alternative form.

#### **Table 4: Categories of hypotheses**

SFAS 142.55 requires that the transitional impairment test be based upon the information and circumstances prevalent at the transition date. Therefore, economic developments taking place subsequent to that date cannot affect the write-off as long as goodwill impairment is measured true to the spirit of the rule. Consequently, all economic-factors variables (see Table 6) represent time periods ending on or before the end of fiscal 2001.

In contrast to this, considering management's financial reporting incentives implies that information is likely to be lost where data are restricted to the pre-fiscal 2002 period. Although strictly required to base impairment testing on the situation as of the transition date, management is given up to one year's time to complete the transitional impairment

1136 With these hypotheses, *ex ante* motivations that predict earnings management are presented, in contrast to relying on *ex post* realizations of actual earnings that are indicative of some earnings management pattern. See Abarbanell and Lehavy (2000, p. 4).

test. 1137 Financial reporting incentives prevailing *subsequent to* the transition date, i.e. during fiscal 2002, are likely to have dominated write-off decision and amount. Consequently, incentive variables represent time periods ending on or before the end of fiscal 2002.

#### 5 .2.2 Economic factors

If, as the FASB suggests, the SFAS 142 procedure measures goodwill impairment reliably, transitional goodwill write-offs reported by the sample firms can be expected to result (in part) from economic value declines that caused (some ot) firms' reporting unit fair values to fall below their respective book values, including goodwill (first test step), and, consequently, led to (some ot) the book values of firms' reporting unit goodwills exceeding their respective implied fair values (second test step). 1138 These two test steps mirror the distinction made above, between the write-off decision and the write-off amount: Goodwill impairment will, first, trigger test step one and, second, determine the amount to be written off on test step two. To the extent that accurate measures for the (unobservable) goodwill impairment can be devised, these proxy variables are expected to be associated with both the write-off decision *and* the amount written off.

Ideally, the individual "true" fair values of firms' reporting units, in combination with these reporting units' respective book values, should be used to detect the existence and extent of impairment. If these values were observable, management would be required by SF AS 142.23 to use them in the actual impairment test. 1139 Based on the spirit of the standard, an ideal-type measure of goodwill impairment is a reporting unit-level "fair value-to-book ratio" or MTB ratio. Where this measure is smaller than one, the book value of any reporting unit goodwill is no longer justified by the reporting unit's fair value. 1140 Since most reporting units are not publicly traded and firms are not required to disclose reporting unit data at this fine level of detail, a second-best solution would imply using operating segment fair values in combination with operating segment book values, i.e. operating segment-level MTB ratios.1141 However, operating segment fair values are

1137SeeSFAS 142.55.

11 38Refer to sections 4.5 and 4.6 for a detailed description of the goodwill impairment testing procedure.

1139As discussed in section 4.5.1, SFAS 142.23-25 describes a fair value hierarchy that firms are expected to adhere to, in order to obtain the best possible estimate of the unobservable "true" reporting unit fair value. Henning, Shaw and Stock (2002) use different valuation models to estimate the write-off amount.

1140See SFAS 142.19.

114 1Refer to section 4.4 for the level of aggregation at which sub-units of the firm are tested for goodwill impairment, and for the relation of reporting units and operating segments.

also not disclosed. 1142 Also, even where such sub-entity-level fair value measures were available, the extent to which such accounting numbers measure "true" fair value is open to debate.

These constraints make it necessary to use entity-level data in this study. This problem is also acknowledged by Segal (2003), who uses enterprise-level estimates of expected goodwill impairment. 1143 The entity-level MTB ratio is a crude proxy for the reporting unit-level MTB ratio because, at the entity level, goodwill impairment in one reporting unit can be offset by internally generated goodwill in another. 1144 However, whenever the entity-level MTB ratio is smaller than one at the transition date, impaired goodwill is likely to be found in at least one of the reporting units. 1145

As discussed in section <IP_ADDRESS> above, extant literature documents that "firms write down assets during periods of poor performance." 1146In most studies of write-off determinants, variables representing the recent developments in market-based performance measures as well as accounting-based performance measures are included to capture the extent to which goodwill write-offs are determined by economic factors.1147 Declining stock prices and decreasing accounting-based performance measures, such as return on assets (ROA),

1142 SFAS 142 requires some segment-level disclosures. However, these do not include segment fair values.

1143See Segal (2003, p. 23). A similar procedure is adopted by Riedl (2002, p. 3), who analyzes SFAS 121 write-offs. This approach is supported by Strong and Meyer's (I 987, p. 650) finding that "[w]ritedown firms exhibit subpar performance [relative to a control group] on ... market-to-book ra**tio".**

1144Refer to section 4.4 above. This problem will tend to occur more frequently in firms with multiple reporting units that are economically dissimilar.

1145 The only exception to this rule occurs when the fair values of all reporting units with goodwill allocated to them are higher than the respective book values. The low entity-level MTB ratio, then, is "caused" exclusively by reporting units that have no goodwill allocated to them.

1146White, Sondhi and Fried (2003, p. 279).

1147See Segal (2003, p. 16), Francis, Hanna and Vincent (1996, pp. 122-3), and Riedl (2002, pp. 9-10). Here again, firm-level data are used as proxy variables for reporting unit performance.

may signal that the future prospects of a firm have deteriorated. 1148 Again, (unavailable) reporting unit performance data should ideally be used because reporting unit underperformance could require a goodwill write-off even where the entity as a whole appears unaffected. The costs of procuring the second-best segment data seem to be out of proportion compared to the expected improvement in proxy variable accuracy.

The likelihood of impairment is frequently assumed to be especially high where firms operate in industries with declining performance.1149 While the obsolescence of individual assets and technologies might affect whole industries, it seems more difficult to justify why poor industry performance as such, incremental to *individual* firm performance, should have explanatory power for goodwill impairment in individual firms. On the contrary, good performers in poorly performing industries might try to "get away" with economically unwarranted write-offs.

### 5.2.3 Financial reporting incentives

Economic-consequences incentives and capital market-related incentives are argued to influence goodwill write-offs. Consequently, the two groups of hypotheses developed in this section are based on different sets of assumptions: First, predictions concerning economic-consequences incentives as discussed in section <IP_ADDRESS> must consider how transitional SF AS 142 goodwill write-offs influence contractual outcomes and how they affect potential regulation. Second, hypotheses about capital market-related incentives as described in section <IP_ADDRESS> presume certain *beliefs* on the part of management regarding

1148 Considering changes (versus levels) in performance variables is more likely to capture economic impairments because accounting for impairment is not intended to capture low performance in absolute terms, but declines in asset value that result from decreasing performance. No explicit assumption is made here regarding the temporal relation between accounting-based and price-based performance measures, i.e. accounting-based performance measures are not expected to lead price-based performance measures and vice versa.

1149 See Francis, Hanna and Vincent (1996, p. 123), Riedl (2002, pp. 9-10), and Segal (2003, p. 17).

the way transitional SF AS 142 goodwill write-offs are perceived by capital market participants, such as (potential) shareholders, debt holders, financial analysts and rating agencies. 1150

#### **<IP_ADDRESS> Economic-consequences incentives**

#### *5. 2. 3.1.1 Compensation*

As discussed in section <IP_ADDRESS>.3, managements' income is frequently determined by reported accounting earnings. To the extent that the present value of managers' current and future accounting earnings-based compensation is affected by transitional SFAS 142 goodwill write-offs, this decision can be expected to be influenced by compensation considerations.1151 Ideally, compensation plan details for each of the individuals relevant to write-off behavior would be used to test this prediction. Since the cost of procuring this information is prohibitive, several simplifying assumptions are necessary.

First, the income of financial reporting decision makers is at least in part determined by the firms' accounting earnings, i.e. accounting earnings-based compensation plans exist. Previous research shows that CEO compensation is positively related to the firm's accounting performance, even where no explicit accounting earnings-based plans are in place. 1152 However, since the actual existence of accounting earnings-based compensation plans cannot be positively ascertained, it is argued, consistent with prior research, that accounting-based plans are more likely to exist in firms with a greater portion of assets-in-place, because high-growth option firms are more likely to have compensation plans based on stock price. In the latter firms, future prospects are considered more relevant to management compensation than is income generated by existing tangible assets. 1153

1150 "Managers", "management", or "firms" in this context refers to the person or group of persons ultimately responsible for making financial reporting decisions. In most cases, this will be either the chief executive officer (CEO) or the chief financial officer (CFO).

1151See also Francis, Hanna and Vincent (I 996, p. 123).

1152Smith and Watts (1992, p. 275) report that CEO compensation varies with a measure of accounting ROA. See also Murphy (1985).

1153See, for example, Dunstan (1999, p. 17), Gaver and Gaver (1995), and Smith and Watts (1992, p. 264). According to Skinner (1993, p. 419), assets-in-place are "those assets whose ultimate value does not principally depend on future discretionary investment by managers", measured by the ratio of the book value of PP&E to total firm value. He documents that the investment opportunity set "affects the nature of the firms' debt and compensation contracts. Specifically, firms with relatively more assetsin-place are more likely to employ (i) accounting-based debt covenants in their public debt contracts and (ii) bonus plans that tie the bonus directly to accounting earnings" (p. 408).

Second, it is assumed that the *transitional* SFAS 142 goodwill write-off is ignored in accounting earnings-based compensation plans, i.e. the CEO's accounting earnings-based bonus is shielded from the effect of SF AS 142 adoption. It has been documented in prior research that executive income reflects positive developments, but is protected from negative accounting entries to the extent that these have an "unusual" character or result from potentially value-enhancing activities such as restructurings. 1154 Since transitional SF AS 142 goodwill write-offs can be argued to have both of these characteristics, 1155 it is assumed that SFAS 142 goodwill write-offs are unlikely to have an adverse effect on the CEO accounting earnings-based compensation *in the year of adoption.* 1156

Third, it is expected that write-off behavior nonetheless does influence managers' *future*  accounting earnings-based compensation and therefore the present value of that income component. Future goodwill write-offs, reported within income from continuing operations, are likely to be perceived as more pennanent earnings components, having relevance for earnings-based bonuses awarded management.

Based on these assumptions, managers with accounting-based plans are expected to report transitional SFAS 142 goodwill write-offs in order to shield future accounting earnings and compensation from adverse effects of future write-offs. 1157

### H~ 1:

Ceteris paribus, a positive relation exists between the write-off decision and the existence of accounting earnings-based compensation plans for top management.

#### *<IP_ADDRESS>.2 Debt covenants*

As discussed in section <IP_ADDRESS>.4, most firms are a party to lending agreements that specify certain cutoff points in terms of accounting-based ratios. The violation of these restrictive covenants triggers default on the loan, which may result in substantial costs to

1154Refer to section <IP_ADDRESS>.3 for a review of this literature.

*1155*For example, Deutsche Telekom AG justified their record-breaking write-off by arguing that it stemmed from a "strategic review". See Deutsche Telekom AG, annual report on form 20-F for the period ending on December 12, 2002.

rn6 This assumption seems reasonable despite Healy, Kang and Palepu's {1987) findings that CEO compensation is affected by voluntary changes in accounting procedures, because mandated accounting changes are more easily unraveled by compensation committees. Similar results are reported by Abdel-khalik ( 1985).

1157Because assets-in-place is intended to capture the probability that an accounting-based compensation plan exists *at all,* it is not expected to be linearly associated with the *amount.* Beatty and Weber (2004, p. 15) use recent bonus payments and the existence of a bonus plan based on net income as indicators that a firm is likely to delay goodwill impairment charges.

the firm. To the extent that the accounting numbers and ratios specified in debt covenants are affected by transitional SFAS 142 goodwill write-offs, it can be expected that writeoff behavior is influenced by managers' desire to avoid covenant violation and the cost associated with it. 1158 In order to assess whether debt covenant motivations play a role in transitional SF AS 142 goodwill write-off behavior, the treatment of the write-off in each of the sample firms' covenants must be known. Since obtaining actual covenant data is associated with prohibitive costs, 1159 a proxy for firms' closeness to covenant restrictions and, consequently, the expected costs of covenant violation is used here.1160

Regardless of the accounting-based proxy used, it is necessary to assume that the transitional SFAS 142 goodwill write-off will have repercussions on the restrictiveness of sample firms' debt covenants at all. For the following reasons, it is assumed that this accounting entry is not entirely ignored in the calculations of debt covenants: 1161 First, debt covenants frequently refer to promulgated GAAP for definitions of accounting numbers. 1162 The relevant GAAP rules are mainly those in force at the date of calculation ("rolling" GAAP), not at the original date of debt issuance ("frozen" GAAP). Therefore, new accounting standards such as SFAS 142 have the potential to influence the probability of covenant default where "rolling GAAP" is used. 1163

Second, where debt covenants do rely on "fixed GAAP", such modifications to promulgated GAAP are regularly conservative, i.e. they *decrease,* rather than *increase,* income and assets.1164 Where no write-off is taken, the elimination of goodwill amortization, ce-

1158See also Beatty and Weber (2004, p. 11).

1159See also Beneish and Press (1995, p. 338), Moehrle (2002, p. 410), and Press and Weintrop (1990, p. 65).

1160It is not explicitly considered how the cost of technical default is likely to vary across firms. See Beneish and Press (1993). Therefore, a finn 's closeness to covenant restrictions is used as a proxy for the expected costs of covenant violation.

1161Much of the following relies on the findings of Leftwich (1983, pp. 35-6).

1162See, for example, Smith and Warner (1979, p. 144). Wans and Zimmerman (1986, p. 213) argue that "[t]he specification and preparation of an additional set of accounting statements solely for a debt contract is costly." By not specifying "fixed GAAP", managers accept that lenders will require favorable terms because of the risk of "covenant-relaxing" earnings management. See also EI-Gazzar, Lilien and Pastena (1989).

1163 To the extent that borrowers and lenders do negotiate debt covenants that specify "tailored" accounting rules departing from promulgated GAAP ("fixed GAAP"), transitional SFAS 142 goodwill writeoff are unlikely to affect the probability of default. However, recent evidence suggests that, while "fixed GAAP" covenants have been gaining importance in recent years, a large portion of extant covenants does resort to accounting numbers based on promulgated GAAP rules. See Mohrman (1996, pp. 79, 85). The author notes that failure to account for "fixed GAAP" in debt covenants impairs researchers' ability to interpret empirical results pertaining to the debt covenant hypothesis.

1164See Leftwich (I 983, p. 36).

teris paribus, makes SFAS 142 an income- and asset-increasing accounting rule. On the opposite, substantial decreases in both income and assets result where write-offs do occur. 1165 Given that the treatment of transitional SF AS 142 goodwill write-offs in actual lending agreements is unknown, the above finding suggests that write-offs do affect the probability of covenant default even where "fixed-GAAP" modifications to promulgated GAAP are in place. 1166 In a related study, Cotter (1998) finds no evidence that goodwill amortization is added back to the numerator of the interest coverage ratios in Australian private debt agreements. 1167 Leftwich's (1983) detailed analysis of "fixed GAAP" provisions suggests that goodwill is "frequently excluded from the asset base against which firms may borrow." 1168 In that sense, transitional SF AS 142 goodwill write-offs would have no potential to influence the asset base, regardless of whether a write-off is taken or not. However, he also reports that "goodwill is eliminated from balance sheet numbers but amortization is required in the income statement."1169 To the extent that goodwillrelated charges are not added back, any transitional SFAS 142 goodwill write-off has the potential to decrease income and equity, which impairs certain accounting ratios such as the DTE ratio. 1170

Third, departures from GAAP are more common in private rather than public lending agreements. 1171 Where sample firms rely at least in part on public debt, the arguments set forth above are likely to apply to them. In conclusion, transitional SFAS 142 goodwill write-offs are likely to be influenced by debt contracting considerations with regard to both decision and amount.

Since no actual covenant data is available, a relevant proxy variable is used to capture the restrictiveness of debt covenants. As discussed in section <IP_ADDRESS>.4, prior research frequently and justifiably relies on the DTE ratio as such a proxy, since a firm's expected cost of covenant violation is assumed to increase in its financial leverage. Even though other ratios are common in actual covenants, the DTE ratio can be considered a suitable

1165 Refer to White, Sondhi and Fried (2003, pp. 527-8).

1166However, Mohrman (1996, p. 85) finds that "there is no one standard way of writing fixed GAAP provisions".

1167 While this finding alone implies nothing about the treatment of transitional SFAS 142 goodwill writeoffs, it does indicate that lenders view goodwill-related charges to be relevant for assessing borrowers' creditworthiness.

1168Leftwich (1983, p. 39). See also Foster (1986, p. 595).

1169Leftwich (1983, p. 39).

1170 In addition, even where such write-offs do not occur, debt covenants potentially require that some form of amortization charge related to goodwill is made nonetheless.

1171See Leftwich (1983, p. 36) and Smith and Warner (1979, p. 144).

proxy since most other leverage-related ratios are affected when the DTE ratio deteriorates.1172 In addition, capital market participants can be assumed to use the DTE ratio as an indicator of firm risk. 1173 Interestingly, an economic standpoint would suggest that financially distressed firms (where financial distress is approximated by the extent of financial leverage) are more likely than others to have impaired goodwill. 1174 Thus, the observation that write-offs are larger and more frequent where financial leverage is comparatively low would be strong evidence that write-off behavior is at least in part determined by financial reporting incentives. Because the absolute DTE ratio in itself is not meaningful, industry-adjusted figures are used. 1175

#### *<IP_ADDRESS>.3 Political costs*