The impairment of purchased goodwill:

effects on market value

Kevin Li

Geoff Meeks

University of Cambridge
Judge Business School
Trumpington Street
Cambridge
CB2 1AG
UK

Contact: g.meeks@jbs.cam.ac.uk

We are grateful for criticisms and suggestions to participants at the British

Accounting Association and European Accounting Association Annual Conferences,
and to Antonia Botsari, Robin Chatterjee, Gishan Dissanaike, Lisa Goh, Kim-Hwa
Lim, Richard Macve and Geoffrey Whittington.

1
Abstract

The impairment of purchased goodwill: effects on market value

This paper exploits two special opportunities to explore the impact on stock prices of

firms’ decisions to impair purchased goodwill. The first opportunity is afforded by the

introduction from 1998 of formal accounting standards for such impairment by the

UK regulators for the world’s second biggest M&A market – several years ahead of

SFAS 142. The second opportunity is provided by the “irrational exuberance” of the

late nineties’ stock markets, which swelled both M&A volumes and market to book

ratios, and consequently purchased goodwill; and this was followed by a bear market

in which valuations were re-appraised and many impairments carried out. We

estimate the impact of purchased goodwill, and of its impairment, on stock prices for

UK firms in the years 1997-2002. We confirm previous findings that purchased

goodwill is value–relevant in the year of acquisition, but this fades thereafter; and that

amortisation is value-irrelevant. By contrast with amortisation, we find that

impairment is associated with roughly pari passu reductions in market value.

Keywords: Goodwill; impairment; value-relevance

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The impairment of purchased goodwill: effects on market value

1.Introduction

US and UK accounting standard setters have in recent years adopted a series of

sharply contrasting treatments of the goodwill purchased in the course of merger and

acquisition. Purchased goodwill could in some circumstances be left out of account

altogether (pooling/merger accounting); or, under one, now defunct, standard, it could

be recognised in the balance sheet, but have no eroding impact on the income

statement (the “dangling debit”); or at another stage, it could be recognised on

purchase but be immediately written off against reserves (again eliminating any

eroding effect on the income statement); or, most recently, it could be recognised in

the balance sheet and then be mechanically amortised through the income statement.

But now FASB and IASB have repudiated all these techniques, in favour of universal

recognition of purchased goodwill on the balance sheet, followed by annual review of

whether the value of the goodwill has been impaired, and, where necessary, debiting

the impairment over the year in the income statement.

The impact on the financial statements of different rules for goodwill is often far from

trivial – particularly where the target is large in relation to the acquirer, and where the

bid takes place late in a bull market, when the disparity between book and market

values, which drives purchased goodwill levels, is unusually big. For example, within

our sample, the giant UK firm Marconi saw purchased goodwill rise to 73% of total

assets in 2001 following a string of takeovers. The goodwill impairment in the

3
following year eliminated 48% of total assets, the equivalent of 85% of that year’s

sales.

Practising accountants have become very exercised about their freedom to choose

how to account for purchased goodwill. Lys and Vincent (1995) report that AT&T

offered to pay at least $50 million more to the shareholders of NT&T if they could

account for the transaction using pooling rather than purchase. Zeff (2002) reports on

the ferocity of lobbying over SFAS 141 and 142 – reaching as far as the US Congress,

and securing major changes in the resulting regulations. Then the Accounting

Standards Board of Japan showed considerable reluctance to adopt the latest

international standard, IFRS 3i.

Academic accountants, on the other hand, have often been more sanguine about the

changes in ruleii. It is argued that, for example, in comparing pooling (no goodwill)

and purchase (with goodwill recognised and then amortised), sufficient information

was routinely disclosed for analysts readily to convert accounts compiled on one basis

into a version on the alternative basis. Thus Ayers et al (2000) were able from

published accounts to estimate imputed goodwill for firms which had used pooling,

and thus to simulate accounts on the alternative basis of purchase-plus-amortisation.

In these circumstances, with semi-strong efficient equity markets, the accounting rule

should be irrelevant to market value: markets should be able to “see through” and

“reverse out” the differences in accounting numbers caused just by different

approaches to goodwilliii. This is indeed consistent with much of the market-based

research (e.g. Hong et al (1978)iv, Jennings et al (1998), Moehrle et al (2001)). And

4
one would have to look instead to, say, contracting explanations for the heated debate

among practitioners about accounting for purchased goodwill.

The same arguments may not be applicable to the now dominant device of

impairment, however. Whereas in the case of pooling versus purchase, the outsider

analyst can often convert from one rule to another using public information (book and

market value of target, amortisation rules), the impairment data represent the release

of information not routinely available to the market. The impairment review requires

executives and auditors to compare their current forward-looking assessments of the

income-generating prospects of their purchased goodwill with their corresponding

earlier estimates. Impairment in the income statement reflects the change over the

year in managers’ forecasts of earnings attributable to the intangible assets they

purchased. And such forecasts were not previously published; nor are they routinely

published for other categories of asset. In this respect, therefore, the impairment

regime represents a qualitative change in disclosurev; so, in contrast with

amortisation, these data might be value-relevant.

In this paper we test for such value relevance for the world’s third largest equity, and

second largest takeover, market – the London Stock Exchange. By a quirk in the

history of accounting regulation, data are available for this market which cannot be

offered by the larger New York market.

In many respects the UK regulators have, with a lag, followed FASB in their approach

to purchased goodwill – in the decisions on permitting, then restricting, then banning

pooling (merger) accounting, and first in requiring, and then in forbidding, the

5
amortisation of purchased goodwill. But in one respect crucial to our paper, the UK’s

ASB anticipated FASB policy – by introducing impairment reviews as a technique for

handling purchased goodwill from 1998, ahead of FASB. And those early years of

experience of impairment are the subject of this paper. We examine for UK listed

companies in this period the use of impairment and the stock market’s reaction to the

new data. We estimate the market’s response using valuation models (cross-section

and panel); and we carry out an event study of the impact of impairment on equity

prices.

These five years are especially significant for two reasons. First, they provide the first

available evidence of the impact of the accounting technique which has now come to

dominate standards worldwide; and, second, they do this for a pronounced cycle of

M&A, and a period of violent change in the market to book ratios – the later years of

Shiller’s (2001) “irrational exuberance”, and then the adjustment to more sober

valuations after 2000. Such swings in the book to market ratio affect the scale of

purchased goodwill, and the subsequent pressure to impair it.

2.Regulatory framework and macroeconomic context

From 2005, UK and US rules on purchased goodwill became largely aligned. The UK

adopted international standardsvi, notably IFRS3vii, which follows SFAS 141 and 142

in its essentials: pooling (merger accounting) is forbidden, so all purchased goodwill

is recognised in the balance sheet; routine amortisation is prohibited in the income

statement; and the only way of adjusting purchased goodwill is via an impairment

review, with impairment debited in the income statement. This harmonisation follows

6
an eight-year period, starting in 1997, the beginning of this paper’s analysis, in which

the UK experienced no fewer than three radically different regimes for reporting

purchased goodwill, and the US two sharply contrasting regimes.

In the US, SFAS 141 and 142 superseded APB 16 and 17 in 2002. The earlier

standards allowed pooling in some circumstances (in which case purchased goodwill

is invisible in both the balance sheet and income statement), but otherwise insisted

that, under purchase accounting, goodwill be routinely amortised through the income

statement over a period up to 40 years.

In 1997, the initial UK regime (via SSAP 22) allowed merger accounting (pooling) in

some cases; but the most common policy was the immediate write-off of purchased

goodwill against reserves – adopted by more than 95% of companiesviii. From 1998

the UK fell into line with some US arrangements in APB 16 – forbidding the

immediate write-off of goodwill, and eliminating discretion over the period of any

amortisation, stipulating no more than 20 years. However, they preceded FASB in

also establishing procedures for goodwill impairment reviews – partly anticipating

SFAS 142, introduced several years later by FASB. The anticipation was partial

because, whereas in 2002 SFAS 142 for the States required impairment review

universally as the treatment of purchased goodwill, instead of amortisation, the 1998

UK standard, FRS 11, offered impairment review as an alternative to amortisationix.

It is this misalignment of UK and US standards in the period from 1998 to 2002

which offers the opportunity in this paper to make an early assessment of the impact

of formal impairment review procedures – before such data were available for the US.

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Moreover, this evolution of standards coincides with and, interacts with, a specially

interesting period for the equity prices which drive much of accounting for goodwill:

the period spans both the climax of the nineties’ bull market in world equities and the

subsequent bear market. This results in great changes in the average book to market

ratio- a key determinant of purchased goodwill levels: the FTSE All Share Index for

the London market ranged from less than 2100 in 1998 to over 3200 in 2000,

returning to below 1800 in 2002 (see Figure 1). Swollen market values can be

expected to have magnified purchased goodwill in the early years of the period; whilst

subsequent impairment reviews of the carrying value of purchased goodwill will have

taken place against widespread downward revisions by the market of valuations

across the whole company sector.

3.Population and data

The evidence in this paper relates to the population of non-financial firms listed on the

London Stock Exchange which were involved as acquirers in mergers and

acquisitions in the period 1997-2002. Acquirers were identified using Acquisitions

Monthly, with supporting checks carried out on Osiris. All members of this

population were studied provided that suitable data for the respective analysis were

available. Basic accounting data were collected from Datastream; but these had to be

augmented by manual extraction of detailed data on goodwill and related variables

from acquiring firms’ actual financial statements, via MergentOnline, or the internet.

The number of firms qualifying for inclusion in any particular analysis is reported

below. The maximum number of LSE listed firms which completed acquisitions in

8
this six-year period and met the data requirements for a particular year was 402, in

2001.

4.How material is purchased goodwill for this population?

A summary indication of the role of purchased goodwill is provided by the ratio of

purchased goodwill to acquirer’s total assets. The mean value of this ratio for firms

which chose purchase accounting was in the range 3.1% to 13.7% (excluding

outliers)x, depending upon the year. Unsurprisingly, the largest observation coincides

with the stock market peak (the year 2000 – see Figure 1), and the smallest with the

lowest value in our period for the FTSE All Share Index.

Goodwill is calculated as the difference between purchase price and the book value of

the purchased assets, where the book values taken from the target’s accounts have

been adjusted to fair value. In practice, on average the fair value adjustment was

scarcely material, representing less than 1% of total consideration in any year.

Within the population, 143 companies impaired goodwill during this period. It is no

surprise that they tended to be companies which had created relatively large goodwill

accounts: in 2000 the goodwill/total assets ratio of the impairing sample reaches 20%

(again excluding outliers) - markedly higher than the population figures reported

above. How significant was the impairment they recorded in the income statement?

For the 2002 sample group of “impairers”, the impairment averaged the equivalent of

35% of that year’s EBITxi.

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Within the population, 17 firms had taken advantage during the period of FRS 10 and

FRS 11’s arrangements for recording non-amortising goodwill (representing 3.5% of

the total). These tend to be companies which had created large goodwill accounts

since FRS 10: in 1999 the goodwill/total asset ratio for this subset of firms reached

29.5% (again excluding outliers).

5.The valuation model

The relationship between aspects of goodwill and market values is examined using the

modified market valuation model originating in Ohlson (1995)xii This links the market

value of the firm’s equity to a stock element of value (book value) and a flow element

of value (earnings adjusted for dividends). Several studies (e.g. Barth et al (1998))

separate the book value and earnings explanatory variables into several components in

order to test the value relevance of new variables and the influence these have on the

overall relation. And that is the approach of this study: different components of the

financial statements related to goodwill are separated from the book value of assets

and the earnings figure in the regression model:

MVit = ait +b1BVit + b2GWit + b3Impairit + b4Cum_GWit + b5Cum_Amortit + b6Eit

+ b7Amortit + eit (1)

MVit = The market value of common stock measured 5 months after

the year-end for firm i in yr t.

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BVit = Net book assetsxiii excluding goodwill acquired in current year,

accumulated goodwill, accumulated goodwill amortisation and current year goodwill

amortisation and impairment for firm i in yr t.

GWit = Goodwill acquired in current year for firm i in yr t.

Cum_GWit = Accumulated goodwill from previous years and adjustment

made to it for firm i in yr t.

Cum_Amortit = Accumulated goodwill amortisation from previous year

and adjustment made to it for firm i in yr t.

Eit = Earningsxiv excluding current year goodwill amortisation and

impairment figure for firm i in yr t.

Amortit = Total current year amortisation for firm i in yr t.

Impairit = Current year goodwill impairment by firm i.

a,b = Regression coefficients

e = Error term

Net book value (BV) is used instead of separate book assets and book liabilities in

order to mitigate multicollinearity (see, e.g. McCarthy and Schneider (1995)); and it is

expected to have a positive coefficient. If goodwill reflected intangible factors, such

as an entry barrier to its markets, or an especially productive workforce, which could

lead to an abnormal profit, then the coefficient on new goodwill purchased during the

year (GW) should also be positive and significant. The coefficient on Cum_GW

should similarly be positive and significant if past years’ accumulations of goodwill

still provide useful information to the stock market. The coefficient for goodwill

impairment should be negative if this newly released information is deemed credible

by the market. It is often argued that the coefficient on the amortisation and

11
accumulated amortisation variables are not expected to be significant: on this view,

the markets view goodwill amortisation as an arbitrary bookkeeping process

conveying no fresh information (see section 1).

The heteroskedasticity which often besets such regression can be tackled by deflating

the regression or adding a scale proxy to the regression (Barth and Kallapur (1996)

and Easton and Sommers (2003)). We follow most research in this area in relation to

heteroskedasticity, and apply deflation – employing the White-t statistic. Several

proxies were used to deflate the regression, including Total Assets Employed, Equity

Capital and Reserves and Market Value. The different deflators did not produce major

differences in results, so just those for total assets are generally reported, plus an

illustration with equity capital and reserves for the panel estimates – for comparison.

The model is estimated for annual cross-sections and for a panel for 1997-2002. The

cross-sections are likely to reveal changes in successive years of our pronounced

cycles of stock price and M&A activity. The panel increases the size of the sample

and thus increases the robustness of the results. A fixed effects model is adopted here

- more suitable when the sample is not randomly selected from the populationxv or

when the unobserved effect is expected to correlate with the explanatory variables.

6.Previous valuation studies

In relation to goodwill in the balance sheet, Jennings et al (1996) analysed US data for

1982-8 and found that goodwill was value-relevant, though its impact on value was

12
smaller than that of tangible assets. And Chauvin and Hirschey’s (1994) study of US

firms in 1989-91 found that goodwill made some contribution to equity value.

In relation to amortisation, Jennings et al (2001) studied the value relevance of

earnings before and after amortisation and found that amortisation “simply adds

noise” and “eliminating goodwill amortisation from the computation of net income

will not reduce its usefulness to investors”. And Moehrle et al (2001) concluded that

income with or without amortisation provides similar value relevance when related to

market returns.

Suggestive evidence on the impact of a formal impairment system comes from studies

of ad hoc goodwill write-offs on market valuations in the period before the US

regulators established formal procedures of impairment in SFAS 142. For 1989-92,

Francis et al (1996) found practically no market response to the goodwill write-off

decision when other types of write-off were included. On the other hand, in Hirschey

and Richardson’s (2002) study for 1992-6, the market responded negatively to

goodwill write-offs, with most of the negative response preceding the announcement

(see section 10 below). An early study of the first effects of SFAS 142 (Chen et

al(2004)) also concluded that the standard generated new information, but again that it

was not timely informationxvi.

7.Regression results for model 1

Table 1 reports the estimates for the annual cross-sections, and for the pooled data for

the period 1997-2002. The sample comprises just the subset of companies with

13
financial year ends in December – to produce a near common valuation date across

firms.

To recap on the context for the annual cross-sections, goodwill capitalisation began in

earnest in the second year of this period, 1998: previously, accounting regulations still

allowed most goodwill not to be capitalised. The years up to and including 2000 saw a

sharp rise in market values and a boom in M&A activity, both of which developments

reversed for the final years of our period. And whilst impairment was approved in the

regulations from 1998, most impairments clustered in 2002xvii.

The book value variable, BV (excluding goodwill), takes on the expected positive

sign and is statistically significant in every year as well as for the panel. The

coefficient value falls in broadly the same range as in the previous work of McCarthy

and Schneider (1995). Our maximum value (3.3) is somewhat higher than theirs (2.1);

but, of course, our period includes years of exceptionally high market to book ratios.

The earnings variable (E) performs somewhat less consistently, though it is, as

expected, positive - and statistically significantxviii - in every estimate except the 1999

cross-section. The declining significance of the earnings variables is a widespread

feature of such models in the recent literature (Collins et al (1997)). Perhaps also, the

anomalous negative coefficient (albeit not significant) for 1999, the penultimate year

of “irrational exuberance”, may be associated with the rise of “glamour stocks” whose

market valuation bore a more tenuous relationship than normal to current earnings (or

book values) – see Rau and Vermaelen (1998).

14
Of the further components of book value analysed in model 1, GW, the goodwill

acquired in the current year, is positive in every estimate – significantly so in every

case but 2001. The estimates follow a similar pattern to those obtained by Jennings et

al (1996) and McCarthy and Schneider (1995). The market appears then to assign

positive value to recently acquired goodwill. The annual estimates are volatile,

however. The lower values assigned at, and soon after, the top of the stock price cycle

(2000 and 2001) may represent a developing scepticism in the market over the prices

being offered by bidders for some targets and, a fortiori, for their intangible assetsxix.

But the pooled values are close to unity.

Accumulated goodwill (Cum GW), acquired in previous years, appears from the

regression results generally to be value relevant (consistent with Bugeja and Gallery

(2003)), although it is accorded a less powerful role than GW, the component of

goodwill acquired most recently. The results for 1997, and to some extent 1998,

should be discounted because of the small number of companies which capitalised

purchased goodwill: capitalisation only became compulsory at the end of 1997, and,

since current year’s goodwill is excluded from Cum GW in the regression, only

assumed a wide role in 1999. Nevertheless, its influence in the regressions is weaker

than for current goodwill, and this is reflected in several features – marginally less

strong statistical significance in most cases; more volatile coefficients in the annual

regressions; and a smaller coefficient in the pooled estimates – around 0.7, compared

with around 1 for recently acquired goodwill. These suggestions of diminishing value-

relevance in the years after a particular purchase of goodwill are consistent with

Bugeja and Gallery (2003) and Wang (2004).

15
Many of the critics of amortisation have suggested that the application of uniform and

arbitrary book-keeping rules to amortise purchased goodwill will do little to inform

market prices of company stock. On these arguments, the variables Amort (current

year’s amortisation) and Cum_Amort (accumulated past amortisation) are not

expected to be value-relevant. And Table 1’s estimates are largely consistent with this

view. The coefficients are mostly not statistically significant, they are highly volatile,

and are not even consistent in their sign.

The option given by the standard setters to impair their purchased goodwill was

exercised most frequently in 2002. In that year, the cross-section regression has the

coefficient on the goodwill impairment variable negative (as would be expected, a

priori) and statistically significant (albeit only at the 10% level)xx. The fact that one

pound of impairment translates into somewhat more than one pound of decline in

market value might be because impairment carries bad news about future earnings

generally, beyond that for the value of goodwill; or, possibly, it is a symptom of

market over-reaction to bad news (De Bondt and Thaler(1985), Dissanaike (1997)).

Since the distribution of impairment clusters in 2002, it is not surprising to see either

insignificant or unexpected results recorded during the earlier part of the sample

period, when impairment was rarexxi.

The explanatory power of the cross-section regressions is greatest in 2002, at 0.75.

There is some tendency (except for 2000) for their explanatory power to be weaker in

years of “irrational exuberance”. This is consistent with Core et al (2003), and would

16
be suggested by the literature on glamour stocks, whose valuations become divorced,

in an “exuberant” market, from book values.

8.A variant model based on the income statement

In their study of the value relevance of goodwill amortisation, Jennings et al (2001)

adopt a more parsimonious model than 1, with just income statement variables as

regressors. For comparability we estimate a version of their model, extended to

incorporate the goodwill impairment which appears in the current year’s income

statement:

MVit = ait + b1Eit + b2Amortit + b3Impairit + eit (2)

MVit = The market value of common stock measured 5 months after

the year-end for firm i in yr t

Eit = Earnings excluding current year goodwill amortisation and

impairment for firm i in yr t.

Amortit = Total current year amortisation for firm i in yr t.

Impairit = Current year goodwill impairment by firm i.

a,b = Regression coefficients

e = Error term

Table 2 reports the estimates of model 2. The results are broadly consistent with those

for model 1. The coefficient on earnings (E) takes on the expected sign, is statistically

17
significant, and takes on a value – of the order of 3 - consistent with those produced

by model 1. Again, the amortisation variable (Amort) is not statistically significant;

and the actual coefficient estimate takes on a sign which is perverse a priori – it would

imply that the higher amortisation, the higher market value. Impairment, however,

again demonstrates its value relevance. It takes on the (negative) sign which is

plausible in theory; the value of the coefficient is close to that of the cross-section

version of model 1 for 2002 (the year of more frequent impairments); and while it is

statistically significant at only the 10% level for the asset deflator variant, this will be

influenced by the fact that impairment arises in only a modest minority of the annual

observationsxxii.

9.An event study of goodwill impairment

To complement the cross-section and panel analyses, the impact of goodwill

impairment was further explored through an event study, estimating the cumulative

abnormal returns (CAR) accruing to firms in periods when they impaired their

purchased goodwill:

y
CAR = ∑ AR
t=x
t

Where

CAR = cumulative abnormal returns

AR = daily abnormal returns

t is an estimation day

x is the first day of the event period

y is the last day of the event period

and we study event periods ranging from 3 to 55 days

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And

∑u it
ARt = i
n

Where

i is a company

n is the number of companies in the study

And

uit = rit – rit

where r is the actual shareholder return (share price appreciation plus dividend)

and r is the expected shareholder return

The literature offers several models of expected returns. We have estimated three (the

market model, market-adjusted returns and mean-adjusted returns), but the results

were not greatly different in relation to the issue we are addressing, and we focus

below on the results for the market model:

rit = a + b rmt

where

rmt is the return from the FTSE All Share Index on day t

a,b are regression coefficients, from estimating rit = ai + bi rmt + eit

where e is the stochastic disturbance term

and the regression is estimated for the one year preceding the event periodxxiii.

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For this part of the analysis, the sample comprises those members of the UK non-

financial listed company sector outlined earlier, which reported a single negative

goodwill impairment in the period 1997-2002, and had a clear announcement date not

confounded by other major events. On these criteria, 87 companies qualified for

inclusion.

10.Cumulative abnormal returns

Figure 2 shows the CARs for the period 65 days before and after the announcement of

goodwill impairment. If we focus on the immediate days around the announcement,

there is a pronounced fall in the CAR. Table 3 reports that average CARs are -4.4% in

days –5 to 0 (where 0 is the announcement day), and –1.9% in days –1 to 1. The

figures are significantly different from 0 at the 1% level, as are almost all the results

in Table 3. The size of the decline in market values within these short windows is

consistent with the main previous contribution to this part of the literature: Hirschey

and Richardson (2002) analyse the impact of US goodwill write-offs in the period

1992-96, and find negative CARs of around 3% in the days surrounding the

announcement. In contrast with Hirschey and Richardson, however, for our sample

this downward adjustment around impairment comes within a period of generally

rising CARs: there are positive CARs in the pre-announcement (post-estimation)

period; and after the announcement period, the average member of this sample

resumed positive CARs for the rest of the period we measure.

Table 3 explores further the negative impact of the impairment event on stock prices.

First, it decomposes the sample according to the materiality of impairment, reflected

20
in the ratio of goodwill impairment to total assets employed, and repeats the CAR

analysis for two subsets from the sample: the top quartile by this measure – the firms

for whom impairment was quantitatively most significant – and the bottom quartile.

In general, the pattern we observed for the full sample is reinforced for the former

group – highly material impairment – and emerges more muted for the latter. The

large impairment group, relative to firm size, experience sharper declines in stock

price around announcement; and also their positive CARs in the periods before and

after announcement are more pronounced.

Table 3 then places the impairment announcement in the context of other performance

data reaching the market. It decomposes the sample into those (38) firms whose

impairment announcement came against the backdrop of negative ebitda in the

respective financial year, and those (48 firms) with positive ebitda. Both subsets

display negative and significant CARs in the period –5 to 0; but those for the

negative ebitda companies are several times larger on average, and only for these

companies is the CAR negative in days –1 to 1.

Finally, recognising that financial information sometimes seeps into the market over

time, rather than in one single announcement event, the Table focuses on those 35

firms which, according to our review of information flows, released no information

regarding their performance or goodwill impairment ahead of the announcement. This

might be expected to produce a sharper announcement effect; and indeed, Table 3

reports a more substantial negative CAR in the immediate announcement period than

for the sample as a whole.

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Taking the results together, then, and focussing on the 5 days up to and including the

announcement of impairment, the impact for the full sample and for each sub-sample

is negative and statistically significant. The bigger is goodwill, in relation to total

assets, the greater the impairment, and the less the earlier leakage of information, the

stronger is the impact on market values.

Are these estimates consistent with the valuation models estimated earlier? The

impairment coefficients in the two valuation models are in the region of -1. The

coefficient for model 1 for 2002, the year in which impairments clustered, was –1.3;

in model 2 the two estimates were –1.2 and –0.9. These figures suggest that, roughly,

if the book value of purchased goodwill is written down by £1million, market value

will be of the order of £1million lower. Turning to the CARs in Table 3, we observe

an average decline in market value of 4.4% in the 5 day event window. This

adjustment of market values is of a comparable magnitude to the typical reduction in

book value implied by the impairment: median impairment was 6% of median book

value for the sample of impairment yearsxxiv. Of course, one should not assign

exaggerated precision to these estimates; but the congruence of estimates from very

different methodologies provides some reassurance. So too does their consistency

with valuation theory. More than some other components of the balance sheet,

purchased goodwill represents an estimate of the discounted earnings expected from

the respective bundle of intangible assets; and so it corresponds directly to the

forward-looking valuation basis of the firm’s stock price. Our results are broadly

consistent with the market adopting the downward valuation announced by the typical

firm when it impairs purchased goodwill.

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11.Conclusions

The paper explores the likely impact of the accounting standards on purchased

goodwill adopted by most jurisdictions from 2005. It does this by econometric

analysis of the UK stock market, the third largest equity market and second largest

takeover market in the world, for the period 1997-2002. This period included a unique

conjuncture of events: the introduction of a formal system of impairment ahead of the

US; and two interconnected financial cycles: first, a pronounced cycle of M&A, and,

second, “irrational exuberance” in stock prices, followed by a major correction. This

conjuncture produces early evidence on the effect of impairment in the accounts, for a

period when, first, exceptional amounts of goodwill were being purchased and, then,

the market revised sharply downwards its estimates of company values.

For our sample of UK listed companies which impaired goodwill, the ratio of

goodwill to total assets reached 20%; and when they impaired goodwill the impact on

the income statement was material: on average, impairment represented some 35% of

earnings.

We estimate the value relevance of accounting variables resulting from different

approaches to reporting goodwill, focussing on impairment, but comparing with

amortisation where possible. We use standard Ohlson-based valuation models

combining asset and income regressors; and an alternative model focussing just on the

income statement. We variously estimate for annual cross-sections, and for panels.

We then explore the impact of impairment announcements via an event study.

23
Although the results are for a different period and market from most of the literature

on the value relevance of variables connected with purchased goodwill, and although

variables are included in our models which were not available to earlier literature,

where variables have been included which are common with those of previous

studies, the analysis largely confirms established results for those variables. And this

provides some reassurance that, while not from the US population which dominates

the literature, the sample is not idiosyncratic, and the new results are likely to have

wider relevance. Thus, the market valuation of book assets and of earnings closely

resembles the findings of earlier work. And we confirm previous findings that

goodwill is value relevant in the year of purchase, but its value relevance decays in

subsequent years. Amortisation is not value relevant – supporting earlier work and the

basic theoretical contention that a semi-strong efficient market will not ascribe any

value to information which a skilled analyst could recreate from published sources.

The new territory explored here, however, is the market’s valuation of the goodwill

impairment figures emerging from the first accounting standards to provide a

systematic framework for impairment. We find that impairment is, by contrast with

amortisation, value relevant – a result supported (with varying degrees of statistical

significance) by our two valuation models and our event study. The economic impact

implied by the range of estimates from very different methodologies is broadly

consistent across the very different methodologies. It is also consistent with a

valuation model in which the market largely believes and adopts the revised

valuations supplied by the firm.

24
Figure 1
FTSE ALL SHARE - PRICE INDEX
3400 FROM 4/4/97 TO 2/4/04 WEEKLY

3200

3000

2800

2600

2400

2200

2000

1800

1600
1997 1998 1999 2000 2001 2002 2003 2004

HIGH 3261.57 1/ 9/00 LOW 1685.04 7/ 3/03 LAST

Source: 2233.98
DATASTREAM

25
Table 1. Estimates for Model 1 [Cross sectional regression - Deflated by total assets employed.
Panel regression deflated by total assets employed (Panel regression 1) and Equity capital and
reserves (Panel regression 2)]

Panel/Pooled Panel/Pooled
Regression Regression
1997 1998 1999 2000 2001 2002 (1) (2)
Cum_GW 3.14 0.498 10.324 3.059 1.522 1.132 0.721 0.717
(2.14)* -0.08 (-1.71) (3.13)** (-1.91) (3.33)** (2.34)* (2.08)*
GW 3.271 6.217 5.774 1.37 0.438 5.073 1.065 0.912
(-1.73) (3.61)** (3.52)** (3.25)** -0.5 (2.46)* (4.98)** (4.61)**
Impair 0 38.801 122.466 2.768 -1.183 -1.333 -0.16 -0.15
(.) (2.94)** -0.65 -1.3 -0.6 (-1.97) -0.24 -0.25
BV 1.671 1.658 3.275 1.437 2.096 1 0.627 0.703
(3.11)** (3.00)** (2.63)** (3.56)** (3.36)** (3.45)** (2.64)** (3.58)**
Amort -882.511 -40.03 -43.543 3.803 0.679 -1.615 -3.486 -2.654
-0.77 -1.41 -0.53 -0.4 -0.13 -1.2 -1 -0.88
Cum_Amort 2,162.74 7.8 -34.936 -36.398 1.266 0.224 -2.596 -2.424
-1.08 -0.99 (-1.75) (2.24)* -0.63 -0.25 (2.46)* (2.73)**
E 8.973 6.728 -1.712 5.301 8.734 5.278 3.522 3.269
(-1.71) (2.50)* -0.55 (2.36)* (2.23)* (2.84)** (3.39)** (3.36)**
Constant 17,138.87 29,340.50 36,139.35 31,867.67 16,150.37 15,259.20
(2.13)* (2.25)* -1.12 (2.26)* (-1.82) -1.58
Observations 100 127 141 138 157 138 825 825
R-squared 0.61 0.54 0.49 0.72 0.74 0.75 0.96 0.95

[Absolute value of t statistics in parentheses : (__) Significant at 10%,* significant at 5%; ** significant at 1%.]

Note: Variable definitions

Bvit = Net book assets excluding goodwill acquired in current year, accumulated goodwill,
accumulated goodwill amortisation and current year goodwill amortisation and
impairment for firm i in yr t.
GWit = Goodwill acquired in current year for firm i in yr t.
Cum_Gwit = Accumulated goodwill from previous years and adjustment made to it for firm i in yr t.
Cum_Amortit = Accumulated goodwill amortisation from previous year and adjustment made to it for
firm i in yr t.
firm i in yr t.
Eit = Earnings excluding current year goodwill amortisation and impairment figure for firm
i in yr t.
Amortit =Total current year amortisation for firm i in yr t.
Impairit =Current year goodwill impairment by firm i.

26
Table 2 Estimates for Model 2 [Panel regressions deflated by total assets employed
(Panel regression 1) and Equity capital and reserves (Panel regression 2)]

Panel Regression 1 Panel Regression 2

Impair -1.232 -0.909
(-1.89) -1.41
Amort 1.981 1.59
-1.25 -0.9
E 3.522 3.728
(3.86)** (3.75)**
Observations 904 877
R-squared 0.95 0.94

[Absolute value of t statistics in parentheses : (__) Significant at 10%,* significant at 5%; ** significant at
1%.]

Note: Variable definitions

Eit = Earnings excluding current year goodwill amortisation and impairment for firm i in
yr t.
Amortit = Total current year amortisation for firm i in yr t.
Impairit = Current year goodwill impairment by firm i.

27
Figure 2 CARs of firms which impaired goodwill

0.2

0.15

0.1
Cars

0.05

0
15

25
35
45

55
65
5

5
5

5
-5
-6
-5

-4
-3
-2

-1

-0.05
Event Days

0 is the day of formal announcement of impairment

CARs are calculated using the market model estimated over a one-year period
preceding the period reported in Figure 2.
The sample comprises the 87 companies which impaired goodwill in 1997-2002,
reported a single impairment, and had a clear announcement date not confounded by
other major events.

28
29
Table 3 Cumulative abnormal returns (%) of firms which impaired goodwill

Days Sample -65 to - -10 to 0 -5 to 0 -1 to 1 0 to 10 10 to 65

Sample Size 10
Full sample 87 4.2** -4.1** -4.4** -1.9** 2.0** 13.2**
High 22 11.5** -7.3 -7.1** -6.1** -1.5** 27.2**
GW/TA
Low 22 -2.3** -4.7** -5.9** 2.1** 4.6** 4.2**
GW/TA
Positive 48 -0.2** -1.4** -1.5** 1.4 3.8** 10.3**
ebitda
Negative 38 7.7** -6.9** -7.2** -6.1** 0.7* 16.6**
ebitda
No leakage 35 0.3** -6.0** -6.5** -2.6** 0.9** 16.9**

* significant at 5% level
** significant at 1% level

30
i
Jopson and Pilling (2005).
ii
At least, about the value-relevance of some of the changes. There have been critiques on other
grounds. For example, Lewis et al (2001) raise significant questions about the implementation of
impairment reviews. And Massoud and Raiborn (2003) discuss the possibility of impairment being
used for “future income cosmetic enhancement”.
iii
Though Duvall et al (1996) emphasised the difficulty in practice of estimating the effect of
amortisation on net income, because of limited disclosure of amortisation; and Hopkins et al (2000)
find in their experimental study that amortisation sometimes affected analysts’ view of stock price.
iv
Though Robinson and Shane (1990) did find an association between bid premium and the use of
pooling.
v
Strictly speaking the possibility of impairment dates back at least to the 1985 Companies’ Act. FRS11
marks its specification in standards.
vi
Strictly speaking this applies for the moment only to the group accounts of listed companies.
vii
For IFRS 3 see IASB (2004). For SFAS 141 and 142, see FASB (2001a and 2001b). For APB 16 and
17, see AICPA (1970a and 1970b). For FRS 10 see ASB (1997) and for FRS 11 see ASB (1998). For
SSAP22, see ICAEW (1984).
viii
In our sample in 1997. Some US executives believed this conferred an unfair advantage on UK
companies when they were competing in the takeover market with US companies – see Zeff (1992).
ix
This is not to suggest that goodwill impairment was never seen in the US before 2002 – rather that
there was not the formal structure provided by SFAS 142 in 2002.
x
Extreme values (top and bottom 5%) were winzorised throughout. Because of extreme outliers in
such data, this procedure is common in studies in this field (e.g. Collins et al (1997)).
xi
EBIT before impairment.
xii
Building on Peasnell (1981,1982).
xiii
Equity Capital and Reserves from Datastream.
xiv
Earnings for Ordinary from Datastream.
xv
The sample selection is non-random insofar as it is limited to companies involved in acquisitions
during 1997-2002 which also had a December year-end.
xvi
Indirectly relevant is Aboody et al’s (1999) analysis of revised asset valuations. Like our paper, this
involves a procedure allowed under UK GAAP, but not US GAAP - the upward revaluation of fixed
assets. And like our paper, it is also concerned with whether managers’ revaluations convey value-
relevant information. It asked whether these revaluations were vindicated by future operating income,
and concluded that, on average, they were.
xvii
Of the 143 impairments in 1998-02, 93 took place in 2002.
xviii
If only at the 10% level in 1997.
xix
Overbidding would be consistent with acquirer managers being infected by hubris in an efficient
market (Roll (1986), or rational acquirer managers using their own inflated stock to buy targets whose
value is also inflated (Shleifer and Vishny (2003)).
xx
In the corresponding regression, not reported here, deflated by market value, the coefficient was -
1.745 and significant statistically at the 1%level.
xxi
1998, which sees an anomalous large, positive and significant coefficient on Impair, had only one
company in the sample which carried out impairment.
xxii
The non-deflated version of the model yielded broadly consistent results: positive significant
coefficient on E, insignificant coefficient on Amort, and significant negative coefficient on Impair.
xxiii
A trade-off arises in the choice of estimation period between number of observations and risk of
structural change in the firm as the start of the estimation period becomes more remote from the event
period. A similar length of estimation period to ours is found in Weber (2004), MacKinlay (1997) and
Brown and Warner (1985).
xxiv
Median impairment £8m; median book value £134m; 184 impairment years.

31
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