Big bath and goodwill impairment.

AutorGoncalves, Cristina

1 Introduction

The recognition of impairment losses in goodwill (designated by Imp_GW) appears in the literature because of the loss of capacity to generate cash in the future (Brutting, 2011; Olante, 2013).

The verification and quantification tests of Imp_GW, according to International Accounting Standard (IAS) 36, have economic impacts (Harris & Caplan, 2002), with reflections on the value of the company and the likelihood of recognizing the loss, its amount, and its timing. Ramanna and Watts (2012) identify three aspects that introduce high discretion into the recognition of Imp_GW: (i) GW's effect on cash-generating units, (ii) estimation of the deducted value of future cash flows, and (iii) determination of fair value of assets and liabilities.

There is evidence of opportunistic earnings management through Imp_GW. In particular, big bath practices and income smoothing depend on a set of factors, in addition to the accounting choice permitted by the standards. Several authors have analyzed this issue in different contexts and using various methodologies, but they have not reached a consensual conclusion. For instance, Carvalho (2015), Jahmani, Dowling, and Torres (2010), and Li, Shroff, Venkataraman, and Zhang (2011) found Imp_GW is used as a tool for earnings manipulation, while Avallone and Quagli (2015), Castro (2012), and Jordan and Clark (2004, 2015) do not confirm the hypothesis.

One other stream of research analyzes the factors inhibiting or facilitating earnings management policies, such as the capacity for credit negotiation (Beatty, Ramesh & Weber, 2002; Beatty & Weber, 2006; Riedl, 2004), the market value of the company (Chen, Kohlbeck & Warfield, 2008; Giner & Pardo, 2015; Jarva, 2009; Lee, 2011; Li et al., 2011; Li & Sloan, 2017), and its indebtedness (Godfrey & Koh, 2009; Hamberg, Paananen & Novak, 2011). The conclusions are neither consensual, nor robust.

The lack of consensus in the various studies, together with criticisms from preparers, auditors, regulators, and investors, have motivated the ongoing process of reviewing IFRS 3 and support the relevance of this research, which has the following objectives: (i) to analyze to what extent the recognition of Imp_GW is associated with periods where earnings before Imp_GW are negative (big bath practices); (ii) to assess to what extent debt and capital markets restrict the recognition of Imp_GW in big bath practices.

This paper focuses on comparing Portuguese and Spanish companies, based on a sample of 105 companies with securities listed on the stock exchange (2007-2015), and it adopts a quantitative methodology and dynamic multivariate regression models, using panel data.

Although the companies apply international accounting standards / international financial reporting standards (IAS / IFRS) and are influenced by code law in both countries (Knobble & Parker, 2004), there is evidence (e.g., Fernandes, Goncalves, Warrior & Pereira, 2016) of more conservative accounting behavior regarding the recognition of Imp_GW, in some companies, thus justifying some interest in this comparative analysis.

This study contributes to the literature in two ways: (i) by comparatively analyzing big bath practices in two countries, which apply the same accounting standards (IAS/IFRS) and are influenced by code law; (ii) by analyzing constraints to big bath practices that use Imp_ GW, such as debt and capital markets.

Our findings suggest the existence of earnings management policies based on the recognition of Imp_GW. So one may question whether the annual assessment of these losses is the best criterion for evaluating GW as guarantor of credible financial information. Thus, the study encourages those bodies responsible for accounting standardization to analyze the efficiency of the mechanisms involved in the recognition ofImp_GW, by pondering regulatory solutions to minimize the degree of discretion associated with the timing and value of these losses and thereby improving the credibility of financial information.

2 Literature Review

2.1 Big bath practices

Earnings management is associated with strategies to achieve benchmarks, namely the smallest variability in inter-period earnings (income smoothing), as a tool for managing shareholders' and other stakeholders' expectations, and the expectation of increasing future earnings (big bath accounting), following the penalization of present earnings. This paper analyzes negative earnings as an inducing factor of those practices.

Several authors (Henning, Shaw & Stock, 2004; Li & Sloan, 2017; Ramanna & Watts, 2012; Riedl, 2004) analyze the recognition of Imp_GW in the context of managers' discretion, namely the amount and time of such recognition, notably through big bath practices, associated with the use of non-current items to manage earnings in periods where they are significantly low. This strategy is justified by the expectation that markets do not penalize companies in proportion to their losses, because investors focus more on the future and companies signal to the market improvements obtained after a bad result (Jordan & Clark, 2004).

Walsh, Craig, and Clarke (1991) define big bath as the use of non-frequent items to adjust earnings and in situations of abnormal losses or gains, while Elliott and Shaw (1988) consider that big bath occurs when the impairment reported in special items represents more than 1 per cent of the accounting value of the assets. These practices are more likely in large companies than in small ones, although a big bath strategy has more impact on the latter (Sevin & Schroeder, 2005).

Li et al. (2011) found evidence of big bath practices that use Imp_GW being associated with the presence of negative earnings, while AbuGhazaleh, al-Hares, and Roberts (2011), Beatty and Weber (2006), and Jordan and Clark (2015) associate big bath practices with recent changes of Chief Executive Officer (CEO). However, the hypothesis that earnings manipulation (big bath) is associated with a new CEO was not validated by Avallone and Quagli (2015), Jordan and Clark (2004, 2015), and Ramanna and Watts (2012). These authors concluded that impairment recognition is associated with other factors, namely the market's perception or the effective deterioration of the assets. For example, Jordan and Clark (2004) conclude that companies recognized more Imp_ GW in 2002 probably because earnings were already diminished and the market would punish them relatively little if they were reduced. Van de Poel, Maijoor, and Vanstraelen (2009) conclude that impairment is recognized in periods where other losses are also recognized or in periods where earnings before impairment are relatively low, while Jahmani et al. (2010) suggest that managers manage the moment of Imp_GW recognition. In turn, Escribano (2015) and Francis, Hanna, and Vincent (1996) conclude that a history of Imp_GW recognition induces similar future behaviors.

In studies applied to Portuguese companies, Carvalho (2015) found evidence of big bath practices, while Castro (2012) did not find such practices. Alves (2013) confirmed the relevance of Imp_GW as a discretionary element of accruals. Escribano (2015) also concludes that these practices exist in Spanish companies.

Whereas the literature is not in agreement regarding the practice of using Imp_GW as an instrument for earnings manipulation, the following research hypothesis is considered:

H1: The recognition of Imp_GW is associated with negative earnings before the Imp_GW, ceteris paribus.

2.2 Constraints to big bath practices

2.2.1 Debt

Several studies associate the tendency not to recognize impairment, in the context of earnings management, with this being able to influence the debt capacity of companies, namely in the risk premium or in obtaining new loans (Beatty et al., 2002; Beatty & Weber, 2006; Riedl, 2004).

When GW and other intangibles have a significant weight in total assets, creditors do not ignore the information contained in those items (Beatty, Weber & Yu, 2008). The perception of credit risk may be flagged by debt-to-equity or liabilities-to-assets ratios. High levels of indebtedness encourage non-recognition of impairment in order not to increase those indicators and to avoid consequences in terms of debt negotiation. This behavior is not, however, generalizable. Beatty et al. (2002), for example, conclude that companies are willing to accept higher interest rates in order to maintain flexibility in their accounting options, thus weighing up other interests besides the cost of indebtedness alone, in particular those related to agency costs, litigation, or taxes (Beatty et al., 2008).

Other authors, notably AbuGhazaleh et al. (2011), Avallone and Quagli (2015), Beatty and Weber (2006), Godfrey and Koh (2009), Hamberg et al. (2011), Ramanna and Watts (2012), Vogt, Pletsch, Moras's, and Klann (2016), and Zhang (2008), associate indebtedness with options in accounting policy. Beatty and Weber (2006) suggest companies are less susceptible to recognizing Imp_GW when they have less negotiating capacity and accounting changes affect credit agreements. Zhang (2008), in turn, analyzes the relationship between conservative accounting policies and credit agreements, noting that there are minor inequalities in more leveraged companies and that lenders offer lower interest rates to more conservative borrowers. However, the author considers that more conservative borrowers are the ones most likely to violate contracts as a result of negative impacts. Ramanna and Watts (2012) also confirm that Imp_GW decreases when changes to debt contracts are at risk.

The results on discretion in the recognition of Imp_GW and indebtedness are neither consensual nor robust. Godfrey and Koh (2009) concluded that managers use discretionary power to reduce hiring costs and found a meaningful but non-robust relationship there. Hamberg et al. (2011) also tested the relevance of the debt ratio in recognizing...

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