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Review of Quantitative Finance and Accounting

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11-07-2020 | Original Research

Did SFAS 141/142 improve the market’s understanding of net assets, goodwill, or other intangible assets?

Authors: Peter M. Johnson, Thomas J. Lopez, Trevor L. Sorensen

Published in: Review of Quantitative Finance and Accounting | Issue 3/2021

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Abstract

Statement of Financial Accounting Standards nos. 141 and 142 eliminated the pooling method of accounting for acquisitions and altered the accounting for intangible assets, respectively. The Financial Accounting Standards Board (FASB) asserts that as a result of these changes financial statement users (i.e., market participants) will be “better able to understand the investments” made and have an improved “ability to assess the future profitability and cash flows” derived from these assets. In this paper, we address whether the FASB accomplished its goals with these new standards. We utilize an OLS regression to assess investors’ ability to forecast a firms’ future performance and to determine whether the information related to these accounting changes are impounded into market prices. The overall evidence partially supports FASB’s assertion of providing better information. While there is a significant improvement in market participants’ ability to assess the future economic benefits associated with goodwill, there does not appear to be any improvement in the market’s ability to understand the future implications of other intangible assets or net assets in general.

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In 2007, the FASB revised SFAS 141 (R). In 2009, the FASB renamed SFAS 141 (R) and SFAS 142 as Accounting Standards Codification 805 and 350, respectively.

Consistent with Lee (2011), we also find evidence that suggests a stronger association between goodwill and future cash flows post-SFAS 142. We discuss those results in detail later in the text.

Other intangible assets that are still amortized continue to follow SFAS 121 (FASB 1995) and are tested for impairment using undiscounted cash flows only when an event occurs indicating impairment may have occurred. SFAS 144 (Accounting for the Impairment or Disposal of Long-Lived Assets) supersedes SFAS 121, and applies to intangible assets that are not amortized. The rules for testing for impairment are consistent with that of SFAS 121.

We estimate 5, 3, and 10-year pre- and post- time periods surrounding the enactment of SFAS 141/142. We also utilize a more recent sample in the post-period (2012–2016) and find consistent results for all tests.

SFAS 141 was revised by the FASB in 2007 as SFAS 141(R). The revision provides additional guidance for recognizing and reporting assets and liabilities that are acquired in a business combination. The revised standard reinforces the FASB’s overall goal of providing financial statement users with better information regarding business combinations.

Only one of the two criterion needs to be met in order to identify a different intangible asset (FASB 2001a).

SFAS 144, Accounting for the Impairment or Disposal of Long-Lived Assets, was implemented in 2001 to replace SFAS 121 and does not apply to certain intangibles such as goodwill or intangibles with indefinite useful lives (FASB 2001c). Under the new standard, the accounting for an impairment of a finite-lived intangible is similar with three exceptions: (1) goodwill is no longer allocated to the long-lived assets tested for impairment, (2) a probability-weighted cash flow model may be used, and (3) a “primary-asset” approach is used to determine the cash flow estimation period.

Intangible assets with a finite useful life are amortized over the estimated useful life of the asset. In addition, when SFAS 142 was issued, the impairment tests for these assets still followed SFAS 121.

SFAS 142 defines a reporting unit as “an operating segment or one level below an operating segment (referred to as a component). 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” (FASB 2001a).

As previously noted, SFAS 144 was also implemented a few months after SFAS 141 and SFAS 142. While SFAS 142 focuses on the subsequent performance of intangible assets with indefinite useful lives (FASB 2001a), SFAS 144 focuses on intangible assets with finite lives (FASB 2001c).

Also see Hayn and Hughes (2006), Ramanna (2008), Ramanna, and Watts (2012).

As discussed previously, prior research documents that managers use the discretion afforded in SFAS 142 to delay recognition of goodwill impairments all of which suggests uncertainty increased post-SFAS 142 (Ramanna 2008; Li and Sloan 2017; Li et al. 2011; and Ramanna and Watts 2012).

See Kraft et al. (2007) footnote #2, p. 1083 and section 6.2, pp. 1102–1106 for a detailed discussion of this issue.

The purpose of this test is to determine whether the market becomes more accurate (i.e., does the overall magnitude of the coefficient move toward zero). If one coefficient is negative and the other is positive, this could result in a significant difference between the two time periods, but the market may simply have changed from overweighting to underweighting the implication that the variable has on future earnings or cash flows. Using the absolute value of both coefficients allows us to assess the change in magnitude, and controls for this potential shift.

Consistent with Lee (2011), we scale all of the variables in our main tests by sales. However, we note that scaling by sales has its own problems, specifically for the earnings tests. Earnings divided by sales is net margin, while net asset (goodwill) are the inverse of net asset (goodwill) turnover. Therefore, the prediction equation is testing if turnover influences the future net margin—not future profitability. Continuing this scenario into the return regression, the analysis relates to whether the market understands the implications of how NA/goodwill turnover influences net margin. Given this concern, we also run all tests using beginning stock price as the scalar and the results are consistent.

We identify these firms using Compustat data item ACQMETH. This data item provides codes that allow us to determine whether the firm accounted for an acquisition of another entity using the pooling or purchase method of accounting.

Although the post-period coefficient for OIA_t in the cash flow model is significant at the 0.10 level, there is no intertemporal difference between the pre- and post-SFAS 141/142 coefficients. This indicates no change in the information provided by the standards, yielding consistent results with those from the test using income.

We also utilized a changes model for the purchasing firms and find results (untabulated) that are consistent with the reported levels tests.

We identify pooling firms using Compustat data item ACQMETH consistent with our method of identifying purchase firms (Table 7 tests).

American Institute of Certified Public Accountants (AICPA) (1970) Accounting principles board opinion no. 17: intangible assets. AICPA, New York

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Title: Did SFAS 141/142 improve the market’s understanding of net assets, goodwill, or other intangible assets?
Authors: Peter M. Johnson
Thomas J. Lopez
Trevor L. Sorensen
Publication date: 11-07-2020
Publisher: Springer US
Published in: Review of Quantitative Finance and Accounting / Issue 3/2021
Print ISSN: 0924-865X
Electronic ISSN: 1573-7179
DOI: https://doi.org/10.1007/s11156-020-00912-x

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