Using Real Activities to Avoid Goodwill Impairment Losses: Evidence and Effect on Future Performance

We examine whether managers postpone the recognition of goodwill impairment by manipulating cash flows and the consequences of such a strategy on future performance. According to SFAS 142, an impairment loss must be recognized if the reporting unit's total fair value to which goodwill has been allocated is less than its book value. A growing body of empirical evidence shows that managers delay the recognition of goodwill impairment in accounting books. However, past literature is silent on how managers convince various gatekeepers (e.g., auditors, financial analysts) that recognizing an impairment loss is unnecessary although it seems economically justified. SFAS 142 requires managers to forecast future cash flows to justify the decision to recognize, or not, an impairment loss. Therefore, we predict that managers manipulate upward current cash flows to support their choice to avoid reporting an impairment loss. We also test whether or not this real earnings management is detrimental to future performance. Based on a sample of US firms over the period 2003–2011, we document that firms suspected of postponing goodwill impairment losses exhibit significantly positive discretionary cash flows compared to various control groups. We also find that this real activities manipulation is detrimental to future performance.