Goodwill and accounting discretion

Authorship: Marco Bisogno, Associate Professor (Accounting) Department of Management & Innovation Systems, University of Salerno: Fisciano (SA). Italy.


According to EU Regulation 1606/2002, since January 2005 all listed EU firms are required to prepare their consolidated financial statements (and, in the Italian context, also their separate financial statements) in accordance with IFRS; therefore, they are required to use the IAS 36, IAS 38 and IFRS 3 to recognise the goodwill as well as to evaluate whether it has to be impaired. In fact, according to the above-mentioned accounting standards, goodwill is not amortised but is subject to an annual impairment test; more specifically, IAS 36 prescribes that goodwill must be written down if its carrying value exceeds the recoverable amount (expressed by the higher of fair value less costs to sell and the value in use).

Even though IASB decided to prohibit amortization in order to express the “true” value of goodwill in the balance sheet, contrasting earnings management behaviour, scholars argue that both the first recognition of goodwill value as well as its impairments provide managers with a substantial accounting discretion (Bloom 2009). In fact, this discretion can relate firstly to the identification of goodwill within the whole price of an acquisition (thus goodwill is considered as a residual value) and, secondly, to the determination of its recoverable amount as well as its allocation within cash generating units (Wong & Wong 2001). More specifically, the decision of writing down goodwill, the time of this decision and the magnitude of the impairment loss provide managers with a good opportunity to manipulate earnings. The magnitude of this discretion is expected to be larger in periods of financial crisis, where a more frequent impairment of goodwill should occur.

Furthermore, a recent study (ASBJ et al. 2014) highlights that impairment losses often come too late and this effect has been made evident in recent years in which many entities recognised impairment losses of goodwill several years after the financial crisis; as a consequence, it concludes that reintroduction of goodwill amortisation would be appropriate, because it reasonably reflects the consumption of the economic resources acquired in a business combination over time. The aim of the paper is to investigate this timely topic by analysing the association between discretionary accruals and yearly changes of goodwill (due to its first recognition because of new acquisitions and to its impairments), referring to a sample of Italian listed firms. By this way, this study will try to add new knowledge to this intriguing accounting issue by considering not only accounting discretion provided by impairment test procedure but also that yielded by the initial recognition of goodwill, as a residual value emerging after allocating the price of acquisition within a business combination.

From a methodological point of view, we adopted the modified Jones’ regression model, which is largely used in many studies investigating earnings quality. Findings provided by this model support the idea that goodwill accounting offers several possibilities to manipulate earnings. The remainder of the paper is structured as follows. The second section focuses on goodwill accounting treatment over time, while the third one reviews the literature on the topic introducing the hypotheses of the study. The fourth section presents and discusses the results while the fifth one concludes, also summarising further developments of the research.

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This article is published in the Scholedge International Journal of Management & Development Vol. 02, Issue 10 (2015).