Article The Accounting Treatment of Goodwill, Idiosyncratic Risk, and Market Pricing Marinilka B. Kimbro' and Danielle Xu2 Journal of Accounting, Auditing & Finance 2016, Vol. 31(3) 365-387 @The Author(s) 2016 Reprints and permissions: sagepub.com/journalsPermissions.nav DOI: 10.1177/0148558X16632414 jaf.sagepub.com SSAGE Abstract We study the relationship between goodwill and future returns by considering how the information content of goodwill before and after Statement of Financial Accounting Standards (SFAS) 142 affects idiosyncratic return volatility (IVOL). Contrary to expectations, previous research has documented that stocks with high IVOL have low future returns (IVOL anomaly). We build on research that shows that high IVOL is a function of low infor- mation on future earnings and define goodwill as a growth option that could be priced through IVOL. Our results show that, during the goodwill amortization period, IVOL is high and the IVOL anomaly is strong. In contrast, nonamortized and tested for impairment good- will is informative and corrects the IVOL anomaly. We find evidence that SFAS 142's recog- nition of goodwill as an asset with indefinite useful life results in value-relevant information about firm growth options and future earnings, thus reducing IVOL, eliminating the IVOL anomaly, and creating an environment of more efficient market pricing of risk. Keywords goodwill, idiosyncratic risk, impairment testing, SFAS 142, stock volatility, fair value, IVOL anomaly Introduction During the last two decades, accounting standards under U.S. generally accepted account- ing principles (GAAP) and International Financial Reporting Standards (IFRS) have pro- foundly changed accounting for business combinations and, in particular, how goodwill is recognized and measured. Prior to 1996, goodwill was subject to periodic straight-line amortization with a maximum useful life of 40 years. From 1996 until 2001, goodwill was still amortized but was subject to an arguably "ill-defined"1 recoverability-based impair- ment test (Statement of Financial Accounting Standards [SFAS] 121: Accounting for the Impairment of Long-Lived Assets). In 2002, SFAS 142 eliminated the amortization require- ment and imposed a more stringent two-step quantitative periodic fair-value-based 'Seattle University, WA, USA 2Gonzaga University, Spokane, WA, USA Corresponding Author: Marinilka B. Kimbro, Albers School of Business and Economics, Seattle University, P.O. Box 222000, Seattle, WA, 98122-1090, USA. Email: kimbrom@seattleu.edu
366 Journal of Accounting, Auditing & Finance impairment test. Thus, from 2003 until 2013, goodwill amortization was not allowed, and yearly impairment testing was required. The debate about the accounting treatment of goodwill is centered on whether it should be amortized, amortized and impaired, or impaired only. At the core of the argument are the questions: Is goodwill an asset with indefinite life that captures future economic bene- fits of a business combination that cannot be measured by other assets? If it does, then amortization might not be appropriate, and it should be tested for impairment yearly. In the alternative, Does goodwill have a useful life that should be amortized? Does goodwill have a useful life that should be amortized and impaired? In this article, we attempt to shed light on the relevance and informativeness of good- will, before and after SFAS 142, by examining the