Effect of Impairment‐Testing Disclosures on the Cost of Equity Capital

Abstract

International audienceInformation risk – the uncertainty regarding the parameters of the distribution of firms’ future cash flows – generates valuation errors and is costly to investors who require a higher return to compensate for greater information risk. We argue that, on average, through their impairment-testing disclosures, managers convey information that reduces information risk. Using disclosures from firms included in the SBF 250 index of Euronext Paris over the period 2006–2009, we document a negative association between impairment-testing disclosures and implied cost of equity capital. We find that prospective entity-specific impairment-testing disclosures are negatively associated with cost of capital whereas descriptive disclosures exhibit no association with cost of capital. Additionally, we document that firms which avoid booking impairments when low performance indicators suggest a greater likelihood of impairments exhibit no association between impairment-testing disclosures and cost of capital. This suggests that those firms’ disclosures are perceived as less accurate by investors. We also find that prospective impairment-testing disclosures are negatively related to analysts’ forecast errors. Our study adds to the literature on the economic consequences of financial reporting and sheds light on the consequences of one accounting mechanism, namely impairment-testing disclosures, ensuring conservatism of financial reporting

The Effect of Mandatory IFRS Adoption on Conditional Conservatism in Europe

“…The European Securities and Market Authority (ESMA) and the chairman of the IASB recently expressed their concerns about accounting for goodwill and insufficient impairment recognition (see Hoogervorst, 2012;ESMA, 2013). Further studies have documented an incomplete and heterogeneous level of compliance with disclosure requirements under IFRS 3 and IAS 36 (Amiraslani et al, 2013;Glaum et al, 2013;Mazzi et al, 2014;Paugam and Ramond, 2014;and Tsalavoutas et al, 2014). The effect of the adoption of IFRS in 2005 on conditional conservatism in Europe is likely dependent on the capacity to apply and enforce various conditional conservatism mechanisms, among which impairment testing principles for non-financial assets play a critical role (Lawrence et al, 2013;Roychowdhury and Martin, 2013).…”

“…4 According to IAS 36 §2: Impairment testing procedures cover all assets but the following: inventories (IAS 2), construction contracts' assets (IAS 11), deferred tax assets (IAS 12), post-employment benefit assets (IAS 19), financial instruments (IAS 39), investment property measured at fair value (IAS 40), biological assets measured at fair value (IAS 41), specific assets that arise from insurance contracts (IFRS 4), and non-current assets held for sale and discontinued operations (IFRS 5). level of compliance with disclosure requirements under IFRS 3 and IAS 36 (Amiraslani et al, 2013;Glaum et al, 2013;Mazzi et al, 2014;Paugam and Ramond, 2014;and Tsalavoutas et al, 2014). Finally, the press recently echoed insufficient and untimely recognition of economic impairment for goodwill (see The Economist, 2013).…”

The Impact of Audit Quality Indicators on the Timeliness of Goodwill Impairments: Evidence from the German Setting

“…With respect to goodwill accounting, prior studies show that goodwill impairments are related to future firm performance (Jarva, 2009;Lee, 2011;Li et al, 2011) and investment opportunities (Godfrey and Koh, 2009;Chalmers et al, 2011), that the impairment-only approach has a positive influence on the accuracy of analysts' earnings forecasts (Chalmers et al, 2012), and that goodwill impairments are generally perceived as value-relevant (Lapointe-Antunes et al, 2009;Xu et al, 2011;AbuGhazaleh et al, 2012;Laghi et al, 2013). There is also evidence that prospective firm-specific impairment-testing disclosures are negatively associated with cost of equity, suggesting that this information reduces information asymmetries (Paugam and Ramond, 2015). However, it is also possible that discretion is used opportunistically by management.…”

The Effect of Joint Auditor Pair Composition on Audit Quality: Evidence from Impairment Tests

“…We use the Impairment-Testing Disclosure Score developed by Paugam and Ramond (2015) to measure the transparency of impairment disclosures. This measure includes up to 40 items disclosed in the annual report that cover technical valuation elements and descriptive elements of impairment tests.…”

“…15 The required disclosures are independent of the outcome of the impairment tests (i.e., they do not depend on whether management decides to book an impairment) and help outsiders to understand how assets were tested for impairment and to assess the reasonableness of the subjective valuation assumptions chosen by management. Paugam and Ramond (2015) assign one point per disclosed impairment item that is included in the annual report for year t, and compute the disclosure 14.…”