Investors aware of issues before goodwill impairment announcements, study shows

By the time a company announces that goodwill is impaired, investors have been aware for months that the company is facing problems, a new study indicates.
 
One objective of the fourth annual Financial Executives International (FEI) Goodwill Impairment Study was to compare the stock price performance of companies that recorded goodwill impairment to the performance of the market as a whole.

The study of more than 5,000 U.S.-based, U.S.-traded companies tracked 1,259 individual impairment events from 2005 to 2009. The stock performance of companies was tracked and compared with the S&P 500 for 12 months before and 12 months after the impairment was announced.

Companies underperformed the market both before and after the announcement that goodwill was impaired. But the more severe underperformance occurred before the impairment announcement:

• From seven to 12 months before impairment was announced, companies underperformed the market by 4.9%.
• In the six months before the impairment announcement, companies underperformed by 2.2%.
• Over the first six months after the impairment announcement, companies underperformed by 1.2%.
• From seven to 12 months after the impairment announcement, companies underperformed by 0.8%.

“It indicates that in general, investors are aware of the issues that may lead to a subsequent impairment long before the actual impairment is taken,” Duff & Phelps director James Harrington said in a webcast devoted to the study results. Duff & Phelps, a financial advisory and investment firm, developed the study in partnership with FEI.

A survey of FEI members included in the report also showed that when performing a discounted cash flow (DCF) analysis with respect to goodwill, companies were inconsistent in matching the basis of projections with the discount rate applied 39% of the time.

The survey of 219 respondents from private and public companies asked what basis they used to prepare their reporting unit projections to apply the DCF method. The survey also asked which discount rate they applied when using a DCF method to estimate the fair value of the reporting units.

FASB Accounting Standards Codification Topic 820 states that discount rates should reflect assumptions that are consistent with those inherent in the cash flows in order to avoid double counting or omitting the effects of risk factors.

But 32% of respondents said they had applied a risk-adjusted discount rate (i.e., risk is reflected in the discount rate by including an additional risk premium) to expected or scenario-weighted cash flow projections.

“This essentially double counts the risk,” Gary Roland, a Duff & Phelps managing director, said during the webcast.

And 7% said they applied an expected present value technique rate to projections which represented a single, most likely case scenario. This could imply that risk was not fully accounted for.

Jouky Chang, a Duff & Phelps managing director who spent two years as a professional accounting fellow in the SEC’s Office of the Chief Accountant, said the results demonstrate why the SEC often seeks to better understand how registrants derive their discount rate, and how that rate matches up with their projections.

“The survey results truly validated the SEC staff’s continuing concern of registrants’ lack of understanding of the importance of appropriately matching the discount rate to the nature and the characteristics of the underlying cash flow projections,” Chang said during the webcast.

The study showed that total goodwill impairments of U.S. public companies in 2011 decreased slightly to $29 billion from $30 billion the previous year. Goodwill impairments had soared to $188 billion at the height of the financial crisis in 2008 from $54 billion in 2007, then plummeted to $26 billion in 2009, with little change over the past three years.

The financial industry accounted for the greatest percentage of total reported goodwill impairments in 2011 at 20%, but that represented a huge drop from the 50% share of goodwill impairments reported by that industry in 2010. Consumer staples ranked second among industries in 2011 goodwill impairments reported with a 17% share.

Thirty-six percent of public company respondents and 34% of private company participants said in the survey that their company recognized goodwill or other asset impairments in 2010 or 2011.

—Ken Tysiac (ktysiac@aicpa.org) is a JofA senior editor.