Accounting Choice through Business Combinations: The Case of Goodwill and Negative Goodwill

We investigate the accounting practices of Korean listed firms that recognized and amortized goodwill or negative goodwill from business combinations in the years of 2000 to 2006. Furthermore, we empirically examine whether firms use the accounting standards for business combinations opportunistically to manage their reported earnings and leverage ratios. The acquirer shall, at the acquisition date, recognize goodwill from a business combination as an intangible asset. The amortization of goodwill results in expenses. However, negative goodwill arises when the acquired company is purchased at a price lower than its fair value. Negative goodwill occur either when the acquirer has a superior bargaining power, or when identifiable assets are overstated or identifiable liabilities are omitted/understated or a combination of both. We have witnessed a big increase in the recognition of negative goodwill from 2000 in Korea thanks to the revised accounting standards for business combinations. The revised standards allow firms to recognize negative goodwill when the acquisition price is lower than the acquirer’s interest in the fair value of net identifiable assets acquired. We believe that the frequent recognition of negative goodwill in Korea is attributable to three factors: business combinations between related firms, use of book value instead of fair value, and low price to book value ratios. We reviewed all the consolidated audit reports of firms that recognized goodwill and negative goodwill during our study period. We note that the footnote disclosures relating to goodwill and negative goodwill are insufficient. Furthermore, the major source of goodwill and negative goodwill recognition comes primarily from business combinations between related firms that are controlled by the same controlling shareholders. We also note that the amortization periods of goodwill and negative goodwill are not systematic. The amortization of goodwill and negative goodwill affects both balance sheet and income statement. It implies that firms may have incentives to manage their reported earnings by using goodwill and negative goodwill accounting. Furthermore, firms choose somewhat arbitrary amortization periods. If firms amortize goodwill and negative goodwill, the amortization becomes a part of reported earnings and will impact debt ratios as well. We investigate how pre-amortization profit and debt ratios affect firms’ amortization policies. We find that firms amortize goodwill unusually high in the year when pre-amortization profits are high relative to prior years. However, we fail to find that the unusually high amortization is related to pre-amortization leverage ratios. When a firm amortizes negative goodwill unusually high, this may indicate that the firm has bad pre-amortization profits or bad debt ratios. We find that firms amortize negative goodwill unusually high in the year when pre-amortization profits are low compared to prior years. The results of our study indicate that the financial reporting standards for business combinations influence accounting choices when firms amortize goodwill and negative goodwill. Our study is the first attempt to empirically investigate the impact of goodwill and negative goodwill on the accounting choices. We expect that our empirical results can have implications for future research to investigate other characteristics of firms with goodwill and negative goodwill.