Search

Under International Financial Reporting Standards, managers can use two approaches to increase the estimated fair value of goodwill in order to justify not recognizing impairment: (1) make overly optimistic valuation assumptions, and (2) increase future cash flow forecasts by inflating current cash flows. Because enforcement constrains the use of optimistic valuation assumptions, we hypothesize that enforcement influences the relative use of these two choices. We test this hypothesis by comparing a sample of 1,958 firms from 36 countries that are likely to delay recognizing goodwill impairment (suspect firms) to a sample of control firms. First, we find that firms in high‐enforcement countries use a higher discount rate to test goodwill for impairment than firms in low‐enforcement countries. We also find a more positive association between discount rate and upward cash flow management for suspect firms than for control firms. This result is consistent with suspect firms substituting optimistic valuation assumptions with inflated current cash flows. Second, we find that, relative to control firms, suspect firms exhibit higher upward cash flow management in high‐enforcement countries than in low‐enforcement countries. Third, we show that suspect firms in high‐enforcement countries are more likely to eventually impair goodwill.

We develop a model in which collateral serves to protect creditors from the claims of competing creditors. We find that borrowers rely most on collateral when cash flow pledgeability is high, because this is when it is easy to take on new debt, diluting existing creditors. Creditors thus require collateral for protection against being diluted. This causes a collateral rat race that results in all borrowing being collateralized. But collateralized borrowing has a cost: it encumbers assets, constraining future borrowing and investment, i.e. there is a collateral overhang. Our results suggest that the absolute priority rule, by which secured creditors are senior to unsecured creditors, may have an adverse effect — it may trigger the collateral rat race.

While it is generally maintained that earnings management can occur to inform as well as to mislead, evidence that earnings management informs has been scarce, and evidence that credibility increases with signal costliness inexistent. We provide evidence that firms use discretion over financial reporting and real activities to report higher earnings on lower sales from continuing operations. Although these firms defy gravity artificially, we show that the upwards earnings management informs rather than misleads investors. We find that firms that defy gravity (1) report higher future earnings and cash flows, (2) earn higher one-year-ahead abnormal returns, (3) have a positive market reaction to the defying gravity earnings announcement, and (4) their CEOs are more likely to be net buyers in the year preceding the defying gravity event. We also show that the upwards earnings management signal is more credible when it is more costly to achieve: Defying gravity firms perform better when they bear the opportunity loss of not taking a big bath in times of crisis — years where poorer performance can be blamed on economy-wide shocks, and when they have fewer degrees of freedom to report higher earnings.