Evidence on the Effects of Unverifiable Fair-Value Accounting

by Karthik Ramanna & Ross L. Watts

Overview — Since the late 1990s, the Financial Accounting Standards Board (FASB) has pressed for the use of fair values in accounting. When such fair values are based on verifiable market prices, they are less likely to be managed. However, in some FASB standards, fair values are based on managers' or appraisers' unverifiable subjective estimates. Agency theory suggests that managers will take advantage of this unverifiability to manage financial reports in order to extract rents. This paper considers a recent FASB standard known as SFAS 142, which relies on unverifiable fair-value estimates when accounting for acquired goodwill. The goal of the research is to see whether firms are using this standard to manage their financial reports. Key concepts include:

The increased use of unverifiable fair-value estimates in accounting will lead to more opportunistic management in financial reports, absent increased monitoring.
Firms that were predicted to have discretion are indeed managing their financials according to SFAS 142.

Author Abstract

SFAS 142 requires firms to use fair-value estimates to determine goodwill impairments. Watts (2003) and Ramanna (2007) argue the unverifiable nature of those fair-value estimates gives firms discretion to manage impairments. We test this argument in a sample of firms with market indications of impairment (firms with book goodwill and market-to-book ratio below one). We find that the frequency of non-impairment in this sample is about 71%, and that non-impairment is increasing in financial characteristics predicted to be associated with greater unverifiable fair-value-based discretion. To investigate whether non-impairment is associated with managers producing on average better estimates of goodwill than the market, we test whether non-impairment increases in industries with higher average information asymmetries. We fail to find evidence consistent with this proposition.