Fair Value Accounting : Consequences of Booking Market-Driven Goodwill Impairment

We examine whether fair value accounting applied to goodwill impairment leads to unintended consequences. Under the fair-value-based goodwill impairment test, a firm's market value is often used as an important reference point for determining whether goodwill is impaired. A below-one market-to-book ratio is considered a reasonable indicator of impairment by external auditors and security lawyers; however, this indicator could be distorted when prices deviate from fundamentals. In fact, mechanical reliance on the market indicator could result in firms being pressured into recording goodwill impairment upon a temporary market value decline, even when the impairment is unsubstantiated by economic fundamentals. Using a comprehensive sample of goodwill impairments, we identify impairment charges of over 14% of our sample as likely market-driven and not backed by fundamentals; this percentage nearly triples in 2008, in the midst of the recent financial crisis. Validating our identification of market-driven impairments, we show that the impairment loss of these firms is significantly associated with a return reversal in the subsequent year, and the reversal is more pronounced for firms facing high litigation pressure. Additional tests indicate that investors do not differentiate between market-driven and other impairments upon the initial loss announcement. Further, we find that firms with market-driven impairments experience an increase in information asymmetry in the subsequent year and “time” share repurchases and insider purchases to benefit from the delay in the market's reversal of the temporary undervaluation. Overall, our findings shed light on the negative consequences associated with the imperfect implementation of fair value accounting