Goodwill Impairment and Corporate Social Responsibility

Table of Contents

List of Abbreviations

1 Introduction

2 Theoretical and Institutional Background
2.1 How to determine goodwill (impairment) under IFRS and US-GAAP
2.2 CSRReporting
2.2.1 CSR Reporting in Europe
2.2.2 CSR Reporting in the United States

3 The link between Goodwill Impairment and CSR
3.1 Goodwill impairment
3.2 CorporateSocialResponsibility
3.3 Association between goodwill impairment and CSR

4 Critical Appraisal
4.1 Evaluation of the applied Models / measurement variables
4.2 Practical Relevance and further research

5 Conclusion

References

List of Laws and Regulations

List of Official Publications

List of Abbreviations

Abbildung in dieser Leseprobe nicht enthalten

1 Introduction

The issue goodwill impairment is controversially discussed in practice and in literature because goodwill or rather the amount of goodwill which has to be impaired primarily based on mana­gerial assumptions and proprietary information and further the recognition and accurate meas­urement is not easy and thus often not free from error.¹ Therefore the International Accounting Standards Board (IASB) and the Financial Accounting Standards Board (FASB) require firms to disclose specific information on how and why goodwill arises in business combinations.²

Goodwill accounting is intended to provide information on the financial consequences of mer­gers and acquisitions. It is therefore potentially very important for recipients of annual financial statements. Goodwill accounting in Europe is generally regulated in the International Financial Reporting Standard 3 (IFRS 3) Business Combinations and International Accounting Standard 36 (IAS 36) Impairment ofAssets.

Goodwill accounting in the US is regulated in Accounting Standards Codification 805 (ASC 805) Business Combinations (formally known as Statement of Financial Accounting Standards No. 141 (SFAS 141)) and ASC 350 Goodwill and other Intangible Assets (formally known as SFAS 142). Goodwill is defined as an asset representing the future economic benefits arising from other assets acquired in a business combination that are not individually identified and separately recognised.³

Besides goodwill impairment, Corporate Social Responsibility (CSR) activities has become another steadily increasing issue around the world and has gained significance in the view of public policy and management practice.⁴ CSR is often defined as “the social responsibility of business encompasses the economic, legal, ethical and discretionary expectations that society has of organizations at a given point in time.”⁵ Especially the relationship between a firm's CSR and its firm performance, earnings quality and information asymmetry has been subject of accounting literature and research.⁶ If specific socially responsible actions tend to be nega­tively correlated with firm performance, managers could be cautious in this area. If, on the other hand, a positive association can be shown to exist, managers might be encouraged to enhance such activities.

The increase in CSR reporting raises questions: What are the rationales behind this type of voluntary disclosure? What benefits do firms gain by spending resources on compiling and publishing these standalone reports?⁷

The seminar paper is structured as follows: Chapter two gives a briefly overview about the theoretical and institutional background in Europe and the United States particularly about how to determine goodwill impairment under IFRS and US-GAAP. Chapter 3 gives a general over­view of the state of current research in Europe and the United States regarding goodwill im­pairment and CSR reporting. Particular attention is set on the association between goodwill impairment and CSR determinants. Chapter 4 evaluates the applied models and measurement variables and the practical relevance and further need for research are highlighted and dis­cussed.

2 Theoretical and Institutional Background

2.1 How to determine goodwill (impairment) under IFRS and US-GAAP

Business combinations are highly relevant to investors and other users of financial statements because they often involve large sums of money, can be of strategic importance for firm value and a high percentage of combinations fail to meet their operational and financial goals.⁸ On the one hand goodwill is an increasingly relevant balance sheet item but on the other hand according to the latest Harvard Business Review Report, about 70% to 90% of mergers and acquisition (M&A) deals are failures. Thus, goodwill impairment has become an economically significant event.⁹

Goodwill arises in M&A deals if the purchase price of the acquisition is greater than the net asset value of the acquired company. Goodwill is defined as an asset representing the future economic benefits arising from other assets acquired in a business combination that are not individually identified and separately recognised.¹⁰

In 2001, the FASB issued SFAS 141(ASC 805) and SFAS 142 (ASC 350), introducing new rules for business combinations and the impairment test for intangible assets acquired. The new standards required that business combinations be accounted under the purchase method and replaced the straight-line amortization of goodwill with an impairment test.¹¹ These new stand­ards had a significant impact on firm's earnings. According to the Fortune Magazine the im­pairment concept downsized the Fortune 500's reported income by more than 70% in the first year the new standards were applied.¹²

In 2004, the IASB followed the FASB and issued IFRS 3. IFRS 3 prohibits the straight-line amortization of goodwill acquired in a business combination, because it is considered to have an indefinite useful life. Instead it requires the testing for impairment annually or more fre­quently if events or changes in circumstances indicate that the asset might be impaired.

IFRS and US-GAAP require firms to annually test for potentially goodwill impairment, regard­less of whether there is an indication for impairment or not (impairment-only approach).¹³ Nev­ertheless, an entity shall assess between annual tests whether there are any circumstances (trig­gering event) that an asset may be impaired.¹⁴ In assessing whether there is any indication that an asset may be impaired, an entity have to consider external sources of information, e.g. sig­nificant and adverse changes in the business environment or indications that the asset’s value has declined during the period significantly more than would be expected and internal sources of information, e.g. evidence of obsolescence or physical damage of an asset or evidence that indicates that the economic performance of an asset is, or will be, worse than expected.¹⁵

SFAS 142 requires firms to test their assets for impairment through a two-step process for each reporting unit to which goodwill is allocated after the acquisition.¹⁶ The first step is to test the existence of any impairment loss. If the recoverable amount of a reporting unit exceed its car­rying amount, goodwill of the reporting unit is considered not to be impaired, but if the carrying amount, including goodwill, is higher than its recoverable amount, the amount of impairment loss has to be measured and recognized.¹⁷ After a goodwill impairment loss is recognized, the adjusted carrying amount of goodwill shall be its new accounting basis. Subsequent reversal of a previously recognized goodwill impairment loss is prohibited once the measurement of that loss is completed.¹⁸

Similar to SFAS 142, IAS 36 requires the allocation of goodwill to reporting units, to be more precise, to cash-generating units (CGUs).¹⁹ A CGU is the smallest identifiable group of assets that generates cash inflows that are largely independent of the cash inflows from other assets or groups of assets.²⁰ Impairment test takes place on level of the CGU. If the recoverable amount of the CGU is less than its carrying amount, including goodwill, goodwill shall be impaired and an impairment loss must be recognised immediately in profit or loss and the carrying amount of the CGU have to be reduced to its recoverable amount.²¹ The recoverable amount of an asset is the higher of its fair value less costs of disposal and its value in use. The carrying amount is the amount at which an asset is recognised after subtracting any accumulated depreciation.

Survey studies indicate that goodwill impairment tests in practice are mostly based on value­in-use estimates. Even where fair values are used to determine the recoverable amount of good­will-carrying CGUs, they are often estimated with DCF-models and only rarely derived from observable market prices.²²

The impairment-only-approach was introduced with the aim of improving the information con­tent of reported acquired goodwill and reducing the managerial flexibility afforded by the for­mer trigger-based standards.²³ However, this approach has been criticized by academics and practitioners because of the managerial discretion inherent in the process of testing goodwill for impairment.²⁴ From the critics' point of view, goodwill is often written off too little or not at all.²⁵ Advocates of the impairment-only-approach counter that discretionary in accounting does not fundamentally contradict the objective of providing useful information, but enables the management to communicate private information to the capital market and thus increase the information content of the annual report.²⁶ The inherent managerial discretion in goodwill impairment is dealt with in more detail in Chapter 3.1.

2.2 CSR Reporting

CSR is a multi-layered field with different affiliations and perspectives such as legal, social, moral and financial aspects. There is no particular common definition what exactly should be included in firms social responsibility, but an understandable fundamental consensus could be as follows: “Corporate Social Responsibility is the continuing commitment by business to be­have ethically and contribute to economic development, while improving the quality of life of the workforce and their families as of the local community at large.”²⁷

CSR activities are communicated by companies in different ways. The most common way is through a CSR report which usually provide information about a company's social, ecological and economic commitment in addition to the annual report.

There is a steadily increasing emphasis on CSR activities around the world as firms have be­come increasingly willing to voluntarily issue CSR reports.²⁸ According to a KPMG survey from 2011, 95 percent of 250 largest companies in the world report on their corporate respon­sibility activities.²⁹

Customer demands are rising, government restrictions regarding social conduct increasing and additionally there is the tendency that investors are not only looking at the financial perfor­mance, but are also valuating the way firms meet their social responsibilities.³⁰ Therefore, CSR could be a part of an answer to the societal uncertainties that companies have to cope within the present dynamic, global, and technological social contexts.³¹

CSR requires managers to make multiple trade-offs between shareholders and other stakehold­ers in the firm.³² There are opinions that CSR has a negative impact of firm performance be­cause it causes additional cost (e.g. Friedman 1970), there are opinions that CSR has a positive impact of firm performance (e.g. Beck et al. 2018; Golden et al. 2017) and there are opinions that CSR initially causes additional costs which has a negative impact on firm performance, but in the long run has a positive impact on firm performance (e.g. Nollet et al. 2016).

Thus, CSR finds itself in the area of tension between the representatives of the view that man­agers’ only responsibility was to increase shareholders’ wealth, because they are employees of the shareholders and therefore, their only responsibility is to make as much money as possible and the representatives of the view that managers have a responsibility to all stakeholders and notjustto shareholders (e.g. Freeman/Dmytriyev 2017; Freeman 1994).

Therefore, the stakeholder theory is a central part of CSR. It suggests that the success of a corporate depends on the extent to which the organization is capable of managing its relation­ships with key groups, such as financers and shareholders, but also customers, employees, and communities or societies.³³

Another frequently heard motive for CSR reporting is the strive to minimise reputation risks. A firm's reputation is a valuable asset which needs to be protected and developed, and a key aspect of this reputation is stakeholders’ perceptions of firm’s CSR respectively perceptions of how well the firm’s CSR policies, practices and outcomes meet stakeholders’ social and envi­ronmental values and expectations.³⁴ Additionally, there is evidence that both positive and neg­ative CSR performance reduce information asymmetries.³⁵

Unlike annual financial reporting, CSR reporting is not mandatory in most countries, thus most of the CSR reports are issued voluntarily. Nevertheless, there has been recent legislation in some countries, particularly in Europe, mandating such CSR disclosure for large listed firms.³⁶

2.2.1 CSR Reporting in Europe

Before 2014 there was no EU-wide directive setting the framework for CSR reporting respec­tively the companies could decide for themselves whether to publish their CSR activities or not. This circumstance has changed with EU-Directive from 2014.

The European Parliament and the EU Member States adopted the CSR-directive extending the reporting requirements of large listed companies. These public-interest entities, with an average number of 500 employees, shall include in the management report a non-financial statement containing detailed information and aspects of their business activities.³⁷ Such statement should include a description of the policies, outcomes and risks related to those environmental, social and governance matters. Additionally the non-financial statement should also include infor­mation on the due diligence processes implemented by the company in order to identify, prevent and mitigate existing and potential adverse impacts.³⁸

In particular, the CSR-directive aims to increase transparency on the environmental and social aspects of businesses in the EU. The disclosure of non-fmancial information is essential for managing change towards a sustainable global economy by combining long-term profitability with social justice and environmental protection.³⁹ This includes information on environmental, social and workers' issues, respect for human rights and the fight against corruption and brib­ery.⁴⁰ These aims are to be achieved by creating market and political incentives that reward positive CSR activities and penalise negative CSR activities.

2.2.2 CSR Reporting in the United States

In contrast to the view that Germany that is commonly cited as being representative of the European Union business system where banks and government play the dominant roles, the United States are typically cited as an example of a business system where private investors play a powerful role in businesses compared with government.⁴¹ Another difference between the United States (U.S.) and Europe is that in Europe implicitly state CSR whereas firms in the United States explicitly state a commitment in CSR activities. One reason could be that in the United States there is less governmental pressure on companies to report CSR while in Europe companies are sometimes mandated to perform a socially active role.⁴²

There are several laws and to address social and environmental concerns in the United States. Companies had to meet the requirements set by the government but there is no requirement on reporting there CSR activities to the public.

The reporting of CSR activities is still voluntary in the United States but there is an increasing number of firms that voluntary disclosing information about their social and environmental activities to meet the demands of share- and stakeholders.⁴³

CSR has become an important part of US firms’ long-term strategy and vision. Many compa­nies have either voluntarily increased their investment in CSR activities over the last decade or as a result of pressure from share- and stakeholders.⁴⁴ Many firms also publish annual CSR reports that provide detailed information about their CSR activities and achievements or use sections of their annual reports to describe their CSR activities.

Most of the US companies that publish CSR reports are large and multinational enterprises. Additionally, there is a growing trend for small-medium enterprises to publish CSR reports in order to increase their transparency, attract customers and grow their business.

Nevertheless, there are concerns from conservatives in the United States that additional regu­lation in particular mandatory CSR reporting could have a negative impact on financial markets and therefore voluntary disclosure is the best option. The United States does not want additional constraints on their companies unless all companies are playing on a level playing field.⁴⁵ That could be a reason why U.S. firms appears to lag foreign firms in terms of the rates of disclosure of CSR activities because many other nations regulate non-fmancial and CSR reports.⁴⁶

3 The link between Goodwill Impairment and CSR

3.1 Goodwill impairment

Goodwill impairment decisions are associated with three main factors: Firm performance, man­agement incentives and firm-level incentives.

There are different measures that can be used in order to evaluate the performance of a com­pany. Some of the most common measures are: revenue respectively return, return on asset (ROA) and market-to-book-ratio (MTB). Return and MTB are market-based, external measures of economic firm performance. ROA is an accounting-based, internal measure of a company’s financial performance that also reflects management's expectation of future performance.

Prior empirical findings indicate that goodwill impairment is a value-relevant event to the mar­ket, because goodwill is an asset, reflecting a significant amount of a firm's balance sheet and is an indicator of future firm performance and thus goodwill impairments are negative news for the market (e.g. Darrough et al. 2014; Li et al. 2011; Henning/Shaw 2003; Jennings et al. 1996). Several other empirical studies suggest that there is a negative relation between firm perfor­mance and goodwill impairment because it is an indicator of a decline in future firm perfor­mance. A better firm performance is generally associated with less goodwill impairment and vice versa (e.g. Glaum et al. 2015; Chao/Homg 2013).

Additionally, other studies suggests that the cause of goodwill impairment losses is that the target firms’ stock was overvalued and thus induces managers to value-destroying acquisitions which lead to goodwill impairment (e.g. Gu/Lev 2011; Li et al. 2011; Hayn/Hughes 2006). Approximately 40 percent of goodwill impairment losses are caused by overpaid acquisition prices.⁴⁷

The second factor that influences goodwill impairment are management incentives. The most common management incentives are bonus, tenure and CEO-turn.

Previous literature suggests that managers cash bonus compensation and the amount of good­will recognised in an acquisition are related to each other. These studies found that there is a negative significant association between bonus and goodwill impairment (e.g. Detzen/Zuelch 2012; Ramanna/Watts 2012; Beatty/Weber 2006). To the extent that managerial compensation respectively bonus depends on current firm performance, managers may have an incentive to delay or avoid recognising goodwill impairment because it would lower reported income and therefore they would lower their own bonus.⁴⁸

Another incentive is a CEO-turn. There should be a positive association between goodwill im­pairment and CEO-turn because the new CEO is usually not responsible for acquisition deci­sions made by his/her predecessors and therefore he does not have to worry about reputational damage arising from impairment of goodwill in his/her first year as new CEO.⁴⁹ Further, rec­ognising goodwill impairment losses in his/her first year reduces the likelihood of future years’ impairments, which could affect his/her reputation and subsequent year’s remuneration (e.g. Glaum et al. 2015; Riedl 2004; Francis et al. 1996).

Tenure is another management incentive. Ramanna and Watts (2012) and Beatty and Weber (2006) find evidence that tenure is significantly negatively associated with goodwill impair­ment. Tenure describes the time period in which a manager/CEO works for the company re­spectively is in charge. Therefore there is an incentive not to impair goodwill because the longer a manager is in the company, the more likely he or she is responsible for the M&A deal and thus also for the failure/for the goodwill impairment. Thus non-impairment is motivated by managers’ interests in shielding their reputations from the implications of goodwill write-offs.⁵⁰ The third factor that influences goodwill impairment are firm-level incentives. Common firm­level incentives are big bath accounting, income smoothing and debt covenant.

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¹ Cf. Carvalho et al. (2016), p. 376; Glaum et al. (2015), pp. 1-2.

² Cf. Mazzi et al. (2017), p. 269.

³ Cf. IAS 36.81.

⁴ Cf. Dhaliwal et al. (2012), p. 60; Kim et al. (2012), p. 762.

⁵ Carroll (1979), p. 500.

⁶ Cf. Cochran/Wood (1984), p. 42.

⁷ Cf. Dhaliwal et al. (2012), p. 60.

⁸ Cf. Glaum et al. (2013), p. 165.

⁹ Cf. Darrough et al. (2014), p. 438.

¹⁰ Cf. IAS 36. 81.

¹¹ Cf. Bini/Bella (2007), p. 904.

¹² Cf. Bini/Bella (2007), p. 904.

¹³ Cf. IAS 36. IN5 (c); SFAS 142.18.

¹⁴ Cf. IAS 36.9; SFAS 142.26.

¹⁵ Cf. IAS 36.12; SFAS 142.28.

¹⁶ Cf. SFAS 142.18.

¹⁷ Cf. SFAS 142.19.

¹⁸ Cf. SFAS 142.20.

¹⁹ Cf. IAS 36. 134 (a) and (c).

²⁰ Cf. IAS 36.6.

²¹ Cf. IAS 36. 59 and 60.

²² Cf Glaum et al. (2015), p. 14.

²³ Cf. AbuGhazalehetal. (2011), p. 166.

²⁴ Cf. AbuGhazaleh et al. (2011), p. 166.

²⁵ Cf. Boecking/Gros/Koch (2015), p. 319.

²⁶ Cf. Boecking/Gros/Koch (2015), pp. 319-320.

²⁷ World Business Council for Sustainable Development (2000), p. 8.

²⁸ Cf. Dhaliwal et al. (2012), p. 60.

²⁹ Cf. KPMG international survey of corporate responsibility reporting (2011), p. 6.

³⁰ Cf. Cho et al. (2013), pp. 71-72.

³¹ Cf. vanBeurden/Goessling (2008), p. 407.

³² Cf. Chen/Gavious (2015), p. 30.

³³ Cf. van Beurden/Goessling (2008), p. 408.

³⁴ Cf. Unerman (2008), p. 362.

³⁵ Cf. Choetal. (2013), p. 79.

³⁶ Cf. Tschopp/Huefner (2015), p. 569.

³⁷ Cf. Directive 2014/95/EU of the EP of 22 October 2014, L 330/3, subsection 14.

³⁸ Cf. Directive 2014/95/EU of the EP of 22 October 2014, L 330/2, subsection 6.

³⁹ Cf. Directive 2014/95/EU of the EP of 22 October 2014, L 330/2, subsection 3.

⁴⁰ Cf. Directive 2014/95/EU of the EP of 22 October 2014, L 330/2, subsection 6.

⁴¹ Cf. Chen/Bouvain, p. 304.

⁴² Cf. Danko et al. (2008), p. 45.

⁴³ Cf. Tschopp (2005), p. 57.

⁴⁴ Cf.Dengetal. (2013), p. 87.

⁴⁵ Cf. Tschopp (2005), p. 57.

⁴⁶ Cf. Holder-Webb et al. (2009), p. 517.

⁴⁷ Cf. Olante (2013), p. 244.

⁴⁸ Cf. Glaum et al. (2015), p. 17.

⁴⁹ Cf. Glaum et al. (2015), p. 17.

⁵⁰ Cf. Ramanna/Watts (2012), p. 752.