Consequences of booking market-driven goodwill Impairments

Under the fair-value-based goodwill impairment test of SFAS 142, a firm's market value is often used as an important reference point for determining the existence of impairment. In fact, a below one market-to-book ratio is considered by many, including external auditors and security lawyers, to be an indicator of goodwill impairment. As a result, firms can be pressured into recording goodwill impairment upon a temporary market value decline which is unsubstantiated by economic fundamentals. From a sample of goodwill impairments recorded during the period 2002-2009, we identify about a sixth of the sample firms which report impairment charges that are most likely market-driven and not backed by fundamentals. Validating our identification of market-driven impairments, we find that the impairment loss of these firms is associated with a return reversal in the subsequent year. It appears from our results that the market does not understand the difference between market-driven and other impairments and reacts equally negatively upon the initial announcement of the loss, resulting in a further price decline for firms with market-driven impairment. In addition, we find that, until the return reversal occurs, firms with market-driven impairment experience an increase in information asymmetry associated with the impairment loss. Finally, our results suggest that the managers of these firms exploit the delay in the market's reversal of the temporary undervaluation related to the impairment by engaging in share repurchases to a greater extent than normal. Overall, our findings shed light on the potential negative consequences of the imperfect implementation of fair value accounting.