Management’s Discretionary Assessments of Goodwill Impairments—Evidence from STOXX Europe 600

1. Introduction

Goodwill is a significant balance sheet item in the accounts of entities that employ International Financial Reporting Standards (IFRS), and it is crucial that the accounting information is relevant and reliable for accounting users. This accounting item is complex, as it is subject to subjective and discretionary assessments in both the initial recognition and subsequent measurements. This study is based on the International Accounting Standards Board’s (IASB) project related to goodwill and goodwill impairment (GI) and reports from national and international supervisory authorities. Approximately 15 years after mandatory IFRS was first introduced among listed companies, the treatment of goodwill remains controversial.

This study examines how GI is related to company- and industry-specific economic factors, as well as proxies for earnings management. Our contributions are threefold. First, we examine a large panel data set over several years by obtaining accounting figures from the mandatory adoption of the IFRS regulations for European listed companies from 2005 to 2018, whereas previous research has considered a shorter time span. This time series includes the global financial crisis in 2008–2009, the European debt crisis in 2011–2012, and the drop in oil and natural gas prices in 2014–2015. Second, this large data set provides a unique opportunity to study the effects on GI of crisis years and recession years in the European market. Third, we extend previous research by including a fixed-effects (FE) model based on the assumption that there are company-specific conditions in the panel data that affect the regression models.

The STOXX Europe 600 index represents a wide range of European listed companies by country, industry, and market capitalization. Out of the 600 companies listed in the index, we obtained a sample of 449 companies, with annual data from January 1, 2005, to December 31, 2018. The study is limited to existing IFRS reporting entities, and all industries are included, except the financial sector.

To analyze the extent of consecutive GI from business combinations, we focus on companies’ key financial figures, proxies for earnings management, and whether the fiscal years are characterized by a macroeconomic recession. Our findings show that GI was significantly higher in the years following the transition to new regulations in 2005, the global financial crisis in 2008–2009, and the European debt crisis in 2011–2012. From 2013, GI stabilized at a lower level. The descriptive statistics show a large variation between the average GI of 9% and the median of 1.7% among the companies that reported GI. The average is driven by large GI in crisis years, as well as by individual companies and industries with significant GI. The study confirms findings by the European Securities and Markets Authority (ESMA, 2013) that most GI is reported by a relatively small number of companies, concentrated in a few industries. The telecommunications services industry stands out as reporting the most GI, both in terms of the extent of GI and capitalized goodwill. For the period 2005–2018, capitalized goodwill, for the entire sample, averaged 43% of total equity and 14% of total assets.

This study confirmed the variation in GI between years by multivariate analysis. The empirics also confirmed that companies with a higher return on assets report GI to a lesser extent. We also confirmed that companies with higher debt ratios and opportunities to implement a one-off big bath charge (see Section 3) report GI to a greater extent. The findings from the FE model are essentially unchanged when compared to the results from the Tobit and Logit regressions.

The results of the study could increase awareness of accounting users about which factors are related to GI. The findings related to crisis years and big baths are also relevant in the context of the recent COVID-19 pandemic. We also believe that the study could contribute to the work of supervisory authorities on impairment issues.

The remainder of the paper is organized as follows. Section 2 surveys the accounting treatment of goodwill in accordance with IFRS. Section 3 presents previous research on the topic and develops hypotheses. Section 4 presents the data and descriptive statistics, while Section 5 elaborates on the methodology. In Section 6, we present and discuss the findings from the multivariate analyses. In Section 7, we present conclusions, limitations, and implications.

2. Accounting Treatment of Goodwill in Accordance with IFRS

IFRS became mandatory for listed companies in the European Union and European Economic Area from January 1, 2005. IFRS 3 introduced the requirement that goodwill should be assessed for impairment following the impairment-only approach. The standard replaced IAS 22, which mainly required amortization of goodwill, but had an element of impairment. This change was mainly due to the difficulties of credibly estimating goodwill lifetime under an amortization model (André, Filip, & Paugam, 2016; Amel-Zadeh, Glaum, & Sellhorn, 2021). In the case of full IFRS, goodwill must be tested annually for impairment, as well as for ongoing indications of impairment in accordance with IAS 36 Impairment of Assets. The impairment test examines whether the recoverable amount of a cash-generating unit (CGU) is lower than the amount in the balance sheet^[1]. The recoverable amount has the highest value in use or net sales value. Meanwhile, the impairment test cannot test goodwill directly as a separable asset and is not designed to signal whether an acquisition is successful. The impairment test relies on management’s discretionary estimates of uncertain future cash flows.

According to Scott (2015), reporting goodwill in accordance with international accounting standards means that accounts could have increased decision-making relevance for accounting users, as GI can present managements inside information on expectations related to future earnings. Hence, it can mitigate information asymmetry and opportunities for principal–agent problems between management and investors and creditors (Knauer and Wöhrmann, 2016). Our study focuses on the subsequent measurement of goodwill. One of the challenges with the impairment-only model is the unintended problem of self-developed goodwill replacing acquired goodwill. This is contrary to the general prohibition on capitalizing in-house developed goodwill in accordance with IAS 38.48, and the prohibition on reversing GI in accordance with IAS 36.124. However, companies can allocate goodwill to units with good economic growth and can allocate parts of the acquisition cost of depreciable assets to achieve evenly distributed depreciation. Therefore, the regulations can lead to incentives to both postpone and avoid GI to varying degrees.

During Europe’s weak economy after the global financial crisis of 2008-2009 and subsequent debt crises, the ESMA published a report in January 2013 summarizing the practice of impairment of goodwill and other intangible assets, based on a survey of 235 companies. Approximately 36% of the companies in the survey reported GI. The impairment for 2011 as a share of capitalized goodwill at the beginning of the year was 5.1%. Moreover, the ESMA pointed out that goodwill was impaired by only a few players, which could indicate differences and biases across companies and industries. Only 5% of the companies in the sample accounted for as much as 75% of the total GI (ESMA, 2013). The ESMA pointed out that companies with net assets greater than the market value of the company did not implement GI, and thus, the reduction in market value did not fully reflect the level of GI. This situation was further exacerbated during economic crises and situations with weak future prognoses, when a company might have lower future cash flows than was the case when first recognizing the goodwill.

The national regulatory authorities followed up the ESMA’s recommendations. To identify impairment problems among companies, financial authorities typically use a model in which they weight several impairment indicators given in IAS 36. Although we do not examine all these key indicators as separate explanatory variables in this study, doing so provides information that company-specific economic factors are important to supervisory authorities, and that their controls have led to demand for increased impairments.

In June 2015, the IASB published the Report and Feedback Statement—Post-implementation Review of IFRS 3 Business Combinations. Relevant findings were that investors had different views on topics, such as the consecutive measurement of goodwill, but also separate recognition of other intangible assets. According to the IFRS Foundation (2015), several accounting users considered that IFRS 3 had implementation challenges, including, among other things, the impairment test for goodwill. Many stakeholders found the impairment test to be complex, time-consuming, and costly, and to involve significant discretionary assessments, especially in determining the assumptions related to value in use and allocations of goodwill to CGUs. At the same time, the IASB mapped research in this area and found that the impairment-only model has continued to replace the previous amortization model, the main argument being that the impairment-only model provides more value-relevant information. Reported GI provides relevant and decision-making information for accounting users, with a focus on investors and creditors. Nevertheless, the IASB has stated that the current regulations, which involve subjective and discretionary assessments by management, could facilitate opportunistic reporting (IFRS Foundation, 2015).

The issues from this report and the feedback from stakeholders were taken up in the IASB’s project Goodwill and Impairment. The main goal is to improve the information provided about business combinations in companies’ notes to the financial statements and in the subsequent measurement of goodwill. The project indicates the importance and complexity associated with the accounting treatment of goodwill and impairments according to the IFRS 3 and IAS 36 standards. In March 2020, the IFRS Foundation conducted a Global Preparers Forum in which the IASB board presented preliminary views. On goodwill, the board considers that the impairment test cannot be made more efficient, and that the rule on annual impairment testing should be continued. Thus, the previous amortization model will not be reintroduced. However, the board considers that the test can be simplified by deviating from the requirement for an annual impairment test. Moreover, the board’s preliminary view is that companies’ equity should be presented, excluding goodwill, as a separate line under the balance sheet (IASB, 2020), which would draw attention to companies whose booked goodwill constitutes a significant proportion of the booked equity.

Hence, there are several issues to be resolved regarding goodwill and GI. The ESMA has addressed the concern that GI does not seem to follow clear indications for value decline by pointing out that most GI is reported by only a few companies. The IASB confirms the issues surrounding GI but is reluctant to disclose information on the level of impairment rates. To solve these puzzles, we examined explanatory variables that may be related to companies’ GI. The results are useful for accountants carrying out impairment tests and for investors and creditors analyzing accounts for decision making. To explain the extent of consecutive GI from a business combination, we chose to focus on companies’ key financial figures, management’s use of earnings management, and the possible correlation with years of macroeconomic recession.

3. Relevant Studies and Hypothesis Development

As a basis for our work, we used elements from Abughazaleh, Al-Hares, and Roberts (2011), who focused on GI according to IFRS with UK data. We also relate to, and acknowledge, the studies of André, Filip, and Paugam (2016), Glaum, Landsman, and Wyrwa (2018) and Gros and Koch (2020). The second study examined whether discretionary assessments represent management’s opportunistic reporting or sharing of inside information about the company. They hypothesized that GI is a function of economic factors that form the basis for a company’s results, reporting incentives from management, or the corporate governance mechanisms to which the company is subject. Their findings suggest that IFRS 3 provides companies with a framework for reliably reflecting their underlying financial attributes. The IFRS and Financial Accounting Standards Board (FASB) regulations are currently largely harmonized regarding the accounting treatment of goodwill.

Relevant explanatory variables on impairments, including proxies for the company’s and industry’s historical equity returns, book-to-market, and return on assets, are significant in explaining the extent and timing of impairments (Francis, Hanna, and Vincent, 1996). Standard setters claim that the impairment model improves the accounting treatment of goodwill and provides users with more useful and value-relevant information about the underlying economic value of goodwill. However, this approach has largely been criticized on the basis that management’s discretion is inherent in the impairment testing of goodwill (Abughazaleh et al., 2011). Ramanna and Watts (2012) addressed the same issue and found that estimates of the fair value of goodwill were based on unverifiable assumptions, such as management’s expectations about the future. The problem was whether the value estimates could indicate the management’s opportunistic reporting, or whether the management actually presented the inside information they possessed about the company’s future cash flows, in accordance with the intention of the standard setters.

Although the FASB wants to improve financial reporting, the lack of verifiability of many value estimates gives management an opportunity to introduce bias and noise in the estimates. However, Watts (2003) was critical of the impairment regime and considered the regulations to motivate earnings management and opportunistic behavior. In their support, Beatty and Weber (2006) considered financial incentives to affect unverifiable fair value estimates. Watts (2003) argued that the FASB’s transition to an impairment regime under SFAS 142 had led to increased incidence of fraudulent financial reporting. In summary, impairment testing for goodwill is a complex accounting task when it comes to defining CGUs, allocating goodwill to CGUs, and determining the fair value of CGUs. In addition, there are challenges related to companies’ compliance and note information in accordance with the accounting standard, so that the market can rely on the underlying economic value of goodwill (Bepari, Rahman, and Mollik, 2014).

Below, we present three hypotheses related to the relationship between GI and company-specific economic factors, earnings management, and macroeconomic crisis years.

Hypothesis 1:

There is a connection between companies’ key financial figures and reported goodwill impairments.

Previous research is consistent with the negative relationship between net profitability and GI (Abughazaleh et al., 2011; Francis et al., 1996; Glaum et. al., 2018; Zang, 2008). Change in turnover is a frequently used parameter for measuring a company’s performance over time (Riedl, 2004). Despite different definitions of turnover growth, neither Abughazaleh et al. (2011) nor Francis et al. (1996) found a significant covariation between revenue growth and reported GI.

The parameter change in cash flow from operations reflects company-specific historical results and changes in performance. Cash flows are a driver of any loss in value decline for goodwill. Consequently, lower cash flows increase the likelihood of impairment decisions. This seems to be intuitive and logical. Previous research has documented that cash flows from operations have a negative relationship with future cash flows (Bostwick, Krieger, and Lambert, 2016; Jarva, 2009). Bostwick et al. (2016) found that GI has a more significant relationship with future cash flows than the sum of all other non-recurring items in the accounts. Jarva (2009) also found that GI according to SFAS 142 was associated with expectations of future cash flows. The GI according to SFAS 142 had a significant ability to predict cash flows 1 and 2 years ahead.

Goodwill, as a share of the company’s total assets, is a widely used explanatory variable. Zang (2008) expected that a high proportion of goodwill in the balance sheet would lead to a higher GI, as a larger part of the total goodwill would be exposed to impairment assessments. Meanwhile, it can be assumed that goodwill-intensive companies with a higher debt ratio may have incentives to avoid GI to avoid conflicting with loan agreements (Chalmers, Godfrey, and Webster, 2011).

Abughazaleh et al. (2011) used the book-to-market ratio as an independent variable in their study and predicted that companies with a high book value of equity in relation to market value reported GI. As expected, the analysis yielded a positive sign and significant correlation with GI. The book-to-market ration is an inverse variable to the price-to-book ratio. The ESMA refers to a book-to-market ratio above 100% as an external impairment indicator, and this should be considered when testing realistic value estimates in the assumptions used in impairment testing (ESMA, 2013).

Hypothesis 2:

There is a connection between proxies for earnings management and reported goodwill impairments.

Earnings management, a well-studied topic in accounting research, can result in either overestimation or underestimation of goodwill by postponing or accelerating GI, for the purpose of manipulating the result (Han, Tang, and Tang, 2020). The proxies for earnings management in our study are debt ratio, big bath, and income smoothing.

On one hand, Zang (2008) found that companies with a high debt ratio reported smaller GI, which implies a negative correlation between debt share and GI. Likewise, Ramanna and Watts (2012) discovered that management’s opportunistic behavior is reflected in the lack of GI when the company risks violating the accounting-based terms of a loan agreement. However, Gros and Koch (2020) find a connection between debt ratio and (negative) GI. Beatty and Weber (2006) and Chalmers et al. (2011) also concluded that a company’s loan agreements constitute an incentive to postpone or accelerate GI. Bepari et al. (2014), on the other hand, found that the debt ratio was not significantly associated with compliance with IFRS for impairment testing of goodwill, as contracts normally exclude intangible assets and goodwill from measuring the debt ratio.

A big bath occurs during periods of organizational stress and restructuring (Scott, 2015). If the company must report a loss in financial statements, management may feel that they might as well report an even larger loss. GI and other asset write-downs are accounting decisions that can be used in a big bath strategy. Scott (2015) stated that the recognition of large write-downs means that future earnings are put ‘in the bank’ (p. 405). Impairment losses on goodwill, meanwhile, cannot be reversed in subsequent periods in accordance with IAS 36.124. Nevertheless, a big bath would reduce the value of booked goodwill and corresponding GI in the future. This makes it possible to show a significantly weaker result than what is real in the current year, and stronger results in years to come.

Income smoothing is another form of earnings management. Management that aims to achieve artificial profit equalization utilizes the room to maneuver within accounting standards to achieve stable positive results, such as to provide stable bonuses (Scott, 2015). This is a principal–agent problem and has been extensively described in contract theory. Another incentive is to avoid volatility in key financial figures so as not to violate the company’s loan terms. Finally, there is an incentive to meet investors’ return expectations, and hence, to avoid stock market punishment. GI cannot be reversed in subsequent periods, in contrast to, for example, loss provisions and other accruals. We can then assume that GI is not as suitable as a tool for income smoothing as big bath reporting is.

Riedl (2004) concluded that increased flexibility for management in accounting standards, such as IFRS 3 and IAS 36, leads to increased reporting of big baths, and that write-downs, to a lesser extent, reflect the company’s underlying financial performance and financial position. Rees, Gill, and Gore (1996) concluded that management impaired assets in years when earnings were already weaker than industry medians. Kirschenheiter and Melumad (2002) argued that companies use a big bath and income smoothing to achieve stable high earnings in the long term. However, Francis et al. (1996), concluded that expected write-downs are reduced by abnormally weak and abnormally strong results for the company, contrary to their own predictions. These findings contradict the expectations of arguments for big baths and income smoothing.

Hypothesis 3:

There is a connection between macroeconomic crisis years and reported goodwill impairments.

Bepari et al. (2014) examined whether there were significant differences between companies’ compliance with IFRS regulations related to impairment testing of goodwill before and after a financial crisis. They found evidence that the degree of compliance increased significantly during the global financial crisis (2008–2009) from the period before the financial crisis (2006–2007). This confirms the findings of previous studies that companies provide more information when the need for transparency about impairment decisions is greater among investors. This applies especially when companies have a high goodwill share in the balance sheet, large GI, and risk of lawsuits.

Several researchers have examined the timeliness of GI in financial crises. The timeliness of impairments can be defined as the frequency of write-downs when there are financial indications for write-downs. André et al. (2016) compared the timeliness of write-downs between the US and Europe. They examined companies that had reported GI and found that American companies reported it to a significantly greater extent than European companies during the 2008-2009 financial crisis. There was also evidence that European companies implemented GI over a longer period but did not accumulate the same impairment rates as US companies.

4. Data and Descriptive Statistics

4.1. Data

The data used in this study are obtained from the Thomson Reuters Eikon financial database for the fiscal years 2005–2018. The data are obtained on an annual basis for active listed companies registered on the STOXX Europe 600 index on March 2020. The index consists of large, medium-sized, and small listed companies across 17 European countries (Stoxx.com, 2020). Based on the original list of 600 unique companies, we chose to exclude the financial industry, following similar studies. This industry is subject to regulatory conditions that result in different financial reporting requirements to those faced by companies in the rest of the sample. The Thomson Reuters Business Classification (TRBC) was used to categorize industries. Companies that were not reported in accordance with the IFRS during the investigation period were also excluded. For a complete overview of the sample of 449 companies, see Table 1.

To minimize currency effects associated with the figures, reporting currency and ratios were used in the multivariate analysis. However, in the descriptive part of the analysis, where we also considered nominal values, the reporting currency was converted to euro.

We encountered challenges in collecting complete data from only one database. Hence, several different databases from Thomson Reuters were used. The data were mainly obtained from Eikon Excel, but due to lack of access to certain accounting data, the other material was obtained from Datastream. These databases do not categorize reporting currencies on an equal footing for all firms. Therefore, for companies with inconsistent currency management across the databases, currency conversion was performed. Different uses of exchange rates in the companies’ annual reports and Datastream led to currency differences for parts of the data. To investigate the effect of this, multivariate regression was carried out both including and excluding the companies that defined the reporting currency differently. The results of this test show that the currency difference has a relatively similar effect to the robustness test shown later in this manuscript. This is because some companies in the telecom munications services industry are excluded from both tests. Thus, the management of currency differences has no effect on the data and regression analyses beyond this industry effect.

Moreover, all observations were obtained for December 31, which means that there are some companies with deviating fiscal years. This may lead to incomparability between accounting data and market data for some companies, but it is not considered a significant factor in this study. We followed up companies with missing values for the accounting item goodwill with manual collection and registration of data. This was mainly because goodwill in some cases was registered as an item under intangible assets. Missing data were obtained in annual reports from company websites.

4.2. Descriptive Statistics

Table 2 provides an overview of the data. We observe the frequency among companies reporting GI and the variation between the years. GI was clearly higher in the initial years after the regulation change in 2005, during the financial crisis in 2008–2009, and in subsequent years when several European countries struggled with high government debt. Based on findings in the note information of annual reports from 2011 and 2012, it appears that several of the impairments in these years are related to CGUs from countries that were hit hard by the debt crisis. This finding is also reflected in the fact that the largest GI rates in the share of both goodwill and total assets was reported in 2011 and 2012. Since 2013, the proportion of companies with GI has stabilized at a low level, with 2018 being the lowest at 14%.

The descriptive statistics on impairment rates in Table A7 in the Appendix show a large difference between the average GI of 9% and the median of 1.7% among the fiscal years in which goodwill was impaired. Of the 4928 fiscal years with incoming capitalized goodwill, 951 fiscal years reported GI. This accounted for 19.3% of the sample. A total of 951 fiscal years with goodwill write-downs were reported by 272 unique companies, representing a share of 28.6%. As the table shows, approximately 10% of the fiscal years have impairment rates of more than 20%.

We used descriptive statistics to examine the difference between the equity ratio including and excluding book goodwill (see Table A8 in the appendix). The equity ratio for all companies was on average 39.3% with a median of 38.6%, but if we exclude goodwill, the average was 23.6% and the median was 24.8%. Moreover, companies that wrote down goodwill had lower equity ratio than companies that did not. For equity excluding goodwill especially, the difference in solvency was significant, with a difference of 5 percentage points on average and 5.3 percentage points in the median, which is disadvantageous to companies with GI. It is noteworthy that 16.6% of companies have a negative equity ratio when excluding booked goodwill. For companies with GI in the actual year, 21.3% had an equity ratio excluding goodwill lower than 0.

We further examined the effect of recession periods on GI by observing the observations across years and industries (see Table A5 in the Appendix). The table reveals the extent of goodwill write-downs that were implemented in the energy and utilities industries during the fall of oil and gas prices in 2014–2015 (see Kjærland, Kosberg and Misje, 2021). Total GI in these industries accounted for as much as 62% of the total GI in the sample for 2015. The energy industry accounted for the largest proportion of write-downs (27%) among companies with goodwill write-downs in–2014–2015. At the same time, this industry had the largest GI in the share of opening goodwill, with 7% in 2014 and 6% in 2015. In turn, the utilities industry had by far the largest goodwill write-downs with 10% of opening capitalized goodwill in 2015.

The ESMA pointed out that significant GI was limited to only a handful of accounting producers (ESMA, 2013). In their findings on accounting figures from 2011, they concluded that 5% of the companies in the survey accounted for as much as 75% of total GI. For our data set, Table 2 shows that this proportion was 9% for 2011. Especially in 2006 and 2007, the percentage was low due to large GI in the telecommunications services industry. Moreover, Table 2 shows that goodwill constituted a stable high share of equity and total assets of the companies in the sample, where 2018 has the largest goodwill share of total assets.

Table 3 shows key figures at industry level. The industrials industry had the most observations and the most GI during the period. The telecommunications services industry had the largest share of GI; goodwill constituted the largest share of equity for both telecommunications services and consumer non-cyclicals. Telecommunications services constituted the largest share of the total sample both for the size of capitalized goodwill and GI. This industry also had the largest write-down rate of 5.2%; by comparison, healthcare had a low write-down rate of 0.4%. In four of nine industries, the goodwill share accounted for more than 25% of total assets.

5. Methodology

5.1. Elaboration on the Variables

In the multivariate analysis, the dependent variable is GI, expressed as a positive value, as a share of total assets in the previous year, following Abughazaleh et al. (2011), Francis et al. (1996), and Riedl (2004). This is referred to as GWIMPA%. The dependent variable does not consider GI acquired in the actual year, but it is reasonable to assume that such GI does not constitute a large part of the observations. To measure the effects of the actual impairment decisions, we also model a logistic regression with a dichotomous dependent variable GWIMP, where the value 1 corresponds to the fiscal year with GI, and 0 otherwise.

To test Hypothesis 1, we used proxies for company-specific financial conditions like the financial results, growth, financing, and cash flows of the companies. The first three variables, ROA, ΔREV, and ΔOCFA, measure a company’s financial performance. ROA, or return on assets, is a measure of net profitability that measures a company’s annual profit as a share of total assets. We relied on the studies of Abughazaleh et al. (2011), Francis et al. (1996), and Zang (2008), and calculated the key figure as an annual result as a share of total assets at the beginning of the year. To measure gross profitability and the growth of the company’s turnover, we used the variable ΔREV. Abughazaleh et al. (2011) considered a change in turnover as a share of total assets at the beginning of the year. We used their interpretation of revenue growth for concise use of total assets, as mentioned in our profitability parameters. They also measured changes in cash flow from operations (ΔOCFA) as the company’s cash flow-related performance, while Riedl (2004) referred to this as a net measure of performance, such as ROA. According to Riedl (2004), cash flows from operations reflect the return on investment in assets. Here, too, we used a change in cash flow from operations as a share of total assets, following the argument above. Companies with good financial performance are expected to have less GI (Glaum et. al., 2018).

The last two variables for measuring company-specific economic conditions are described as proxies for the characteristics of goodwill, including goodwill share and the book-to-market ratio. Francis et al. (1996) and Beatty and Weber (2006) also used book-to-market versions as proxies for goodwill characteristics. We used the price-book (P/B) ratio and expected a low ratio to lead to increased GI. As a measure of companies’ goodwill intensity, we included goodwill as a share of the company’s total assets at the beginning of the year (GWA), like, for example, Chalmers et al. (2011) and Zang (2008). This is because, in most cases, this goodwill item is tested for impairments at the end of the year. Abughazaleh et al. (2011) and Zang (2008) expected that a high proportion of goodwill in the balance sheet would lead to increased GI, as a larger part of total goodwill would be exposed to impairment assessments. The prediction of the sign of this variable is associated with uncertainty, as it can also be assumed that companies with a high goodwill share of total assets refuse to write down goodwill.

To test Hypothesis 2, three proxies were used to investigate whether key financial figures facilitate earnings management: debt ratio (DEBT), big bath (BATH), and income smoothing (SMOOTH). We followed several previous studies by including debt ratio as a proxy for earnings management. DEBT represents a company’s total debt as a share of total capital and is used to investigate whether there is a connection between the company’s debt share and GI. The debt ratio can also be an expression of solvency and not exclusively a proxy for earnings management. A high debt ratio can be assumed to involve an increased risk of insolvency for the company, which indicates weaker key financial figures.

According to Abughazaleh et al. (2011), Francis et al. (1996), and Riedl (2004), a sign of a big bath could be, on the one hand, that the company reports GI in periods when it has weak profitability. On the other hand, income smoothing could occur in cases in which a company reports GI despite strong profitability. To address this ambiguity, we introduced two dichotomous variables. The dichotomous variable BATH is expressed as a value of 1 if the company has operating profit this year (t) below 0, and the change in operating profit is lower than the industry median, and 0 otherwise. Conversely, the value of SMOOTH is expressed as a value of 1 for companies with an operating profit this year (t) above 0 and where the change in operating profit is higher than the industry median. We also tested the semi-dichotomous variables GOOD and POOR from Francis et al. (1996) as a robustness test of the findings of the previous proxies for earnings management. These explanatory variables refer to unexpectedly good operating results after write-downs and unexpectedly weak operating results. The intuition behind this approach was to measure whether accounting figures facilitate write-downs.

To investigate the effect of crisis years, we included dummy variables for the fiscal years (YEAR). We expected crisis years and years with recessions to have a greater effect on GI and to be significantly different from years without special economic downturns. In the regression models, the reference year was set to 2018, as this is the last fiscal year in our data set that does not contain known macroeconomic crises.

For a complete overview of the variables, see Table A1 in the appendix. As our continuous explanatory variables are largely divided by total assets, or measured in the form of change, there is low risk of lack of stationarity. To confirm stationarity in the data set, we selected 20 companies that carried out a visual check of the time-series graphs of all variables. In addition, the panels were tested using a Fischer test, as shown in Table A4 in the Appendix. The controls indicate that the variables and panels were stationary.

5.2. Statistics on the Independent Variables

Before introducing the models, we present more information on the independent variables. Table 4 shows the statistics for continuous explanatory variables in the multivariate analyses in this study. Using a two-tailed t-test and a two-tailed Mann–Whitney U-test, we measured whether average values and medians were significantly different between the sample of companies with GI versus those that did not. Consistent with Abughazaleh et al. (2011) and Glaum et. al. (2018), we found that companies with GI had weaker financial performance and financial position than companies that did not report any GI. In our study, this was proved by significantly lower medians and averages of profitability, changes in sales revenues, and changes in cash flows from operations. The debt ratio was also significantly higher for companies with GI than for those that did not report it. In addition, the goodwill share was significantly higher for companies that wrote down goodwill than for those that did not.

Moreover, Table 5 shows the results of a test of the dichotomous explanatory variables BATH, SMOOTH, and YEAR, which tested whether there were differences in the frequency of observations distributed between the sample of companies with and without GI. Here, we used a two-tailed chi-square test to test the significance level of differences in the occurrence of observations between the two samples. For the dichotomous explanatory variable BATH (as a proxy for earnings management using big bath), the incidence of these observations is significantly greater for companies with GI. For the variable SMOOTH, the frequency of observations is greatest for companies that did not implement GI, which is contrary to the findings of previous research. For the variable YEAR, the years 2005–2006 and 2008–2009 had significantly more frequent GI, while the opposite case held for most years after 2013, as discussed previously. In Table A6 in the Appendix, we present a Pearson correlation matrix that shows the correlation between the independent variables in the regression models^[2].

5.3. Two-way Fixed Effects Model

The companies in our data set reported financial accounts annually, giving us a panel data structure. Since the companies joined the STOXX Europe 600 at different times, the data set was unbalanced. Panel data models have the advantage that they can be used to control for time-invariant variables using FE models. This enables us to test for variables that cannot be observed or measured. At the same time, the models check for variables that change over time, but not across units. In cases in which unobserved effects are likely to correlate with the included explanatory variables, an FE transformation may be preferable to exclude the time-invariant component of the error term. During the FE transformation, the variables are time-demeaned for each unit, and thus, the estimator explores the relationship between GI in a year (t) as a share of total assets (t-1) and the exponential variables within units.

If, we assume that the error term is not correlated with the included explanatory variables, a random-effects (RE) transformation might be preferable. We estimate both the FE and RE models. However, the FE model seems to be more reasonable because of unobserved effects, such as firm culture, which are likely to be constant over time and therefore, correlated with the included explanatory variables.

Although we used the Hausman specification test (Hausman, 1978), we compared the consistent FE model with the efficient RE model. Note that the time-invariant explanatory variables dropped out during the FE transformation.

We estimated the following equation:

$$Y_{it}={\theta }_i+{\delta }_t+{\beta X}_{it}+{\epsilon }_{it}$$

(1)

$Y_{it}$ is the GI for firm i in year t, ${\theta }_i$ is the firm FE for firm i, the term ${\delta }_t$ represents the year dummy coefficients for year t, $X_{it}$ are independent exponential variables for company i at time t, ${\beta }_{it}$ are the accompanying coefficients, and ${\epsilon }_{it}$ is the error term.

5.4. Tobit Model

We followed Abughazaleh et al. (2011) and applied a multivariate Tobit model, where negative observations on the dependent variable were censored and unobservable, while the explanatory variables were available for all observations (Maddala, 1991). Previous research, such as Francis et al. (1996), used the Tobit model to censor negative observations of the dependent variable, as negative observations of general write-downs are not of interest. In accordance with IAS 36,124, GI losses cannot be reversed, and thus, the dependent variable GI losses cannot have values below 0.

Negative observations of the latent dependent variable were given a value of 0, while positive values remain the actual percentage GI as a proportion of total assets. This can be expressed in the following form:

$$y_i^{*}=\left\{\begin{array}{c}yi, if c<yi\\ c, if yi\le c\end{array}\right.$$

(2)

where c is the censored value of yi. We remove negative observations of the value yi manually, because in practice, reversals of goodwill write-downs are not permitted.

The final formula is as follows:

$$y_i^{\mathrm{*}}=X{i}^T\beta +{\epsilon }_i$$

(3)

$y_i^{*}$ is the GI for firm i’s share of all firms’ total assets the year before, $X{i}^T$ constitutes the various independent variables, $\beta$ is the corresponding regression coefficient, and ${\epsilon }_i$ is the error term. In our case, Tobit models with FE are likely to produce biased results, and thus, we report only results with RE.

5.5. Logit Model

Beatty and Weber (2006) applied a Logit model in addition to a Tobit model. They examined what was behind management’s impairment decisions using a dichotomous dependent variable for GI. The model cannot analyze the amount of the write-down, but it can be used as an overall indicator of whether the company should carry out impairment tests or, ultimately, GI. The dichotomous value 1 was assigned if the company had written down goodwill, while 0 was assigned if the company had not done so.

We defined the probability $P_i$ for $y_i=1$ by for the Logit model with FE:

$$P_{it}=\frac{1}{\begin{array}{c}1+e^{-({\theta }_i+{\delta }_t+\beta X_{it}+{\epsilon }_{it})}\\ \end{array}}$$

(4)

where $P_i$ is the probability that company i reports a goodwill write-down,${\theta }_i$ is the firm FE for firm i, ${\delta }_t$ represents the year dummy coefficients for year t, $X_{it}$ are independent exponential variables for company i at time t, ${\beta }_{it}$ are the accompanying coefficients, and ${\epsilon }_{it}$ is the error term. We modeled the logit model with both FE and RE and conducted a Hausman test.

6. Results

6.1. Fixed Effects Model

In Table 6, we present the multivariate analysis with the results from the FE and RE models. These models include all industries. After conducting a Hausman test, we rejected the hypothesis that RE is the best model; thus, we focused on the FE models. One version of the model consisted of only explanatory variables on company-specific key financial figures, while another version also included proxies for earnings management. After including these proxies, we found that the findings from the company-specific key financial figures had the same sign, but a somewhat changed level of significance. At the same time, the degree of explanation of the model increased.

Return on total assets had a negative sign and was significant at the 5% level. However, change in turnover as a share of total assets turned out to be positive and non-significant. We found a strong significant positive correlation with GI at the 1% level for changes in operating cash flow from operations as a share of total assets. The share of goodwill in the share of total assets was positively associated with increased GI, with a significance level of 10%. Price-book was non-significant.

The variable debt ratio was positively correlated with GI and significant at the 10% level. The proxies for a big bath and income smoothing were significant, where BATH was strongly and significantly positively correlated with GI, while SMOOTH was negatively correlated. The dummy variable year reveals that there were three accounting years that were significantly different from the reference year 2018. The years 2008 and 2011 were significantly different from 2018 at the 5% level, while 2007 was significantly different at the 10% level. The connection between the years was examined in more detail through an extended Wald test, as shown in Table A2 in the Appendix.

6.2. Tobit and Logit Regression

Table 7 presents the findings from the other two regression models: Tobit and Logit. The Tobit model has the same continuous dependent variable as the FE model, while the logit model has a dichotomous dependent variable that measures the actual write-down decision.

The Hausman test rejected RE using the logit model. Nevertheless, we could assess the extent to which FE by Logit was applicable, as several groups and observations were excluded from the FE model owing to lack of company-specific changes over time. However, Table 7 shows that the findings from the logistics models correspond to a large extent. Only the variable that measures goodwill share deviated. ROA stood out as the only variable with a strong significant negative correlation with GI at the 1% level. DEBT and BATH also had a significant positive correlation with GI. We found that the years 2006 to 2012 were significantly different from the reference year 2018 regarding impairment decisions.

The Tobit regression also reflected these findings, despite the use of different dependent variables between the models. GWA was significantly correlated with GI in the Tobit regression, but with a higher level of significance. Another common feature of the three models in Table 8 is that GI was not significantly correlated with ΔREV, P/B, and SMOOTH.

Thus, the findings from the Tobit and Logit regressions build on the findings from the FE model (Table 6). Specifically, the Tobit model provides the same findings apart from the proxy for income smoothing. By not including company-specific factors, we found that all years between 2006 and 2012 were significantly different from the reference year 2018. In the Logit models especially, this indicated more frequent GI in the years before 2013.

6.3. Robustness Test

Table 3 shows that goodwill constitutes a large proportion of total assets for the Consumer Non-Cyclicals, Healthcare, Technology, and Telecommunications Services industries after GI was completed. Telecommunications Services accounted for a large share of the total GI in the data set and had a significant impact on the data used in the multivariate analyses. The industry accounted for a large proportion of both total GI and goodwill share. Thus, a robustness test was carried out with the regressions excluding this industry (see Table 8).

By comparing the findings from the robustness test in Table 8 with those in Table 7, we observe that the FE models are essentially unchanged. Nevertheless, the robustness test reveals that by excluding a goodwill-intensive industry, the significant connection between the companies’ goodwill share (GWA) disappears. We further observe that the significance level of the proxy for income smoothing reduced from 5% to 10%. When excluding the Telecommunications Services industry, we found that the years 2007 and 2011 were no longer significantly different from the reference year 2018. The differences between the years were further investigated through a new Wald test that excluded Telecommunications Services. These findings are shown in Table A3 in the Appendix; we observe that 2008 is still significantly different from all years, while 2011 is significantly different from 4 of the other 12 years. The effect of the 2008-2009 financial crisis was maintained in this robustness test, while the effect of the debt crisis of 2011-2012 was somewhat reduced.

6.4. Discussion

The findings associated with ROA were robust. All models corresponded to our expectations and had a negative sign with a strong level of significance. The trend shows that companies with higher net profitability wrote down goodwill to a lesser extent than unprofitable companies. One reason may be that GI was reported at the same time as write-downs of other assets, accruals, and extraordinary items. Thus, ROA was confirmed to be a very relevant variable in the explanation of what is related to GI and the decision to report GI. By contrast, ΔREV was non-significant. This is consistent with the findings of Glaum et. al. (2018), Abughazaleh et al. (2011). Francis et al. (1996) and Riedl (2004) also concluded that revenue growth had no significant correlation with write-downs, even though they had a different approach to the calculation of this key figure. ΔREV was not significant in either the Tobit or Logit regression, which reinforces the finding that gross profitability targets in the form of revenue growth are not particularly important, regardless of the type of regression model. Thus, our findings confirm that gross profitability does not appear to have the connection with GI that net profitability has.

Our findings show a positive correlation of ΔOCFA with GI, which is opposite to the expectations from the net profitability parameter based on previous research. This finding is contrary to that of Abughazaleh et al. (2011). Our findings indicate that this underlying economic factor at the company level is not a relevant variable for GI losses. We referred to Bostwick et al. (2016) and Jarva (2009), who found that GI in the current year was connected only to cash flow from operations in subsequent years. From a financial theory standpoint, and financial intuition, GI should be reflected in expectations of weaker future cash flows, and thus, there should be a reduction in the recoverable amount in the impairment test. Bostwick et al. (2016) studied the relevance of GI in predicting future cash flows and concluded that GI was significantly negatively correlated with cash flows 1 and 2 years ahead. The other regression models deviated when interpreting this variable. The FE model had a strong significant positive sign even after the robustness test. The Tobit model produced a slightly significant positive correlation, while the Logit model showed no significant correlations. Thus, the strength of this discovery can be questioned, as the results suggest that a change in cash flows from operations last year did not necessarily have any connection with GI.

One of the other two variables for testing Hypothesis 1, GWA, had a positive sign and was weakly significant at the 10% level, in line with our expectations. This was the same result as that of Zang (2008), who expected that a higher share of goodwill in the balance sheet would lead to increased GI, as a larger part of total goodwill would be exposed to impairment assessments.

The results of the robustness test in the FE model (Table 8) show that the goodwill share was no longer a significant explanatory variable for GI when excluding the Telecommunications Services industry. This was contrary to the findings of Zang (2008), but consistent with Abughazaleh et al. (2011). Telecommunications Services’ higher frequency of GI and larger goodwill shares than those of other industries affected the results of the multivariate analyses. Thus, the share of goodwill seems to have had the greatest impact on write-downs in goodwill-intensive industries. Meanwhile, the findings from the Tobit model show a strong significant connection between GI and the companies’ goodwill shares. This contradicts the findings of Abughazaleh et al. (2011).

The results further reveal that P/B had no significant connection with GI according to IFRS 3. Like other explanatory variables in our study, P/B was treated as if the company were a CGU. Our findings indicate that GI had no relationship with market value in the current year. Furthermore, IAS 36.12 indicates asset impairment when the book value of the entity’s net assets is higher than its market capitalization. Therefore, we also tested a price-book ratio under 1 as a dichotomous independent variable, without showing any significant connection with GI.

Concerning Hypothesis 2, we found that the debt ratio was significantly positively correlated with GI, which differs from several other studies. The literature has produced ambiguous results in this area, and thus, no sign of the connection was predicted in our study. We found that an increased debt ratio was related to increased GI. This finding was opposite to that of both Zang (2008) and Ramanna and Watts (2012). Accounting-based contracts provide management with incentives for earnings management, which is a well-known principal–agent problem. Beatty and Weber (2006) also concluded that a company's debt agreements constitute an incentive to defer or accelerate GI. Gros and Koch (2020), who find higher negative discretionary GI associated with leverage – links this to the incentive of avoiding covenant breaches.

Our results for the debt ratio support those of Bepari et al. (2014), who considered loan contracts to normally exclude goodwill from measuring the debt ratio. Similarly, Chalmers et al. (2011) concluded that the debt ratio did not constitute a significant factor in explaining GI, which implies that the content of traditional debt contracts had little significance for write-downs of goodwill. Our study proves that the positive relationship with the debt ratio was significant. Companies with weak solvency might have had a generally more challenging economic and financial situation. This could have increased pressure from investors and creditors to document and report reliable values of the company’s assets to avoid overestimation of capitalized goodwill in the accounts. This might have led to the increase in write-downs.

We confirmed a significant positive correlation between the proxy for Big Bath and GI. We stress, however, that the variable cannot be interpreted in isolation, and we cannot conclude that it amounts to accounting manipulation. Impairment losses due to unexpectedly weak operating results, and weaker growth than the industry median, might indicate that management was using its acquired knowledge of the future to change its assumptions about future earnings of ‘value in use’ calculations in the impairment test. This contrasts with management’s subjectivity and judgment being used for accounting manipulation and opportunistic reporting. Therefore, we could not confirm that earnings management took place, even though the Big Bath variable was significantly positively correlated with GI. Nevertheless, it is a solid finding that GI had a significant positive correlation with unexpectedly weak operating results. We also tested the variable POOR, like Francis et al. (1996), and obtained the same sign and level of significance as when we tested the variable Big Bath. This supports our evidence that companies write down goodwill when results are unexpectedly weak, in line with their own expectations, and is consistent with previous research on big bath reporting.

However, we did not obtain the expected sign on the proxy for income smoothing, especially when considering predictions and findings from previous research, which expected income smoothing for unexpectedly good operating results. There may also be metrological challenges with the explanatory variable. The study is limited by such a key financial figure not being able to capture the possibility of income smoothing by itself. We also tested the variable GOOD, like Francis et al. (1996), and found no significant connection with GI. Our findings indicate that there was no income smoothing in connection with GI. This may seem logical, as many studies consider write-downs in general, and not just goodwill write-downs. As GI cannot be reversed in accordance with IAS 36.124, we suggest that goodwill write-downs are not as powerful a tool to achieve income smoothing as write-downs of other types of fixed assets.

Hypothesis 3 investigated the timing of GI. Bepari et al. (2014) found that compliance with regulations improved significantly during the financial crisis of 2008-2009. Our findings indicate that companies’ GI also had covariation with crisis years and years with recessions, both in terms of the frequency and size of GI. Furthermore, reported GI was concentrated in certain industries during periods of recession. This was reflected in the Energy and industries in connection when oil and natural gas prices fell in 2014 and 2015.

We showed that the financial crisis of 2008, the debt crisis of 2011, and 2007 were the only years that were significantly different from the reference year 2018. The results from the Wald test (see Table A2 in the Appendix) strengthened these findings by showing a collection of significant differences between 2008 and 2011. All years were significantly different from 2008, at least at the 10% level, which points to the effect of the financial crisis in relation to other years. However, 2011 was significantly different at the 10% level compared to seven of the other years in the sample, and the effect was reduced when excluding the Telecommunications Services industry. The Wald test confirmed the findings in the multivariate regression that 2008 was particularly significantly different from years without known macroeconomic recessions and crises. The test also revealed that despite the fall in oil and gas prices, 2014–2015 was not significantly different from other years, which might have been because this event largely affected specific industries rather than the macroeconomic picture in general.

Hence, we suggest that macroeconomic crisis years are significantly different from other years and seem to have an increased effect on GI. In a figurative sense, this means that the macroeconomic consequences of the COVID-19 pandemic could have a comprehensive effect on GI in 2020 and subsequent years. The crisis can be assumed to affect the world economy as a whole and to radically change economic prospects in the coming years. If the crisis is similar to those in 2008 and 2011, we could expect increased frequency and size of GI in the period ahead.

Furthermore, the impairment rates from our descriptive statistics were very low for most firm-year observations in the sample. Given that the economic value of goodwill consists of the expectation of future excess returns, this may indicate that the observed impairment rates do not reflect the life of the goodwill item. This issue is highlighted by the stakeholders in the IASB reports PIR 3 and Goodwill and Impairment, that too little goodwill has been written down after the introduction of IFRS 3 and the impairment-only model. Impairment testing and the associated calculation of the recoverable amount have a high inherent degree of managerial subjectivity and discretion in the assumptions, which can facilitate opportunistic accounting reporting by management. In our opinion, the main challenge with the current IFRS regulations is that acquired goodwill is in practice replaced by in-house developed goodwill, which the impairment test in IAS 36 does not prevent under the current regulations. In addition, we suggest that this problem gives management an incentive to carry out business combinations to have in-house developed goodwill capitalized in subsequent periods. Moreover, the results from the descriptive statistics provide a basis for supporting the IASB in its view of highlighting equity excluding goodwill as an important key figure for solvency, based on the challenges that the goodwill item entails. In our study, the equity ratio excluding goodwill was significantly lower for companies that wrote down goodwill than those that did not. Thus, we support the IASB’s efforts to improve information in the notes to financial statements to obtain more reliable and relevant accounting information related to goodwill (see also Han et al., 2020) by providing sufficient and good information on subsequent acquisitions and assumptions in the impairment test.

7. Conclusion, Limitations, and Implications

7.1. Conclusion

Our comprehensive empirical study considered GI in accordance with the IFRS. It complements the knowledge base on goodwill and contributes to the final phase of the IASB project Goodwill and Impairment. Especially, our contribution relates to the finding that crisis years have covariation with GI – made possible since previous relevant studies have used shorter time spans in their investigation. We also extend previous research by including a fixed-effects (FE) model on the relationship between GI and company-specific economic factors and proxies for earnings management.

We confirmed that return on total assets is significantly negatively associated with GI – yet found ambiguous results for the other economic factors. We also found significant positive correlations between GI and the earnings management proxies for debt ratio and Big Bath. This finding indicates that GI losses may be the result of opportunistic reporting. A positive correlation with the variable Big Bath may also indicate that management gains new knowledge about expected future earnings. Thus, GI can be reported because of changes to the assumptions in the impairment test based on management’s new expectations related to future cash flows, growth, and risk for use in the ‘value in use’ calculations.

7.2. Limitations

We do acknowledge some limitations of our study. Our observations might be affected by some other (un)observable factors as we do not include some of the variables used in e.g., Glaum et. al. (2018) and Gros and Koch (2020) – like CEO characteristics and other corporate governance type variables. Moreover, we also see that macroeconomic effects are a driver of GI decisions – mitigating the role of the managerial discretions in this regard. Nonetheless, we do not find this compelling with regard to the overall contribution of the study.

7.3. Implications

Our descriptive statistics show that goodwill share, both of equity and total assets, is high. Impairment rates are low when considering the index, in terms of the frequency, average, and median of GI. Like the Board of Directors of the IASB, in this study, we found no basis for either significantly changing the impairment test in accordance with IAS 36 or abolishing the impairment-only model in accordance with IFRS 3. We nevertheless recommend that the IASB should focus further on improving information in the notes to the financial statements related to business combinations and write-downs, particularly regarding the information on subsequent performance of acquisitions and management’s assumptions used in the ‘value in use’ calculations. Furthermore, we support the IASB’s preference for looking at equity excluding goodwill as a separate key financial figure for solvency, based on our finding that companies that write down goodwill have a significantly lower equity ratio excluding goodwill than those that do not do so.

The results of the multivariate analysis show significant differences between years characterized by crises compared to other years. This is the case especially for the financial crisis in 2008-2009, but also the debt crisis in 2011, which stands out in the data set. This finding indicates that crisis years have covariation with GI. We expect a significant increase in the amount of GI losses, which is an important implication for accounting users because of the COVID-19-induced economic crisis. The real consequences of the pandemic for GI provide a basis for further research. At the same time, it would be interesting to investigate further the possible interaction between big bath reporting and crisis years, and to consider in more detail the timeliness of GI in the accounts for 2020 and subsequent periods.