Goodwill Impairment and Earnings Management in the year of the pandemic

Abstract: Purpose: The purpose of the research is to analyze managers’ use of accounting discretion in goodwill impairment losses of European firms in 2020 – a year of financial distress caused by the COVID-19 pandemic – and whether the discretion employed reflects earnings management. Methodology: The difference in earnings between impairers and non-impairers is analyzed by employing a Mann-Whitney U-test and an independent T-test. Consequently, a multivariate tobit regression is used to investigate the association between big bath earnings management and goodwill impairment in times of financial crisis (2020) compared to previous years. Finally, an OLS regression is applied to analyze discretionary impairment in 2020. The quantitative findings are complemented by flexible semi-structured interviews. Theoretical perspectives: Previous literature on goodwill impairment regarding value relevance and managerial discretion, linked to signaling theory and agency theory respectively, are used to assist in explaining the effectiveness of impairment tests and why managers may engage in earnings management and discretionarily recognize goodwill impairments. Empirical foundation: The empirical data consists of primary data from interviews with 7 European managers and secondary data from financial databases such as Bloomberg. 8,974 firm-year observations of European companies between 2010 and 2020 were analyzed. Conclusion: Our findings suggest that the majority of companies that chose to impair in 2020 did not do so to take a big bath. However, negative pre-impairment earnings levels as opportunity to take a big bath seem to be a significant determinant of goodwill impairment, with stronger association in times of crisis. When analyzing discretionary goodwill impairment, we find that negative pre-impairment earning levels even tended to motivate an understatement of goodwill impairment compared to the economically induced value loss.