Auditing Goodwill in the Post‐Amortization Era: Challenges for Auditors

Abstract

The elimination of goodwill amortization in 2001 brought about significant change in how companies are required to account for goodwill. This change in accounting also brought with it new challenges for auditors, namely evaluating the reasonableness of management's assumptions related to goodwill valuation. In addition to introducing technical challenges, this task is particularly difficult given the misalignment in incentives it creates between managers who likely prefer to avoid recording an impairment and auditors who seek to minimize the bias in management's impairment testing. This study focuses on the consequences of the misaligned incentives that auditors face under the current goodwill assessment process. We find that the decision to record a goodwill impairment is associated with an increase in the probability of auditor dismissal. Consistent with the presence of significant friction with clients, our results also indicate that the likelihood of auditor dismissals is negatively related to the favorability of the impairment decision. Furthermore, we find that companies impairing goodwill prior to dismissing auditors subsequently employ auditors that are, on average, more favorable to clients in their impairment decisions.

Step Zero: Determinants and Implications of Reliance on the Qualitative Goodwill Impairment Assessment

“…I expect that the riskiness of an underlying goodwill impairment ("goodwill riskiness") is a function of a firm's recent acquisition and impairment history, recent performance, and other characteristics shown in prior literature (e.g., Ayres, Neal, Reid, and Shipman 2018) to be predictive of goodwill impairments. Prior studies demonstrate that a primary driver of goodwill impairment is overpricing at the time of acquisition (e.g., Gu and Lev 2011).…”

“…I expect that goodwill riskiness is negatively associated with recent performance and that firms with better recent performance are more likely to rely on a qualitative assessment in the absence of managerial opportunism. I also include a broad measure of ex-ante impairment probability that encompasses several variables (e.g., leverage, change in EBITDA, return volatility) shown to be predictive of goodwill impairments (Ayres et al 2018). 16,17 Finally, I expect that both the perceived risk of an underlying goodwill impairment and regulatory scrutiny are increasing in the materiality of goodwill.…”

“…Along these lines, Lawrence et al (2013) provide evidence that the likelihood of an asset write-off is positively associated with the firm's beginning BTM ratio with a discontinuity around a ratio of one. However, given that MTB is included in the impairment prediction model in Ayres et al 2018 and that beginning BTM is highly correlated with my impairment probability variable, I exclude this measure from the determinants model. 17 I also considered the possibility that a firm's auditor could influence management's choice of goodwill impairment testing method.…”

“…In order to construct a goodwill impairment probability score for my cross-sectional tests, I adapt the goodwill impairment prediction model used by Ayres et al (2018). Consistent with Ayres et al (2018), the dependent variable IMPAIR equals one if the firm has a goodwill impairment greater than 0.5% of total revenue in the current year and zero otherwise. Due to lack of data availability, I exclude number of segments and indicator variables for auditor expertise from my model.…”

Auditor Independence and Fair Value Accounting: An Examination of Nonaudit Fees and Goodwill Impairments

“…A commonly cited challenge the financial executives faced during their most recent impairment was “auditor issues”(Holtzman and Sinnett , 27). A result of this tension is highlighted by Ayres et al (), who document an increase in auditor dismissals after a goodwill impairment has occurred. The presence of such a significant consequence to the auditor suggests that auditor incentives may lead to potential independence concerns in the goodwill impairment process.…”