Does CEO tenure lead to risky behavior? Dr. Gloria S. Cas..

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Does CEO tenure lead to risky behavior? Dr. Gloria S. Castro

Dr. Globia Castro 

Goodwill impairment according to recent researches can be considered risky management.  Recent research on the issuance of SFAS No. 142 Goodwill and Other Intangible Assets suggests that CEO behavior may be encouraged to use goodwill impairment as a new tool for earnings management (Masters-Stout, Costigan, & Lovata, 2008).  The following paragraphs discuss the relationship of CEOs tenure and earnings management after the issuance of SFAS No. 142 in June 2001.

Background

SFAS No. 142, was issued in June 2001and became effective on December 2001 states that goodwill impairment is tested for impairment on an annual basis rather than treated as a pro-rata expense.  Prior standard prescribes a write-down of goodwill if it was no longer considered a wasting asset.  Thus, contrary to previous standard, SFAS No. 142 notes goodwill impairment could occur at an unprecedented amount and rate (Davis, 2005).  As a result, CEOs could manipulate goodwill impairment as a tool to manage earnings performance.

As mentioned, the test consists of evaluating the fair value of goodwill and making adjustments as appropriate on an annual basis or periodic annual tests, if warranted, at the reporting level.  The fair value of goodwill, according to FASB (2001) is done at a reporting level.  Two steps on impairment tests were promulgated by FASB (2001) for specific testing procedures.  First, the fair value of a reporting unit is compared to its book value that is, if the book value is more than the fair value, impairment may be present.Step two involves determining the appropriate impairment to goodwill, as required, based on management judgment.

However, little guidance was presented by FASB in measuring a reporting unit’s fair value; hence, it is asserted that quoted market prices are the best source of fair value.  Further, in the absence of market value, present value techniques, cash flow estimates, and multiples of earnings may be used (Masters-Stout st al., 2008).  Subsequently, when step one shows a decrease in goodwill, a need for a more comprehensive testing is warranted.  The result may determine if a decrease in the reporting unit’s overall fair value was the result of goodwill impairment or a decrease in other assets.  Since goodwill and some intangible assets will no longer be amortized, the reported amounts of goodwill and intangible assets will not decrease in the same manner resulting in irregular reporting and increased volatility in reported income.

Discussion(s)

The flexibility allowed by FASB on the estimation of goodwill impairment opens a window of risky management.  Goodwill impairment could be used by the CEOs to smooth earnings. According to Masters-Stout et al., (2008) CEOs should exercise prudent judgment  and implement robust procedures for taking impairments in accordance with appropriate changes in business objectives and asset performance.  However, a transition from a predecessor CEO to a successor CEO involves a period of potentially heightened risk which could lead to more aggressive treatments in goodwill and intangible assets.  Radical change in standard procedures should be vetted by the Board’s Audit Committee to ensure appropriate marks are validated.   Notwithstanding the ulterior motives of CEOs to commit fraud (i.e., opportunity, personal ambitions, and realization), internal auditors should be aware of in the potential for fraud risk and perform assessments during the early stage of each audit process.    Recent research noted that the study of goodwill impairment should include explanatory variable of potential significance by the audit firm (Carlin & Finch, 2007).  Hence, future empirical research is needed to examine in detail the relationship of CEOs in committing fraud through impairment.

Conclusion

              Recent studies noted that tenure and earnings management should be the focus of compliance auditors and internal auditors when red flags are noted during the early stage of audit.  The issuance of SFAS No. 142  on the reporting level of impairment on an annual basis could be a loophole for CEOs to manipulate net profit to their personal advantage. As such, impairments could pose great danger to the public.   Firms should establish procedures for evaluating impairments with input from finance, compliance and audit to reduce risks.  Board involvement in changes to material accounting practice helps to provide checks on CEO behavior that could lead to earnings management.  The mechanics of SFAS No. 142 on goodwill impairment testing has yet to be updated to IFRS framework to be well understood globally. Hence, empirical studies to test the theories of prior researchers will contribute to updated standards for international guidance.

           Prior theories such as Gynther (1969) residing theory, which is viewed as the balance of the legitimate vales of the various identifiable assets of the business taken individually. Another theory of Miller (1973), the aggregation theory suggests that goodwill be immediate written off against earnings, since according to this view, goodwill results, literally, from faulty measurement (Carlin & Finch, 2001). These competing theories could be the bench mark of empirical research as to amend standards that can lead to manipulation of financial reporting. This article could open up scholarly research in focusing to risky management during the early assessments of audit.

 

References:

Carlin, T.M., & Finch, N. (2001). Towardsa theory of goodwill impairment testing choices under IFRS. Journal of Theoretical Accounting Research.  Vol 3, pp. 74-95.

Davis, M. (2005) Goodwill impairment improvement or boondoggle?  Journal of American Academy of Business.  6(2) pp. 230-237.

Financial Accounting Standards Board (FASB).  (2001).  Goodwill and other Intangible Assets, Statement of Financial Accounting No. 192.(Stanford, CT; FASB).

Maters-Stout, B., Costigan, M.L., & Lovata, L.M. (2008).  Goodwill impairments and chief executive officer tenure.  Critical Perspective on Accounting.  19. Pp. 1370-1383.

Dr. Gloria S. Castro is a Behavioral Risk Consultant out of Las Vegas, Nevada.

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