Earnings management around a change of goodwill rule

The adoption of AASB 3 Business Combinations when Australia transitioned to International Financial Reporting Standards from 1 January 2005, changed the accounting for goodwill. The new goodwill rule, requiring impairment testing of goodwill rather than its systematic amortisation, may affect earnings henceforth. Our investigations show that on average, goodwill firms’ net revenue growth in the adoption year is significantly lower than the pre-adoption year. However, on average, return on assets (ROA) in the adoption year is higher than the pre-adoption year. Our findings show that managers of most goodwill firms manage earnings upwardly, in particular, using discretionary long-term accruals, and/or by not recording goodwill impairment loss, particularly at the mandatory adoption time. Of the goodwill firms, 82.5% did not record impairment loss on adoption. We find also that the magnitude of income decreasing discretionary long-term accruals of impairment goodwill firms is larger than for non-impairment goodwill firms. One plausible explanation is that some impairment goodwill firms use the new goodwill rule to take ‘big bath’ charges by managing earnings downwardly. These findings are important since extant studies assume that managers are unlikely to use discretionary long-term accruals to manage earnings (Guenther, 1994; Teoh et al., 1998, 1998a and 1998b).