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Swedish firms' untimely financial reporting - A study of goodwill impairment as a tool used to mislead financial users.

Master's Thesis 30 credits

Department of Business Studies

Uppsala University

Spring Semester of 2019

Date of Submission: 2019-05-29

Viktor Axelsson

Ludvig Eriksson

Supervisor: Leon Caesarius

Abstract

Title Swedish firms' untimely financial reporting

- A study of goodwill impairment as a tool used to

mislead financial users.

Date of submission 2019-05-29

Authors Viktor Axelsson, Ludvig Eriksson

Supervisor Leon Caesarius

Course 2FE840, Master Thesis, Advanced course, 30 ECTS

Five key words Earnings management, Real acitivites management,

Cash flow manipulation, Untimely reporting,

Goodwill impairment.

Purpose The purpose of the study is to investigate how

postponement of goodwill impairment is conducted

and if managers thereby contribute to a distortion of

the underlying qualitative characteristics in financial

reporting.

Methodology Proxies for earnings management activities, through

cash flow manipulation, are computed cross-

sectionally by sector-year with at least ten

observations. Suspect firms are then matched with

control firms within the same sector and operating

year to control for these effects.

Theoretical perspective The transition to the IFRS framework has contributed

to changes in the handling of goodwill. The yearly

impairment test has contributed with subjectivity in

the measurements resulting in fewer but larger

impairments.

Empirical foundation The study consists of quantitative secondary data

collected from Thomson Reuters Eikon. The data

consists of 1090 observations covering seven years of

Swedish listed firms with goodwill in their balance

sheet.

Conclusion The study concludes that suspect firms experience

abnormal current free cash flows compared to control

firms, which indicate managers manipulating cash

flows in order to postpone goodwill impairment. Also,

growth opportunities and analysts' coverage have a

significant impact on earnings management activities.

Acknowledgment

We would like to acknowledge everyone who contributed to our academic accomplishments.

First of all, we would like to thank our supervisor Leon Caesarius and fellow students who have

provided insightful comments and guidance. Secondly, we would like to thank David Randahl

from the Department of Statistics for the time and help with statistical guidance throughout this

writing process.

Table of content

1. Introduction .......................................................................................................................... 1

1.1 Background ..................................................................................................................... 1

1.2 Problem statement .......................................................................................................... 2

1.3 Purpose ............................................................................................................................ 4

1.4 Research question ........................................................................................................... 4

1.5 Delimitation ..................................................................................................................... 4

2. The theoretical framework of IFRS.................................................................................... 5

2.1 The objective of financial reporting.............................................................................. 5

2.2 Business combination framework ................................................................................. 5

2.3 Impairment of goodwill.................................................................................................. 6

3. Literature review .................................................................................................................. 7

3.1 Earnings management ................................................................................................... 7

3.1.1 Goodwill impairment ................................................................................................ 8

3.2 Abnormal cash flows ...................................................................................................... 9

3.3 Incentives to manipulate earnings .............................................................................. 12

3.3.1 Analysts and earnings thresholds ............................................................................ 13

3.3.2 Growth opportunities ............................................................................................... 14

3.4 Asymmetric information .............................................................................................. 14

3.5 Summary and hypotheses development ..................................................................... 16

3.6 Criticism to precedent literature................................................................................. 18

4. Method ................................................................................................................................. 19

4.1 Research Design ............................................................................................................ 19

4.2 Sample method ............................................................................................................. 19

4.3 Test of earnings management ...................................................................................... 21

4.3.1 Real activities management (RAM) ........................................................................ 21

4.3.2 Operating cash flow management (OCFM) ............................................................ 22

4.3.3 Free cash flow management (FCFM) ...................................................................... 23

4.4 Factors affecting earnings management..................................................................... 23

4.5 Method discussion ........................................................................................................ 24

4.5.1 Reliability & replicability ........................................................................................ 24

4.5.2 Validity and ethical considerations ......................................................................... 25

4.5.3 Criticism of research design and method ................................................................ 25

5. Sample and result ............................................................................................................... 27

5.1 Sample selection and descriptive statistics ................................................................. 27

5.2 Test results .................................................................................................................... 28

5.2.1 Economic impairment ............................................................................................. 29

5.2.2 Summary hypotheses result ..................................................................................... 31

6. Discussion ............................................................................................................................ 32

6.1 Dispersion of the sample .............................................................................................. 32

6.2 Earnings management through cash flow manipulation .......................................... 33

6.2.1 Analysts coverage and growth opportunities .......................................................... 34

6.2.2 Timeliness of goodwill impairment ........................................................................ 35

7. Conclusion ........................................................................................................................... 38

7.1 Contribution.................................................................................................................. 38

7.2 Limitations and future research ................................................................................. 39

8. References ........................................................................................................................... 40

9. Appendix ............................................................................................................................. 48

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1. Introduction

In the following chapter, a background of the study's subject is presented and problematized,

which leads to the formulation of a question and a purpose. The chapter ends with a

delimitation.

1.1 Background

During takeovers, firms are paying premiums to acquire other businesses. Takeover premiums

can be defined as the difference between the purchase price and the fair value of the acquired

firm's identifiable net assets (Gore & Zimmerman, 2010). Previous studies have shown the

average paid premium in takeovers between 1990 and 2002 is 45% (Betton, Eckbo & Thorburn,

2008) and the past deals made in the U.S. have shown acquiring firms tend to pay an average

43% takeover premium (Woo, Cho, Park & Byun, 2018). The reason why takeover premium

exists is due to the belief the entire business is greater than the individual sum of all the assets

(Gore & Zimmerman, 2010) and absence of a premium would result in shareholders refusing

to sell (Eccles, Lanes & Wilson, 1999). This belief originates from synergy effects and the

premium can, therefore, be explained by the future additional value generated from the

combination of business units, a value that would not be available if the businesses were

operating independently (ibid). This premium is then categorized as goodwill (Gore &

Zimmerman, 2010; Marton, Sandell & Stockenstrand, 2016) and is visualized as an intangible

asset on the acquiring firm's balance sheet.

The accounting of goodwill has been a frequently discussed subject over the past century by

standard setters and producers of financial reports all over the world (Chalmers, Godfrey &

Webster, 2011; Garcia, Katsuo & van Mourik, 2018). The debate has regarded questions such

as the recognition and measurement process of goodwill in financial reports and whether it is

an asset under depletion or permanent one (Chalmers, Godfrey & Webster, 2011). Throughout

history, the answers to the questions have differed depending on which country and legislative

framework that has been used at the time (Garcia, Katsuo & van Mourik, 2018). The definition

of goodwill has differed the last century but the general perception of what is considered as

goodwill in modern times is that goodwill is inseparable from the entity and cannot exist by

itself (Ma & Hopkins, 1988). This definition corresponds to International Financial Reporting

Standards (IFRS) where it is stated goodwill are future economic benefits pertaining to assets

which are incapable of being individually identified and recognized separately (IFRS 3, 2009).

The differences in definition and practice between countries inspired a movement toward

harmonization of standards in the 1970s which has inspired new rules and regulations along the

way (Garcia, Katsuo & van Mourik, 2018). The practice for goodwill throughout this period

was to use a conservative approach and amortize the goodwill which impacted the company's

profit. However, the year 2005 contributed with conversions and changes for both companies

and investors regarding the value handling of goodwill due to the transition to the legislative

framework IFRS (Hellman, Andersson, Fröberg & Cahan, 2016; Johansson, Hjelström &

Hellman, 2016). In the application of IFRS the amortization of goodwill is not sanctioned and

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a yearly impairment test should be conducted to determine the fair value of an asset (Hamberg,

Paananen & Novak, 2011; IAS 36.96; Marton Sandell & Stockenstrand, 2016). The reason

behind this change was the argument from International Accounting Standards Board (IASB)

where impairment of goodwill better reflects the underlying economic value compared to the

previous practice of amortization (Chalmers, Godfrey & Webster, 2011).

Previous research has identified the valuation process of impairment as problematic due to its

subjective nature and that miscalculations might result in a future need for impairment which

can have a negative impact on shareholders (Hirschey & Richardson, 2003; Li, Shroff,

Venkataraman & Zhang, 2011). The existence of real-world examples of goodwill impairments

is not absent, and some recent examples constitute of Ericsson, Nordea, and Kraft Heinz. In

2018 the telecom manufacturer Ericsson was forced to make a goodwill impairment of 12.7

billion SEK which had a negative impact on the operating profit for the quarter (Privataaffärer,

2019). Another example is the bank Nordea, due to a change of investment strategy, who

performed a goodwill impairment in the Russian market of 1.4 billion SEK (Nordea, 2019).

The impairment for Kraft Heinz amounted to 15.4 billion dollars which is one of the largest

impairments in history (Gara, 2019). This impairment was triggered by short term financial

developments which surprised the market and caused a rapid decline in the company's stock

price, thus destroying value for both investors and the company. The impaired goodwill in

Ericsson pertained to investments made in 2008 and the timing of the impairment raises

questions about credibility and if the impairment had been delayed. Thus, the transition to IFRS

has provided greater flexibility and subjectivity in the accounting choices (Capkun, Collins &

Jeanjean, 2016) which can impact the market's credibility and the value of the company.

1.2 Problem statement

The increased use of accounting estimates in financial reporting have faced major criticism and

concerns due to misstatements of earnings and equity, inappropriate fair value measurements

originating from management bias (Beatty & Weber, 2006) and its unethical approach

(Smieliauskas, Bewley, Gronewold & Menzefricke, 2018). In addition, impairment losses from

goodwill are perceived to lack verifiability and contain significant measurement uncertainty

and the possibility of being opportunistically reported (Francis, Hanna & Vincent, 1996;

Ramanna & Watts, 2012; Riedl, 2004). This will, therefore, conflict the objectives of the

financial reporting which state financial information should be useful for decision making

(IFRS, 2018a) and thereby represent what it intends to disclose (Nobes & Stadler, 2015). Under

the framework of IFRS, impairment tests allow managers to imply a wide level of discretion

(Filip, Jeanjean & Paugam, 2015; Lhaopadchan, 2010). Estimates of the fair value of goodwill

reflect management's assumption regarding the firm's future actions, strategy (Filip, Jeanjean

& Paugam, 2015), productivity and profitability (Roychowdhury & Martin, 2013). Subjective

views and assumption of future performance might reduce transparency and reliability of

reported financial information which might cause an information gap between shareholders and

management (Caruso, Ferrari & Pisano, 2016), defined as information asymmetry. Standard

setters, on the other hand, expect managers to mediate private information, which is the basis

of the estimates of future cash flows, to the market (Filip, Jeanjean & Paugam, 2015) and

therefore mitigate the asymmetric information distribution. Also, the difficulties arising from

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impairment processes forces standard setters to regulate an increment of impairment disclosure

as a method of reducing information asymmetry and thereby increase the level of transparency

and reliability (Caruso, Ferrari & Pisano, 2016).

Despite these regulations of increased disclosure, there are some problems arising from

discretionary methods and assumptions in impairment tests of goodwill. Impairments are

considered faithfully reported when impairment losses reflect economic impairment (Ramanna

& Watts, 2012; Riedl, 2004). When they are not, goodwill impairment can be seen as a tool

used in earnings management (Caruso, Ferrari & Pisano, 2016; Ramanna & Watts, 2012).

Francis, Hanna and Vincent (1996) argue managers perform impairments out of two reasons.

The first reason is that managers want to reflect changes in future economic conditions,

strategies, competitive situations or previous and current poor firm performance. The

alternative reason is that managers take advantage of the discretion and only recognize

impairments when it is advantageous to do so, without investors being able to undo these

manipulations which impact them unfavorably.

A growing body of empirical evidence shows that managers do not recognize economic

impairments of goodwill in accounting books in a timely manner and tend to manipulate

impairment tests (Filip, Jeanjean & Paugam, 2015; Paugam & Ramond, 2015; Ramanna &

Watts, 2012). Consequently, when assets with indications of impairment are not impaired

delayed goodwill impairments contain lack of timeliness (André, Filip & Paugam, 2016) with

the result in overvalued firms due to overstated booked values (Li & Sloan, 2017). Ramanna &

Watts (2012) find evidence of managers manipulating earnings by selectively delaying

goodwill impairment in circumstances where they have agency-based motives to do so. This is

in line with the prediction of the agency theory which predicts the average manager tends to

take advantage of the unsecured elements of goodwill accounting rules to alter the financial

reports opportunistically (Filip, Jeanjean & Paugam, 2015). In applying previous study results

with the definition of earnings management that managers using judgment in financial reporting

to mislead some stakeholders about the company's underlying economic performance (Healy

& Wahlen, 1999), one could argue goodwill impairment tests could be a useful tool for

managers to manipulate financial reporting.

Previous studies of firms which have market indications of goodwill impairment show a 69%

frequency of non-impairment of goodwill (Ramanna & Watts, 2012) and that only 53% actually

impairs when they have an indication (Verriest & Gaeremynck, 2009). The evidence presented

in Ramanna and Watts (2012) is consistent with predictions from the agency theory regarding

a positive association between non-impairment and CEO compensation, debt covenant

violation, and CEO reputation concerns. On the contrary, the study finds no explanation of the

predictions that non-impairment is related to the flexibility of managers and the possession of

private information about the firm. Previous research by Filip, Jeanjean and Paugam (2015)

focused on the managerial postponement of goodwill impairment recognition through

manipulation of the cash flows and the future consequence on performance due to this strategy.

The conclusion from their study is that real activities manipulation is detrimental to future

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performance and firms which were suspected of postponing their goodwill impairment losses

were exhibiting an increased discretionary cash flow compared to other control groups.

The empirical evidence indicates managers in firms, with market indications of goodwill

impairment, engage in manipulation of cash flows to avoid impairment losses. The reason for

goodwill manipulation can be grounded in managements unwillingness to admit that the firm

overpaid for previous acquisitions and to uphold a facade of adequate stewardship of company

assets (Li & Sloan, 2017; Roychowdhury & Martin, 2013). Such manipulations would,

therefore, be unethical and in conflict with IFRS fundamental qualitative characteristics of

useful financial information. For financial information to be useful, it must possess relevance

and be faithfully represented (IFRS, 2018). With other words, it must be relevant and represent

the substance of an economic phenomenon instead of exclusively representing its legal form

(ibid.). In addition to prior research, a study by Duff and Phelps (2018) showed goodwill

impairments for US firms increased with 23% and reached a total value of 35.1 billion dollars

in 2017, despite a strengthening global economy. The study also showed a marginally

increasing number of impairment, which indicates the magnitude of goodwill impairment has

become larger and therefore more important for investors to understand.

Previous studies have shown that earnings management is used by managers for their own

utility maximization and to disclose higher financial earnings for the firm. The present study

assumes this phenomenon occurs in different geographic and demographic contexts and the

investigation of the phenomenon can contribute with further knowledge to academic literature,

standard setters and users of financial information. Consequently, the present study investigates

goodwill to determine if, and thus how, managers engage in earnings management through

manipulating current cash flows in order to delay goodwill impairment.

1.3 Purpose

The purpose of the study is to investigate how postponement of goodwill impairment is

conducted and if managers thereby contribute to a distortion of the underlying qualitative

characteristics in financial reporting.

1.4 Research question

How do managers separate accounting and economic impairment of goodwill and thereby

disrupt timeliness of financial reporting?

1.5 Delimitation

An investigation by Gauffin and Nilsson (2018) on listed firms on the Stockholm Stock

Exchange shows approximately 56% of the purchase price is allocated to goodwill during

acquisitions in 2016. In addition, the result showed only 0.9% of total goodwill was impaired

during the same period. Due to these results of low impairment and a large amount of distributed

goodwill to acquiring firms' balance sheet this study will focus on how managers can disrupt

timeliness of financial reporting by separate accounting and economic impairment of goodwill

by delimiting the investigation of the phenomenon within a Swedish context.

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2. The theoretical framework of IFRS

Chapter two narrates parts of the IFRS framework since it constitutes of a fundamental basis

for complying with the purpose of the study.

2.1 The objective of financial reporting

IFRS is an international accounting standard which is mandatory to use in the consolidated

financial statements for listed companies on regulated markets (IFRS, 2018). The theoretical

framework of IFRS presents foundational concepts for financial reporting and is applied by the

International Accounting Standards Board (IASB) when developing new standards (ibid.) IFRS

has a principle-based view which gives companies the ability to tailor the financial reporting to

fit their specific organization (ibid.). The intention of IFRS is to achieve transparency,

accountability and efficiency to financial markets all over the world (ibid.). The framework of

IFRS currently contains 17 principles and the additional framework IAS (International

Accounting Standards) contains 28 principles (ibid.). To support the purpose of the study the

objective of financial reporting and IFRS principles are presented.

The objective of financial reporting is to provide financial information that is useful to users in

making decisions relating to providing resources to the entity” (IFRS, 2018a). The users of

financial information are firms', both existing and potential, investors, lenders and other

creditors (ibid.). The decisions, made by the users based on this information, regard for example

buying, selling or holding equity or debt instruments and influence management actions (ibid.).

In order to make these decisions, the users of financial information evaluate the firm's prospects

for future net inflows and management's stewardship of the firm's financial resources (ibid.).

Also, a majority of information is obtained by the users from financial reports. Therefore, to

make these assessments users need useful financial information to make their decisions as good

as possible.

For financial information to be perceived as useful, it requires to be relevant and faithfully

represent what it intends to disclose (Nobes & Stadler, 2015). Faithful representation and

relevance are deemed as elementary qualitative characteristics for financial information to be

useful (IFRS, 2018a). When financial information is verifiable, timely, understandable and

comparable the usefulness can be enhanced (ibid.). For information to be considered as relevant,

it needs to be capable of making a difference in decision-making and possess confirmatory or

predictive value (Beaver, 1968; Nobes & Stadler, 2015). For information to be considered

faithfully it should be, to the highest possible extent, neutral, free from error and complete

(Nobes & Stadler 2015).

2.2 Business combination framework

The IFRS 3 principle regards business combination framework, and presents an outline of the

accounting treatments to consider when an acquirer obtains control over another business (IFRS

3, 2009). The standard is intended to enhance the reliability, relevance and comparability of

information disclosed pertaining to acquisitions and the effect on financial disclosures. In an

acquiring situation, the business unit should use the acquisition method to identify the acquirer,

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acquisition date, recognition and fair value measurement of the transferred assets and liabilities

and the recognition of goodwill or gains pertaining to the acquisition (ibid.). Goodwill is

considered as an intangible asset and constitutes of the difference between the transferred

amount and the acquired company's net assets (Hamberg, Paananen & Novak 2011; Marton,

Sandell & Stockenstrand, 2016). Goodwill is recorded on the balance sheet and gains pertaining

to the acquisition is recorded in the profit and loss statement (Gore & Zimmerman, 2010, IFRS

3, 2009).

2.3 Impairment of goodwill

According to the IAS 36.96 principle an entity is required, annually, to test whether goodwill

indicates a loss in value which therefore needs to be impaired (IFRS, 2018). To perform an

impairment test the goodwill is allocated to all the acquirer's cash generating units which are

deemed to benefit from the synergies of the combination (IAS 36.80). A cash-generating unit

is an identifiable asset or group of assets generating cash inflows which are separable from cash

inflows from other assets. When a cash-generating unit has been allocated with goodwill the

impairment test is performed by a comparison of the carrying amount and the recoverable

amount of the unit (IAS 36.90). The carrying amount is the value in which an asset is recognized

in the balance sheet after accumulated depreciation and accumulated impairment losses (ibid.).

The recoverable amount is the highest of an asset's fair value less cost to sell and it's value in

use (ibid.) If the carrying amount is higher than the recoverable amount the value of the unit is

overstated unless the unit is impaired to equal the recoverable amount (ibid.). The value of the

asset is decreased on the balance sheet and the loss pertaining to the decrease in value is

accounted for as a loss in the profit and loss statement (ibid.). When an impairment is

recognized the entity must disclose detailed information to the financial users with estimates

and assumptions used to measure recoverable amounts of cash generating units (IAS 36.134-

135).

Impairment tests are usually based on the discounted cash flow model when estimating the

present value of future cash flows, normally forward-looking three to five years, generated from

a cash-generating unit (Filip, Jeanjean & Paugam, 2015; Nie, 2018). It is mostly used due to its

direct link with Modigliani and Miller's finance theories (Lander & Reinstein, 2003). This

model is an absolute valuation method which obtains the current value of an assets future free

cash flow based on an appropriate discount rate (Nie, 2018). The model is affected by several

parameters, such as the weighted average cost of capital, discount rate, growth assumption,

profitability margins and terminal growth rate (Filip, Jeanjean & Paugam, 2015). The use of a

discounted cash flow (DCF) model requires to first estimate the free cash flow (FCF), which is

the remaining and distributable cash flow after the firms operating and financing needs have

been covered (Lander & Reinstein, 2003). The DCF model estimates the sum of the firm's

equity and debt, the market value of the firm's debt netted for excess cash then determines the

value of the entity (ibid.).

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3. Literature review

Chapter three narrates the relevant theories and literature given the research question and

purpose of the study. The literature review was conducted with a narrative approach. To build

the studies theoretical foundation literature were identified within the field of earnings

management, goodwill impairment and information asymmetry. The chapter concludes with a

formulation of hypotheses and critique against the presented literature.

3.1 Earnings management

Even though the earnings management theory has been researched since the 1960s (Beaver,

1968), and is a widely researched and relevant topic within accounting studies (Caruso, Ferrari

& Pisano, 2016) the theory lacks a clear definition (Ronen & Yaari, 2008). The consensus of

the literature is however that earnings management is manipulation of an entity's economic

performance made by insiders to mislead external stakeholders, influence contractual outcomes

(Leaz, Nanda & Wysocki, 2003; Ronen & Yaari, 2008) and most importantly avoid earnings

decline and reporting losses in order to meet certain earnings thresholds (Graham, Harvey &

Rajgopal, 2005; Roychowdhury, 2006).

Earnings management can be perceived as something unethical rather than illegal. The reason

behind the allowance of managerial discretionary actions is the argument that standard setters

must allow managers to exercise judgment in financial reporting in order to make financial

reports more informative for users through an extension of managers' knowledge and

information about their entity's future performance (Healy & Wahlen, 1999). This allows

managers, through judgment, to create opportunities for earnings management and the

allowance of preferring methods which do not accurately reflect the entity's underlying

economic situation (ibid.). Managers can use the opportunities given and their expert

knowledge about the business to select methods of reporting, altering estimates and disclosures

to match the business economics of the firm, which might increase the value of accounting as

a communication tool (Healy & Wahlen, 1999).

The literature highlights different fields of earnings management constituting of earnings

smoothing, minimization, maximization, accrual management and real activities manipulation

(Ronen & Yaari, 2008; Filip, Jeanjean & Paugam, 2015). The real activities manipulation is

argued to be more attractive for managers to use compared to other forms of earnings

management, due to difficulties for auditors and gatekeepers to detect such manipulations

(Cohen & Zarowin, 2010; Cohen, Dey & Lyz, 2008; Huang & Sun, 2017). The real activities

management literature indicates companies use overproduction to reduce the cost of goods sold

(COGS), use price discounts to temporarily boost cash flows and decreases discretionary

expenditure to meet certain earnings thresholds (Graham, Harvey & Rajgopal, 2005; Huang &

Sun, 2017; Roychowdhury, 2006). The body of literature indicates real activities manipulation

can have negative effects on the future performance of a firm due to the measures taken to

increase the profit of the current period (Caruso, Ferrari & Pisano, 2016; Huang & Sun, 2017;

Roychowdhury, 2006). Further, it is argued that reductions in investments could be potentially

harmful to companies due to the lack of investments will not support the future growth of the

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company. The methods used for real activities manipulation mentioned in the literature regards

the reduction of research and development (R&D) expenses, advertising and selling, general

and administrative (SG&A) expenses (Cohen & Zarowin, 2010; Filip, Jeanjean & Paugam,

2015).

Previous research found a positive effect on companies' earnings due to the removal of

mandatory goodwill amortization in the transition to IFRS 3 (Hamberg, Paananen & Novak,

2009). The literature shows a growing acquisition rate after the adoption to IFRS 3 which

resulted in increased levels of goodwill being recorded on firms' balance sheets (Caruso, Ferrari

& Pisano, 2016; Hamberg, Paananen & Novak, 2009; Ramana & Watts, 2012). On the other

hand the literature also highlights the absence of goodwill impairments during the later period

(Hamberg, Paananen & Novak, 2009). The result in the study by Hamberg, Paananen and

Novak (2009) indicates goodwill-intensive firms were revalued upwards by the stock market

which implies that subjective methods have made financial reporting less useful to investors.

Previous studies have found evidence of managerial incentives being influential for the choice

of accounting method and for altering expenses such as debt contracts, bonuses and current

turnover in an opportunistic way (Beatty & Weber, 2006; Francis, Hanna & Vincent, 1996). In

contradiction, Capkun, Collins and Jeanjean (2003) found no link between changes in

incentives which could explain increased earnings management behavior. The study by Leuz,

Nanda and Wysocki (2003) found earnings management to be less occurring in countries which

had strong investor protection with an explanation that the risk of detection is a limiting factor

for earnings management due to high detection costs. The literature highlights detection cost as

a motivator for using real activities manipulation due to difficulties for auditors to find the

manipulation which present a low risk of scrutinization (Roychowdhury, 2006). The literature

indicates that managers use their discretion and subjectivity to postpone recognition of losses

and thus opportunistically inflate company performance (Dinh, Kang & Schultze, 2016; Filip,

Jeanjean & Paugam, 2017; Jarva, 2009; Ramanna & Watts, 2012).

3.1.1 Goodwill impairment

The literature points out the legislative transition to IFRS 3 facilitates earnings management

activities through goodwill impairment. The literature regards two perspectives of research

pertaining to goodwill impairment where the first focuses on the determinants for timeliness of

goodwill impairments and the latter focuses on the stock market consequences from non-

impairment of goodwill (Chen, Schroff & Zhang, 2014). A study by André, Filip and Paugam

(2016) found goodwill impairments to lack timeliness, defined as the consequences when

accounting impairment is separated from economic impairment. The sample from Ramanna

and Watts' (2012) study showed a frequency of 69% for goodwill non-impairment, which

means firms with lower price-to-book ratio than one do not write down goodwill during the

second year. The findings are corroborated by the findings by Roychowdhury and Martin

(2013) that firms, with price-to-book ratios below one, exhibit between 22-26% probability of

goodwill impairment. The study found evidence of managers avoiding timely goodwill

impairment when they have agency-based incentives to do so, even though the market indicates

for impairment. The literature stream indicates that subjectivity of impairment tests has caused

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financial reports to not reflect the underlying economic reality in relation to goodwill (Ramanna

& Martin, 2013; Roychowdhury & Martin, 2013). In contrast to these studies, Jarva (2009)

investigates non-impairment firms and finds no supporting evidence of opportunistically

evasion of impairments by managers in firms with market indications of impairment.

A theme within the goodwill impairment literature is the postponement of goodwill impairment,

referred to as timeliness of goodwill impairment (Chen, Schroff & Zhang, 2014; André, Filip

& Paugam, 2016). Both study results in Hayn and Hughes (2006) and Jarva (2009) indicate a

significant delay in the booking of goodwill impairments, the lag pertains to the recognition of

impairment loss when assets are economically impaired. Previous studies have found firms tend

to delay recognition of asset impairment even in the presence of economic impairment (Hayn

& Hughes, 2006; Jarva, 2009), such firms are referred to as suspect firms (Ramanna & Watts,

2012; André, Filip & Paugam, 2016). Prior studies show goodwill impairment to lag behind the

entity's operating performance and negative stock returns from two years (Li & Sloan, 2017)

up to three to four years (Hayn & Hughes, 2006), which indicates managers could selectively

delay accounting impairments.

Li and Sloan (2017) argue managers delay impairment tests due to the fear of negative stock

market reactions and managerial pride. The argument is corroborated by Roychowdhury and

Martin (2013) who argue that negative effects on firm value and managers' unwillingness to

admit to overpaying for prior acquisitions cause postponement of impairments. Therefore,

impairment of goodwill is portrayed as the least favorable action for managers and impairments

are strictly performed when it is clear that the benefits have expired from non-impaired goodwill

(Li & Sloan, 2017). The study by Chen, Shroff and Zhang (2014) gives other explanations for

non-impairment and argue that investors do not understand the intentions of goodwill

impairments and the signals of future performance. Further, it is argued that investors do not

learn the effects of goodwill impairment until the publication of the following annual report.

The postponement and untimeliness of goodwill impairment are argued to possibly be

detrimental for both investors and companies due to that investors systematically overvalue

firms with overstated goodwill values in their balance sheet (Li & Sloan, 2017). To sum up, the

literature highlights that the underlying economic value of goodwill was better reflected prior

to the legislative change and before the annual impairment tests were implemented (Hamberg,

Paananen & Novak, 2009; Li & Sloan, 2017).

3.2 Abnormal cash flows

One of the reasons for the postponement of impairments could be the unfavorable effect on firm

value because it sends signals to the market about reduced expectations of future performance.

To delay these impairments firms engage in earnings management, through real activities, such

as manipulating cash flows (Filip, Jeanjean & Paugam, 2015) because of its importance when

calculating the fair value of goodwill. Managers manipulate real activities to avoid reporting

losses (Roychowdhury, 2006) and use their discretion and subjectivity to postpone recognition

of losses and thus inflate the performance of the company (Filip, Jeanjean & Paugam, 2017;

Jarva, 2009; Ramanna & Watts, 2012). Filip, Jeanjean and Paugam (2015) extend the research

10

of firms carrying impaired goodwill and find a relation between upward cash flow manipulation

relative to firms not carrying impaired goodwill.

Similar as Filip, Jeanjean and Paugam (2015), a study by Greiner (2017) found aggressive cuts

in R&D, discretionary expenses, to be associated with changes and higher levels of cash

holdings for companies. A finding corroborated by the study of Graham, Harvey and Rajgopal

(2005) who found that 80% of executives are prepared to reduce R&D costs in order to meet

earnings thresholds. Roychowdhury (2006) argue that earnings can be increased by selling off

inventories to meet demand or reducing COGS by overproducing inventory. In line with this

argument Cohen and Zarowin (2010) highlight that overproduction gives managers the

opportunity to spread fixed overhead costs over a larger number of units, thus lowering fixed

costs per unit. The total cost per unit is argued to decline as long as any increase in marginal

costs does not offset the reduction in fixed cost per unit (Roychowdhury, 2006), a procedure

argued to decrease reported COGS in favor for increased reported earnings. Cohen and Zarowin

(2010) highlight that firms still incur alternative production and holding costs that lead to

increased production costs compared to sales, which lead to reduced cash flows from operations

given the relative sales level. However, cutting discretionary expenditures will lead to increased

cash flows, due to the fact that such expenses will increase current periods earnings (Cohen &

Zarowin, 2010). The study by Roychowdhury (2006) shows that firms can increase earnings by

reducing discretionary expenses, especially the reduction of reported expenses. Further,

Roychowdhury (2006) argue if the reduction in discretionary expenses are conducted to meet

earnings targets the firms should exhibit uncustomary low discretionary expenses.

Kothari, Wysocki and Shu (2009) argue goodwill impairment is subject to a magnitude of

manipulations due to the permitted subjectivity in the accounting standards. Further, it is argued

managers use their given discretion to withhold bad news from outsiders and that auditors

accept a certain degree of optimism in the estimations from managers if the forecasts are

consistent with the current level of cash flows. Pertaining to goodwill, a survey from KPMG

(2014) showed goodwill to be relevant for outsiders to assess the financial outcome of

managerial decisions and to be able to hold management accountable for their capital allocation

decisions.

It is highlighted by Penman (2006) the preferred method to use when preparing an impairment

test is the DCF model. The factors affecting the outcome of the test constitutes of growth

assumptions, the used discount rate, short term growth, estimated profit margins, if the model

extrapolates data and the assumption used for terminal growth. As a consequence, auditors may

challenge the initial forecast for the current years' operating cash flows used in the DCF model

due to the material impact it has at the end of the time horizon for the forecast (ibid.). Since the

DCF model is used to test for impairment indication the present study considers the model to

have a direct link to operating activities and the final impairment decision.

A theme in the literature regards the postponement of impairments which are showed to be

detrimental for investors due to a loss of critical informative signals (Chen, Shroff & Zhang,

2014; Filip, Jeanjean & Paugam, 2015; Schatt, Doukakis, Bessieux-Ollier & Walliser, 2016).

11

It is argued when companies perform an impairment it sends signals that the benefits from those

assets has expired and thus indicates a decline in revenue from those assets (Li & Sloan, 2017).

However, it is argued by Rockness, Rockness and Ivancevich (2001) the effects on financial

results from goodwill impairment is significant in years of impairment and the impairment

charges are prone to be shifted between periods to achieve desired targets. The study by Jarva

(2009) investigates a sample of non-impairing companies with indications that the assets are

impaired but fails to find evidence of opportunistic postponement of impairment. In contrast,

the study by Ramana and Watts (2012) finds evidence that non-impairment is increasing in the

presence of managerial incentives such as for example CEO compensation, CEO reputation and

debt covenants tied to financial performance.

In order to avoid a goodwill impairment despite impairment indication the current cash flows

need to support the non-impairment which is argued to be a motivator for managers to

artificially inflate the current cash flows according to the agency theory (Cohen & Zarrowin,

2010; Graham, Harvey, & Rajgopal, 2005; Jensen & Meckling, 1976; Ramanna & Watts, 2012;

Zang, 2012). As a consequence, the present study examines abnormal cash flows because

current cash flows can be increased by a faster collection of account receivables, inventory

reduction, stretching payables to suppliers and by reducing operational expenses (Cohen &

Zarovin, 2010; Zang, 2012).

Previous studies have shown managers' ability to decrease R&D expenditure increases when

firms have earnings considerations (Dechow & Sloan, 1991; Graham, Harvey & Rajgopal,

2005). The article by Canace, Jackson and Ma (2018) highlight R&D-intensive firms also

account significant amounts of capital expenditure, which is argued to present managers with

the opportunity of shifting expenses between the two categories in case of an earnings shortfall.

A theme in prior studies has regarded the usage of R&D reductions to increase earnings in the

short term, which can decrease the firm value in the long run (Canace, Jackson & Ma, 2018;

Graham, Harvey & Rajgopal, 2005). Canace, Jackson and Ma (2018) argue that unspent R&D

resources are spent on capital expenditure to offset the long-term negative effects. The

managerial incentives toward meeting the current year's earnings threshold, and the fact that

their job security and reputation depends on the long-term financial performance, affects

managers willingness to shift expenses (Fama, 1980).

The effect of shifting R&D expenses to capital expenditures is that instead of being recorded

as an expense in the income statement the capital expenditure is expensed as an asset in the

balance sheet (IFRS, 2018). Kothari, Languerre and Leone (2002) argue the shifting of R&D

expenses to be subjective due to the difficulties in determining the future benefits pertaining to

the assets, which is not helpful for outsiders' investment decisions. Further, it is argued that

capital expenditures are associated with higher future stock returns and lower variability in

earnings (ibid.). Since the shifting of R&D expenses to capital expenditure has a direct impact

on a firm's earnings, the present study assume managers are prone to alter these expenses in

line with the predicted utility maximization of the agency theory (Filip, Jeanjean & Paugam,

2015; Jensen & Meckling, 1976; Ramanna & Watts, 2012). The idea is corroborated and

extended by Filip, Jeanjean and Paugam (2015) who highlight that investments in capital

12

expenditures could be affected by the managerial willingness to avoid recording the economic

impairment. Thus, capital expenditure can be exposed to earnings management due to that

reduction in capital expenditures improves the free cash flows that are used in the valuation

models to determine impairment indications.

3.3 Incentives to manipulate earnings

The literature highlights managerial incentives to be a contributing factor of managing goodwill

impairment disclosures (Cohen & Zarowin, 2010; Filip, Jeanjean & Paugam, 2015; Ramanna

& Watts, 2012; Roychowdhury, 2006; Zang, 2012). Ramanna and Watts (2012) found evidence

which indicated if managers compensation is based on the profit and loss of the company the

incentives inspire to postpone goodwill impairment. Bergstresser and Philippon (2006) argue

managers can be encouraged to exploit their discretion in reported earnings if their incentives

are tied to the company stock price. Their study shows incentivized managers to be a

contributing factor for earnings management and years of high accruals are found to be

correlated with significant option exercises by managers. In addition to this, a theme in the

literature highlights CEO tenure as an influencing factor for opportunistically reported earnings

(Ali & Zhang, 2015; Cheng, 2004; Dechow & Sloan, 1991). The study by Ali and Zhang (2015)

finds that earnings overstatement is greater at the beginning of the service period of a CEO

compared to the later years of service, due to the willingness of CEOs to convince outsiders of

their capabilities. Further, the results are robust when controlling for other earnings

management measures, such as abnormal discretionary expenditures, namely R&D.

Within the framework, developed by standard setters, it is expected managers will, on average,

use judgment and assumptions while estimating the fair value of goodwill in order to transfer

private information associated to future cash flows (Filip, Jeanjean & Paugam, 2015). On the

other hand, the agency theory challenge this view by predicting managers, on average, will

utilize goodwill accounting rules, due to its unverifiable nature, to opportunistically tamper the

financial reports to fit their private incentives (Filip, Jeanjean & Paugam, 2015; Jensen &

Meckling, 1976; Ramanna & Watts, 2012). In addition, the real activities management behavior

has gained traction as an agency problem due to that managers modify the underlying operations

to disguise the true performance (Cohen & Zarowin, 2010; Graham, Harvey, & Rajgopal, 2005;

Zang, 2012). Because the value of goodwill is estimated with discounted projected cash flows

managers may have incentives to manipulate cash flows to delay goodwill impairments (Filip,

Jeanjean & Paugam, 2015). One of the reasons behind postponing impairments is the audit

process of impairment testing (Filip, Jeanjean & Paugam, 2015). Both auditors and financial

analysts can be seen as financial gatekeepers between users of financial information and the

reporting entity (ibid.). The gatekeepers will review the information disclosed by firms' by

evaluating the feasibility of estimated future cash flows based on current cash flows. Thereby,

managers will have incentives to manage cash flows in different ways to make their estimate

more reliable because if current cash flows are high auditors will perceive large future cash

flows as more reasonable (ibid.). Also, Roychowdhury (2006) argues managers have incentives

to manipulate real activities, e.g. R&D expenditures, which affects cash flows in order to meet

certain earnings targets.

13

3.3.1 Analysts and earnings thresholds

As earnings management can be used to govern earnings (Graham, Harvey & Rajgopal, 2005;

Roychowdhury, 2006) it could be used as a tool to beat analysts' forecasts. Analysts can be

considered as gatekeepers (Filip, Jeanjean & Paugam, 2015) and external monitors of managers

(Jensen & Meckling, 1976) because they have the task of providing the market with

information, containing public forecast with future earnings and cash flows, which also are

reflected in their recommendation and target prices (Bonini, Zanetti, Bianchini & Salvi, 2010;

Simon & Curtis, 2011). If these analyst recommendations or ratings are unfavorable Abarbanell

and Lehavy (2003) show managers have weak incentives to manipulate earnings in order to

meet earnings expectations. Consequently, favorable analyst recommendation or ratings tend

to encourage more earnings management activities to meet these expectations (Madhogarhia,

Sutton & Kohers, 2009).

Graham, Harvey and Rajgopal (2005) argue analysts influence on stock share prices is

perceived by managers as an important factor. As a result of this, their coverage can be

considered responsible for creating immoderate pressure on managers to engage in earnings

management activities (Yu, 2008), called the pressure hypothesis (Hong, Huseynov & Zhang,

2014). Those firms who miss analyst forecasts usually suffer significant declines in their stock

price (ibid.), where firms with growth opportunities are penalized more by the market when

these earnings thresholds are not fulfilled (Skinner & Sloan, 2002). Accordingly, managers are

sometimes willing to sacrifice economic value in order to meet a short run earnings target

because of the market's severe reactions (Graham, Harvey and Rajgopal, 2005). On the

contrary, analysts' incentives and governance role could be affected by the pressure from a

variety of sources (Yu, 2008). These pressures include the need to pursue investment banking

business (ibid.) and to please management and thus obtain greater access to managers' private

information (Lin & McNichols, 1998). Hence, managers seeking to increase the number of

analysts covering the firm could, therefore, choose to disclose more inside information and put

greater emphasis on management communication (Graham, Harvey & Rajgopal, 2005).

Even though Hughes and Ricks (1987) conclude analysts' earnings forecasts can be a poor proxy

for market expectations, researchers often use analysts' earnings forecasts in accounting and

finance literature (Eames & Kim, 2012). Burgstahler and Eames (2003) are unable to present

evidence suspect firms manipulate earnings in order to avoid minor losses, but the result show

analysts have the ability to predict earnings management activities. Further, Yu (2008) found

firms with lower analyst coverage exhibit higher incoherence around earnings targets in

comparison with firms with high coverage, which suggests that firms followed by more analysts

manage their earnings to a lesser extent. The finding is corroborated by Ali and Zhang (2015)

who found earnings overstatement to be less frequent in firms with stronger monitoring and

analyst coverage. Also, the existing literature has shown analysts tend to cover firms with better

information environment (Yu, 2008) which could be interpreted as analysts choose to cover

firms with fewer earnings management activities. On the other hand, analysts following firms

can have a dampening effect because they can see through such unethical activities and thereby

reduce their opportunity to manipulate earnings (Graham, Harvey and Rajgopal, 2005).

14

3.3.2 Growth opportunities

A firm's total value is composed of the sum of the total value of assets in place and growth

opportunities or expected future investments (AlNajjar & Riahi-Belkaoui, 2001).

Consequently, the lower the proportion of assets in place representing the firm's total value, the

higher are the growth opportunities for a given level of firm value (ibid.). That is also why

growth opportunities constitute a significant part of the market value of equity (Pindyck, 1988).

When firms have free cash flow surplus investors expect managers to invest these and in order

to maximize firm value (Jensen, 1986). With fewer growth opportunities, managers are more

likely to invest these cash flows in unprofitable projects (Chung, Firth & Kim, 2005). Thus,

when firms have high free cash flows in combination with low growth opportunities agency

problems can arise because they can be used in a way that not maximize shareholders' wealth.

Also, Chung, Firth and Kim (2005) show that firms with high free cash flow and low growth

opportunities tend to manipulate earnings in order to report better financial information.

Inconsistent with the agency view, Li and Kuo (2017) show that, on average, managers with

equity pay engage in earnings management activities. The result indicates growth opportunities

can mitigate the positive relationship between earnings management and equity pay at the same

time equity pay align managers' incentive more effectively for firms with greater growth

opportunities. In these firms with high growth Watts and Zimmerman (1986) argue managers

are more likely to have opportunistic behavior. In addition, Smith and Watts (1992) highlight

that the literature indicates managers' incentives increase in firms with greater growth

opportunities because such firms often have more convex executive pay contracts which will

result in more benefits when the opportunities are utilized. This means the economic benefit of

maximizing firm value by motivating managers outweighs other alternatives and firms with

growth opportunities are less likely to manipulate earnings (Li & Kuo, 2017). This argument is

in accordance with previous result (see Madhogarhia, Sutton & Kohers, 2009), which shows

managers in growth firms manipulate earnings upward and downward more aggressively in

comparison with managers in value firms.

A study by Avallone and Quagli (2015) finds that the variable growth rate manipulation has a

significant explanatory value for managers' postponement of goodwill impairment. The study

presents evidence that higher growth rates are used to manage impairment tests and thereby

avoid or postpone goodwill impairment. Furthermore, even though Roychowdhury (2006) finds

evidence that growth opportunities are positively associated with real activities manipulation,

such activities can have negative effects on future performance of a firm due to the measures

taken to increase the profit of the current period (Caruso, Ferrari & Pisano, 2016; Filip, Jeanjean

& Paugam, 2015; Huang & Sun, 2017; Roychowdhury, 2006).

3.4 Asymmetric information

The literature indicates subjectivity in financial accounting has increased after the transition to

IFRS, especially regarding the rules for impairment tests (Caruso, Ferrari & Pisano, 2016). Li

and Sloan (2017) argue increased subjectivity can decrease reliability and transparency of

financial statements and work as a catalyst for information asymmetry between outsiders and

insiders. The research applies the information asymmetry aspect to goodwill where it is argued

15

opportunistic postponement of impairments can increase the information asymmetry due to the

loss of critical signals about the future performance of the firm (Filip, Jeanjean & Paugam,

2015). Public information is information known by investors which are used to alter their

assumptions about future cash flows and earnings (Schatt, Doukakis, Bessieux-Ollier &

Walliser, 2016). Consequently, investors are considered to be in a position of information

disadvantage in relation to managers about the economic value of goodwill (Filip, Jeanjean &

Paugam, 2015).

Schatt, Doukakis, Bessieux-Ollier and Walliser (2016) argue impairment disclosures send

signals to investors that future cash flows or earnings will come in short compared to the

expectations at the initial goodwill activation. However, it is argued in the literature increased

level of disclosures may contribute with benefits in terms of a more stable stock and a decreased

bid-ask spread of the company stock (Leuz & Verrecchia, 2000). A study by Richardson (2000)

found that earnings management increases in the presence of information asymmetry, especially

significant are income increasing activities. This is in line with the study by Leuz and

Verrecchia (2000) which showed increased disclosures limits the extent of earnings

management.

The literature indicates asymmetric information is higher in R&D intensive firms (Aboody &

Lev, 2000). Aboody and Lev (1998) argue increased disclosure about R&D operations might

mitigate the possibilities for opportunistic actions since it is a part of real activities earnings

management. Schatt, Doukakis, Bessieux-Ollier and Walliser (2016) argue impairment of

goodwill is not always deemed as reliable information to change investors perception and may,

therefore, be seen as useless information. Furthermore, Vanza, Wells and Wright (2018) show

no evidence of information asymmetry being the motivator for the recognition of asset

impairments. However, the consensus of the literature highlights managerial incentives are

influential for financial disclosures, which are influential for information asymmetry (Chen &

Liu, 2013; Schatt, Doukakis, Bessieux-Ollier & Walliser, 2016). Increased level of information

in financial disclosure can, therefore, reduce the information gap between insiders and outsiders

of the company resulting in a transparent capital market (Jo & Kim, 2008).

Further, impairment of goodwill can provide useful information for investors if they are not

able to independently formulate expectations about future earnings and when reliable numbers

are provided by management (Schatt, Doukakis, Bessieux-Ollier & Walliser, 2016). Also,

unlike amortization, impairment of goodwill should provide financial statements users with

more and greater inside information if implemented correctly (Seetharaman, Sreenivasan,

Sudha & Yee, 2006). In this context, the information content from goodwill impairment can

result in a distribution shift from managers private information to public information (ibid.).

Under the assumption managers have incentives not to disclose reliable information to

investors, goodwill impairment could convey useful information to investors if a mechanism

which forces reliable information is present (ibid.). The impairment of goodwill can, therefore,

be helpful to investors, in some cases, as a tool to revise their expectations about the future

performance of a company. In other cases, impairments may be useless due to investors ability

16

to revise their expectations in line with public information or due to mistrust of accounting

numbers provided by dishonest managers (ibid.).

3.5 Summary and hypotheses development

The reasons for postponing goodwill impairments could pertain to unfavorable effects on

company value, due to reduced expectations of future performance. To delay the unfavorable

effects firms engage in earnings management, through real activities, such as cash flow

manipulation (Filip, Jeanjean & Paugam, 2015) because of its importance when calculating the

fair value of goodwill which is used in the impairment test (Roychowdhury, 2006). Managers

have been found to use their given discretion and subjectivity to avoid reporting losses, thus

inflating the performance of the company (Filip, Jeanjean & Paugam, 2015; Jarva, 2009;

Ramanna & Watts, 2012). Real activities manipulation such as R&D can be reduced to meet

earnings thresholds and overproduction can reduce the fixed costs per unit thus lowering the

COGS (Cohen & Zarowin, 2010; Roychowdhury, 2006). The hypothesis H1 builds on the idea

that firms carrying impaired goodwill in their balance sheet, manipulates cash flows from real

activities upwards compared to firms not carrying impaired goodwill in their balance sheet. The

hypothesis is stated as follows:

H1: Firms with an indication of economic impairment manage current cash flows from real

activities upwards in order to avoid goodwill impairment.

Apart from real activities, cash flows can also be managed in the operating activities of the firm.

The accounting standards permit subjectivity in goodwill calculations which present managers

with an opportunity to manipulate impairment tests (Kothari, Wysocki & Shu, 2009). The

preferred method for preparing impairment tests is to use the DCF model where estimations of

growth, discount rate and profit margins are used (Penman, 2006). Further, auditors accept a

certain degree of optimism in the estimations from managers if the forecasts are consistent with

the current level of cash flows (Kothari, Wysocki & Shu, 2009), which is argued to be a

motivator for managers to artificially inflate the current cash flows (Cohen & Zarrowin, 2010;

Graham, Harvey & Rajgopal, 2005; Jensen & Meckling, 1976; Ramanna & Watts, 2012; Zang,

2012). The hypothesis H2 builds on the idea that current cash flows are manipulated by a faster

collection of account receivables, inventory reduction and reduction of operational expenses.

The hypothesis is stated as follows:

H2: Firms with an indication of economic impairment manage current cash flows from

operating activities upwards in order to avoid goodwill impairment.

Building on hypotheses H1 and H2, managers can shift expenses between R&D and capital

expenditures (CAPEX) which has a direct impact on a firm's earnings due to the recognition of

assets rather than expenses in the income statement (IFRS, 2018). The willingness of managers

to decrease R&D expenditure increases when firms have earnings considerations (Dechow &

Sloan, 1991; Graham Harvey & Rajgopal, 2005). Investments in CAPEX can be affected by

the managerial willingness to avoid recognition of economic impairment due to that CAPEX is

used in the valuation models to determine impairment indications (Filip, Jeanjean & Paugam,

17

2015). The hypothesis H3 builds on the idea that CAPEX can be exposed to earnings

management due to that reduction in CAPEX improves the free cash flows. The hypothesis is

stated as follows:

H3: Firms with an indication of economic impairment manage current free cash flows upwards

in order to avoid goodwill impairment.

Analysts can be considered as gatekeepers and external monitors of managers (Filip, Jeanjean

& Paugam, 2015; Jensen & Meckling, 1976) because they provide the market with information

containing public forecasts with future earnings and target prices (Bonini, Zanetti, Bianchini &

Salvi, 2010; Simon & Curtis, 2011). As depicted in hypotheses H1, H2 and H3, earnings

management can be used to govern earnings and be used as a tool to beat analysts' forecasts

(Graham, Harvey & Rajgopal, 2005; Roychowdhury, 2006). Further, favorable analyst

recommendations tend to encourage earnings management through current cash flow

manipulation to meet these expectations (Madhogarhia, Sutton & Kohers, 2009) and

unfavorable recommendations give managers weak incentives to manipulate earnings

(Abarbanell & Lehavy, 2003). Firms with lower analyst coverage are found to exhibit higher

incoherence around earnings targets in comparison with firms with high coverage, which

suggests that firms followed by more analysts manage their earnings to a lesser extent. Also,

the existing literature has shown analysts tend to cover firms with better information

environment (Yu, 2008) which could be interpreted as analysts choose to cover firms with fewer

earnings management activities. The hypothesis H4 builds on the idea that analyst coverage has

an impact on earnings management. The hypothesis is stated as follows:

H4: Analyst coverage has a significant impact on earnings management through current cash

flow manipulation.

The total value of a firm is composed of both the value of total assets, future growth

opportunities and investment needs (AlNajjar & Riahi-Belkaoui, 2001). Consequently, when a

lower proportion of assets are representing the firm's total value, a higher proportion of growth

opportunities constitutes the firm value (ibid.). The managerial incentives can increase in firms

with greater growth opportunities because such firms often have more convex executive pay

contracts, thus giving the manager fewer motives to manipulate earnings (Li & Kuo, 2017).

Connecting to all the previous mentioned hypotheses cash flow manipulations are conducted to

e.g. inflate firm value. Firms' growth rates are found to be used in order to manage impairment

tests and to avoid or postpone impairment recognition. We interpret such a result as an

indication that firms with high growth don't have incentives to manipulate impairment tests

because current high growth will function as a good enough basis to support future growth. The

hypotheses H5 builds on the idea that growth opportunities have an impact on cash flow

manipulation. Thus, the hypothesis is stated as follows:

H5: Growth has a significant impact on earnings management through current cash flow

manipulation.

18

3.6 Criticism to precedent literature

Consensus exists among the presented literature about the difficulties in capturing earnings

management, especially real activities earnings management (Cohen, Dey & Lys, 2008; Huang

& Sun, 2017). The literature presents several methods for the measuring of real activities

manipulation (see Cohen, Dey & Lys, 2008; Filip, Jeanjean & Paugam, 2015; Ramanna &

Watts, 2012) where it is argued Roychowdhury's (2006) model captures both income increasing

and decreasing activities. A majority of the studies presented have been conducted in a different

geographic setting compared to the present study which can limit the possibilities to draw

conclusions regarding the alignment with other geographical jurisdictions. A critique could be

raised towards the presented literature which includes studies predating the IFRS transition.

The fact is acknowledged by the authors and used to form the theoretical knowledge of the

study.

A general criticism lifted in several studies (see Hamberg, Paananen, Novak, 2009; Hirschey &

Richardson, 2003; Li, Shroff, Venkataraman & Zhang, 2011; Li & Sloan, 2017) is the increased

subjectivity that the transition to the IFRS framework has contributed with, especially the fair

value estimations and DCF calculations. The ongoing drive for harmonization of accounting

standards is critiqued due to the possibility for managers to exercise their given discretion and

use their expert knowledge about the firm, which macerates the accounting quality (Ewert &

Wagenhofer, 2005; Healy & Wahlen, 1999). A critique lifted in the literature is that earnings

management is a product of managerial discretion and that less interference of managerial

judgment would increase the accounting quality (Callao & Jarne, 2010). Finally, the presented

literature consists of several studies highlighting different forms of earnings management and

impairment than the investigated forms in the present study. In line with the approach of pre-

IFRS studies, the literature has been used to build a foundation of earnings management through

goodwill impairment.

19

4. Method

Chapter four gives a description of how the study approached the collection of data and the

matching process of firms. The formulas used for measuring earnings management are

disclosed and a regression model is presented. Finally, the chapter gives a critical discussion

of the chosen method and the qualitative consequences of the study's methodological choices.

4.1 Research Design

The focus of this study is on how managers in firms, under IFRS, use real activities to avoid or

postpone goodwill impairments. In order to fulfill the purpose of the study, the study measures

if, and how, managers engage in earnings management through manipulation of cash flows,

which have a direct impact on the valuation process of goodwill in impairment tests and the

qualitative characteristics of financial reporting. To enable the investigation of such activities

the study identified firms carrying impaired goodwill in their balance sheet. In the identification

of such firms', the study focused on firms with market indications of goodwill impairment, an

operationalization validated by previous studies (Beatty & Weber, 2006; Chen, Shroff & Zhang,

2014; Filip, Jeanjean & Paugam, 2015; Li & Sloan, 2017; Ramanna & Watts, 2012;

Roychowdhury & Martin, 2013) where firms' price-to-book ratio exceeds one. Roychowdhury

and Martin (2013) argue managers are likely to manipulate, especially boost earnings, when

there are indications of economic impairment, e.g. price-to-book ratio below one, in order to

postpone goodwill impairments. In addition, shorter periods of price-to-book ratios below one

could be a reflection of managers possession of private information, regarding goodwill's true

economic value, and therefore market inefficiency (Filip, Jeanjean & Paugam, 2015).

The present study used the price-to-book ratio as a measurement of economic impairment and

reported firm-level data were used due to that outsiders rely on firm-level market value as an

indicator to determine if book values are overstated (Filip, Jeanjean & Paugam, 2015; Ramanna

& Watts, 2012). At the firm-level, a price-to-book ratio below one for two successive years

indicates the market perceives that goodwill is economically impaired due to that the book value

is higher than the market value (ibid.). When impairment indications are present but not reduced

to equal the market value, the value of the assets are overstated in the balance sheet. To control

for impairment indications and to gather all data, the study used the financial database Thomson

Reuters Eikon, through the excel-function. The functions used to collect the study's variables

can be seen in appendix A.

4.2 Sample method

All of the sampled firms are still or have been, listed on the Stockholm Stock Exchange during

the period 2011 to 2017. Due to the timing of the study, all of the investigated firms' annual

reports for 2018 had not yet been published, which limited the study to the latest fiscal year as

2017. To avoid noise from the financial crisis, where the median level of impairment was larger

(André, Filip & Paugam, 2016), this thesis excluded the period prior 2011 and collected data to

the last fiscal year of available and published data. To enable comparison between sectors

companies were assigned with sector identifiers through the Global Industry Classification

Standards (GICS), where firms were given a specific sector code between 10-60. Banks and

20

financial institutions were excluded in accordance with prior studies (see André, Filip &

Paugam, 2016; Filip, Jeanjean & Paugam, 2015; Ramanna & Watts, 2012; Roychowdhury,

2006; Zang, 2012) due to different business models and additional regulations by the financial

supervisory authority. The reasons for dividing the observations by sector, and not industry as

used in prior studies (see André, Filip & Paugam, 2016; Filip, Jeanjean & Paugam, 2015;

Ramanna & Watts, 2012; Roychowdhury, 2006; Zang, 2012), was because of the statistical

requirement of having at least ten observations per sector. The statistical requirement enabled

the study to apply cross-sectional calculations for each sector-year, whereas the dividing of

observations by industry code would have resulted in too few groups, thus obstructing the study

to achieve statistical results. To be able to test this study's hypotheses we required data regarding

goodwill for at least two consecutive years, during the whole period, and firms without booked

goodwill were sorted out from the sample. An additional requirement was that all sampled firms

should have data regarding price-to-book ratios for at least two consecutive years. Thus, firms

with missing values for price-to-book ratios or firms lacking booked goodwill in their balance

sheets were excluded.

In order to identify suspect firms, the ones carrying impaired goodwill forward and have not

yet recognized an impairment, we used price-to-book ratios because investors, analysts and

researchers often use this measurement as a proxy at firm-level when they evaluate if booked

values are overstated (Chen, Schroff & Zhang, 2014; Ramanna & Watts, 2012; Roychowdhury

& Martin, 2013). First, we divided our sample into two groups, based upon whether or not they

have booked an impairment or not. Then we applied the requirement of indications of economic

impairment to separate these two groups into four (see figure 1). As an indicator of firms that

should impair goodwill, the present study used previous fiscal year (lagged) price-to-book ratios

below one in (see Beatty & Weber, 2006; Ramanna & Watts, 2012) which have found price-

to-book ratios to be an important indicator of potential goodwill impairment. The present study

followed the methodology presented by Filip, Jeanjean and Paugam (2015), where firms which

have booked an impairment (control group) were matched with firms within the same sector

(GICS code) and firm-year which have not booked an impairment (suspect firms). The

matching of firms within the same sector-year and valuation interval (P/B +-0.25), allowed the

present study to include and control for the argument that companies within the same sector,

year and valuation experiences similar market conditions and economic cycles. The matching

procedure resulted in two separate groups (control and suspect) which can be seen in the second

step in figure 1 below.

21

Figure 1: Used method to identify suspect firms

The literature review indicates the recognition of impairment losses lag behind economic

impairments with at least two years (Hayn & Hughes, 2006; Jarva, 2009) and firms with price-

to-book ratios below one indicates managers postpone goodwill impairment in order to increase

earnings (Roychowdhury and Martin, 2013). Therefore, in addition, the present study applied

an additional requirement, a methodology used in Ramanna and Watts (2012) and Filip,

Jeanjean and Paugam (2015), to group three, where the requirement of a price-to-book ratio

below one at the end of the fiscal years for two consecutive years were applied. With the

additional requirement, the likelihood of identifying suspect firms which actually not postpone

economically impaired goodwill is lower, which means a lower risk of type 1 error.

4.3 Test of earnings management

To measure earnings management through manipulation of real activities affecting current cash

flows the present study used three different proxies. In accordance with previous studies (Cohen

& Zarowin, 2010; Roychowdhury, 2006; Zang, 2012), the present study used real activities

(RAM) in which cash flows are affected. Further, following the methodology used by Filip,

Jeanjean and Paugam (2015) the study used operating cash flow management (CFM) and free

cash flow management (FCFM). Prior literature have identified the three proxies to measure

earnings management through real activities mainly because the proxies allows real activities

to be measured across several dimensions.

4.3.1 Real activities management (RAM)

In order to measure manipulation of real activities, the study examined such real activities

which increase cash flows across two dimensions, by practicing a methodology used in prior

research (e.g. Roychowdhury, 2006; Filip, Jeanjean & Paugam, 2015; Zang, 2012). To measure

both of these dimensions, abnormal production costs were used for activities associated with

inventories and COGS. For abnormal levels of discretionary expenditures, the present study

examined expenditures arising from R&D and SG&A. These measures were then combined to

capture real activities management (RAM). Thus, to estimate the normal level of production

this study used the following model:

22

𝑃𝑅𝑂𝐷𝑡

𝐴𝑡−1= 𝛼0 + 𝛼1 (

1

𝐴𝑡−1) + 𝛼2 (

𝑆𝑡−1

𝐴𝑡−1) + 𝛼3 (

Δ𝑆𝑡

𝐴𝑡−1) + 𝛼4 (

∆𝑆𝑡−1

𝐴𝑡−2) + 𝜀𝑡 (A)

where:

𝑃𝑅𝑂𝐷𝑡 = sum of cost of goods sold in year t and the change in inventory from 𝑡−1 to 𝑡;

𝐴𝑡−1 = lagged total assets adjusted for the amount of goodwill;

𝑆𝑡 = total sales in year 𝑡;

∆𝑆𝑡= change in total sales from 𝑡−1 to 𝑡.

Model A was calculated cross-sectionally for each sector-year with at least ten observations in

accordance with Filip, Jeanjean & Paugam (2015). The sector is defined by a two digit GICS-

code in accordance with previous research (Cohen & Zarowin, 2010; Kothari, Leone & Wasley,

2005). To measure the abnormal level of production (denoted as 𝐴𝑅𝑃𝑅𝑂𝐷) the study calculated

and used the residuals from model (A) where higher residuals indicates higher overproduction.

Higher 𝐴𝑅𝑃𝑅𝑂𝐷 leads to higher reported earnings due to a reduction of COGS and lower current

cash flows (Filip, Jeanjean & Paugam, 2015; Zang, 2012). To enable that 𝐴𝑅𝑃𝑅𝑂𝐷 indicates

higher cash flows we multiplied 𝐴𝑅𝑃𝑅𝑂𝐷 with (-1). In order to estimate the normal level of

discretionary expenses this study used the following model:

𝐷𝐼𝑆𝐶𝐸𝑋𝑃𝑡

𝐴𝑡−1= 𝛼0 + 𝛼1 (

1

𝐴𝑡−1) + 𝛼2 (

𝑆𝑡−1

𝐴𝑡−1) + 𝜀𝑡 (B)

where:

𝐷𝐼𝑆𝐶𝐸𝑋𝑃𝑡 = sum of R&D, advertising, and SG&A expenditures in year 𝑡;

𝐴𝑡−1 = lagged total assets adjusted for the amount of goodwill;

𝑆𝑡−1 = lagged total sales.

Model B was calculated cross-sectionally for each sector-year with at least ten observations. To

measure the abnormal level of discretionary expenditures (denoted as 𝐴𝑅𝐷𝐼𝑆𝐶𝐸𝑋𝑃) we calculated

and used the residuals from model B. In order to allow the formula to show lower discretionary

expenditures (higher 𝐴𝑅𝐷𝐼𝑆𝐶𝐸𝑋𝑃) has a positive effect on current cash flows we multiplied

𝐴𝑅𝐷𝐼𝑆𝐶𝐸𝑋𝑃 by (-1). The consequences of this procedure are that higher values of 𝐴𝑅𝐷𝐼𝑆𝐶𝐸𝑋𝑃

indicates greater amounts of discretionary expenses have been managed to increase earnings

(Zang, 2012). To capture real activities management (RAM) we computed the sum of

𝐴𝑅𝑃𝑅𝑂𝐷 and 𝐴𝑅𝐷𝐼𝑆𝐶𝐸𝑋𝑃.

4.3.2 Operating cash flow management (OCFM)

In order to measure normal level of operating cash flow (hereafter mentioned as OCFM), this

study examined real activities which increases cash flows by practicing a methodology used in

prior research (Cohen & Zarowin, 2010; Dechow, Kothari & Watts, 1998; Filip, Jeanjean &

Paugam, 2015; Roychowdhury, 2006; Zang, 2012). In order to determine the normal level of

current operating cash flows the study used the following model.

23

𝑂𝐶𝐹𝑡

𝐴𝑡−1= 𝛼0 + 𝛼1 (

1

𝐴𝑡−1) + 𝛼2 (

𝑆𝑡−1

𝐴𝑡−1) + 𝛼3 (

Δ𝑆𝑡

𝐴𝑡−1) + 𝜀𝑡 (C)

where:

𝑂𝐶𝐹𝑡 = operating cash flows;

𝐴𝑡−1 = lagged total assets adjusted for the amount of goodwill;

𝑆𝑡 = total sales in year 𝑡;

∆𝑆𝑡= change in total sales from 𝑡−1 to 𝑡.

Model C was calculated cross-sectionally for each sector-year with at least ten observations. To

measure the abnormal level of current operating cash flows (OCFM), this study calculated and

used the residuals from model C.

4.3.3 Free cash flow management (FCFM)

The testing of impairment is based on discounted free cash flows and operating cash flows

subtracted with capital expenditures (CAPEX) which can work as a proxy for free cash flows.

To measure abnormal levels of free cash flows, the present study used the abnormal operating

cash flows in model (C) and subtracted the abnormal level of CAPEX in model (D). In order to

determine the normal level of CAPEX the study used the following model.

𝐶𝐴𝑃𝐸𝑋𝑡

𝐴𝑡−1= 𝛼0 + 𝛼1 (

1

𝐴𝑡−1) + 𝛼2 (

𝑆𝑡−1

𝐴𝑡−1) + 𝛼3 (

Δ𝑆𝑡

𝐴𝑡−1) + 𝛼4 (

𝑃𝑃𝐸𝑡

𝐴𝑡−1) + 𝜀𝑡 (D)

where:

𝐶𝐴𝑃𝐸𝑋𝑡 = capital expenditures in year t;

𝐴𝑡−1 = lagged total assets adjusted for the amount of goodwill;

𝑆𝑡 = total sales in year 𝑡;

𝑃𝑃𝐸𝑡 = gross property, plant and equipment in year t;

∆𝑆𝑡= change in total sales from 𝑡−1 to 𝑡.

Model (D) was estimated cross-sectionally for each sector-year with at least ten observations.

To measure the abnormal level of CAPEX (𝐴𝑅𝐶𝐴𝑃𝐸𝑋) we calculated and used the residuals from

model D. In order to calculate free cash flow management (FCFM) we subtracted

𝐴𝑅𝐶𝐴𝑃𝐸𝑋 from 𝐴𝑅𝑂𝐶𝐹𝑀.

4.4 Factors affecting earnings management

To examine if managers are able to postpone goodwill impairment by manipulating cash flows,

the present study tested if identified suspect firms experience abnormal levels of cash flows

while controlling for such factors. Previous studies (see Cohen & Zarowin, 2010; Filip, Jeanjean

& Paugam, 2015; Roychowdhury, 2006; Zang, 2012) have identified such factors to be

affecting both ability and willingness of managers to engage in earnings management. Skinner

and Sloan (2002) showed listed companies with growth opportunities are penalized more by

24

the market when earnings thresholds are not fulfilled. Furthermore, Roychowdhury (2006)

argues firms with growth opportunities could also experience pressure to fulfill these earnings

thresholds and therefore engage more in earnings management activities. The present study

tests for growth opportunities in accordance with Skinner and Sloan (2002) and Roychowdhury

(2006). In addition, this study controlled for variables such as firm size, performance and sector

characteristics. These factors were included as control variables in the following formula to

investigate if a relationship exists between control and suspect firms.

𝑀 = 𝛼0 + 𝛽1𝑆𝑈𝑆𝑃𝐸𝐶𝑇𝑡 + 𝛽2

𝑃

𝐵𝑡+ 𝛽3𝑙𝑛𝑆𝐼𝑍𝐸𝑡−1 + 𝛽4∆𝑆𝐴𝐿𝐸𝑆𝑡 + 𝛽5𝐶𝑂𝑉𝐸𝑅𝐴𝐺𝐸𝑡

+ 𝑌𝑒𝑎𝑟𝐹𝑖𝑥𝑒𝑑𝐸𝑓𝑓𝑒𝑐𝑡𝑠 + 𝑆𝑒𝑐𝑡𝑜𝑟𝐹𝑖𝑥𝑒𝑑𝐸𝑓𝑓𝑒𝑐𝑡𝑠 + 𝜀𝑡

where:

M = One of the following three variables:

𝑅𝐴𝑀𝑡= cash flows management through real activities management for year t measured as the

sum of the residuals of models (A) and (B);

𝑂𝐶𝐹𝑀𝑡= operating cash flows management for year t measured as the residuals of model (C);

𝐹𝐶𝐹𝑀𝑡= free cash flow management for year t measured as the difference between the

residuals of models (C) and (D);

𝑆𝑈𝑆𝑃𝐸𝐶𝑇𝑡= = Dummy variable which equals 1 for suspect firms and 0 for control firms

𝑃 𝐵𝑡⁄ = Price-to-book ratio of equity;

𝑙𝑛𝑆𝐼𝑍𝐸𝑡−1= natural logarithm of lagged total assets;

𝑆𝐴𝐿𝐸𝑆𝑡= change in sales for year t divided by lagged total assets adjusted for goodwill;

𝐶𝑂𝑉𝐸𝑅𝐴𝐺𝐸𝑡 t= Dummy variable which equals 1 if at least 1 analyst covers the firm and 0 if no

analyst coverage exists.

4.5 Method discussion

4.5.1 Reliability & replicability

Reliability relates to the issue of whether or not the measures used in the study will yield the

same result multiple times (Bergström & Boréus, 2012), which can enhance the replicability of

the study. To assure consistency and stability of the studied variables, multiple calculations

have been performed and the accounting figures have been cross-referenced with the

companies' annual reports. The statistical tests have been conducted and re-tested by both

authors to ensure accuracy and stability in the results, which can uphold the criteria of reaching

same result and conclusions indifferent of the practitioner (Skärvad & Lundahl, 2016). The

study used the three measures RAM, OCFM and FCFM where secondary data was gathered

and calculated from the financial database Thomson Reuters Eikon. The collected information

is public and reported prior to the collection of the data which sustains the stability of the data

and makes it possible for other researchers to replicate the study. A measure taken in the present

study to increase the replicability is the presentation of the formulas used to compute and extract

data from Thomson Reuters Eikon, as can be seen in Appendix 1. Since Thomson Reuters Eikon

has a magnitude of data ranging from historical values, mean and quarterly measures for the

25

same metrics the present study strives to be transparent of the used metrics, which increased

the replicability of the study.

4.5.2 Validity and ethical considerations

The validity of a model refers to if the model measures what is intended and if the concepts

used in the study are aligned with the measurable definitions of the concepts (Eriksson &

Wiedersheim-Paul, 2014). The models and concepts used in the present study are validated

through previous research (see Filip, Jeanjean & Paugam 2015; Ramana & Watts 2012;

Roychowdhury, 2006) which motivates the application of used models and concepts in the

present study. This study's used models are based upon publicly available data where financial

disclosures can exhibit variance between regulatory settings, this could result in reduced

validity. However, due to the geographical setting of the present study, the used financial

disclosures were regulated by the same standards which made the data obtainable and thus

assured the output of the models. To validate the output, the study performed collinearity

diagnostics to obtain the variance inflation indicator (VIF) value to check for multicollinearity.

The VIF values of the present study range between 1.04-1.56 which showed no violation of the

critical levels, because such low VIF values do not need to be further investigated due to the

absence of multiple correlations (Hair, Black, Babin & Anderson, 2014; Pallant, 2016).

Therefore, this validates one of the statistical assumptions in regression models.

The assumption of homoscedasticity, meaning equal variance for all values of the predictor

variable, is central to linear regression models (Norušis, 2008). Therefore, this study controlled

and checked for heteroscedasticity by using the natural logarithm of lagged total assets to obtain

normal distribution and an even spread of the error term along the regression line. The

illustration of the dispersion of residuals and the conducted tests, Breusch-Pagan and the

Koenker test, allowed the present study to analyze the investigated observations and to control

for heteroscedasticity which enabled the study to run the statistical tests (Norušis, 2008). It is

significant to point out that the models do not prove if earnings management are conducted or

not, the results presented in the models however gives indications of the phenomenon with

explanatory power (R2) of 5.3-21.6%. Since the gathered data is publicly available this study

has not reached out to the investigated companies to receive consent. The ethical consideration

in the present study has regarded to compute data in a trustworthy, truthful and reliable way,

with no intention of harming the investigated companies.

4.5.3 Criticism of research design and method

Even though the used methods are established in previous earnings management research (e.g.

Filip, Jeanjean & Paugam, 2015, Ramanna & Watts, 2012; Roychowdhury, 2006; Zang, 2012),

the literature has highlighted difficulties in measuring such activities. To enhance the possibility

to identify whether or not managers actually engage in earnings management activities,

interviews could have been chosen. On the other hand, the truthfulness of respondents would

have been jeopardized due to that admitting to earnings management can have unfavorable

effects for the company (Leuz, Nanda & Wysocki, 2003) because it can be considered unethical

(Smieliauskas, Bewley, Gronewold & Menzefricke, 2018).

26

Both Beatty and Weber (2006) and Verriest and Gaeremynck (2009) argue when a firm's market

value minus its book value of equity is smaller than the amount of goodwill reported on the

balance sheet, there are indications of impairment. Despite this, we have used price-to-book

below one for two consecutive years as a proxy for economic impairment in accordance with

other studies (see André, Filip, Paugam, 2016; Filip, Jeanjean & Paugam, 2015, Ramanna &

Watts, 2012). With both proxies for economic impairment, there is a risk of labeling such firms

which do not postpone impaired goodwill as suspect firms and therefore make a type 1 error.

That is why we have an additional test where the requirements have been strengthened in order

to minimize this risk. Prior studies (see Caruso, Ferrari & Pisano, 2016; Cohen, Dey & Lys,

2007; Ramanna & Watts, 2012) have gathered data from different sources and geographical

settings than the present study which might result in a different yield for the present study due

to country-specific effects. Prior research (see Leuz, Nanda & Wysocki, 2003; Roychowdhury,

2006) has found earnings management to be less occurring in countries with strong investor

protection and regulation which can reduce the chance of obtaining significant results in the

present study.

The present study raises critique of the method for identifying firms who impair goodwill due

to the need for using firm-level data instead of cash-generating unit data. The design of IFRS 3

and IAS 36 framework leads to that goodwill is activated on the balance sheet on the firm level

but the impairment test is conducted at the specific cash-generating unit where the fair value of

the asset is unobservable for outsiders (Filip, Jeanjean & Paugam, 2015). This aspect forces the

present study to use firm-level data which could result in omittance of observations who

conduct small impairments and simultaneously conducts acquisitions larger than the

impairment itself, resulting in a net positive effect. However, to control for this aspect the price-

to-book ratio has been used which together with the actual impairment is an indicator of market

expectations and if an impairment should have been conducted or not (ibid.).

The matching of suspect and control firms could limit the generalizability of the present study

due to the matching of equal valued companies in the same sector. However, the matching

increases the comparability between firms and the matched companies are now facing the same

economic cycles which increases the reliability of the results (Filip, Jeanjean & Paugam, 2015).

In opposite of prior research (see André, Filip & Paugam, 2016; Caruso, Ferrari & Pisano, 2016;

Ramanna & Watts, 2012) the present study excludes observations with missing data due to

differences in reporting practice compared to studies carried out in different geographical

settings. However, the power of the study was not jeopardized due to that the companies

presented has valid and comparable data. Further, even though a critique against the used

method is the difficulties in handling a vast amount of information (Saunders, Lewis &

Thornhill, 2016) the outcome of such data motivates this study's choice of using the database

Thomson Reuters Eikon in accordance with previous studies (see Jarva, 2009; Roychowdhury,

2006).

27

5. Sample and result

Chapter five presents the sample and empirical findings of the study. The descriptive statistics

is presented to give an overview of the data. The results from the t-test and regressions are

disclosed. The present studies empirical findings are limited to the purpose of the study.

5.1 Sample selection and descriptive statistics

In Table 1 descriptive statistics is presented for the full sample of 1090 firm-year observations.

Goodwill averaged 22.2% of total assets, while an average goodwill impairment amounted to

3.9% of total goodwill. Controlling for size, impairments larger than 1.0% have been made by

11.4% of the observations. As can be seen in the total sample, 4.0% has booked a goodwill

impairment larger than 5% and 2.1% larger than 10.0%. The price-to-book ratio (P/B) for

observed firm-years shows an indication of firms' equity in period t is valued higher by the

market in comparison with equity value during period 𝑡−1. ∆𝑆𝑎𝑙𝑒𝑠𝑡, used as a proxy for growth

opportunities, shows the average firm experiences positive growth. The dummy variable

Coverage shows that 79.5% of the firms have at least one analyst following the firm.

Table 1: Descriptive statistics

The data presented in Table 2 shows the sample when it is divided into firm-year groups. As

can be seen, there is a slight difference between the firm-year observations. On average,

goodwill accounts for approximately 21.7% of total assets in 2012 and have increased in 2017

when goodwill accounts for approximately 24.1%. Of the firms with impaired goodwill, it can

be seen the magnitude of the impairments differ during the period. In 2012 the average

impairment of goodwill was 9.2% while the largest average impairments of 19.3% took place

28

in 2016. The average price-to-book ratio has increased from about 1.9 to 3.1 during the

investigated period which in turn could be interpreted as the market's expectations on firms'

future performance and earnings have increased. Table B also shows between 22.7% to 42.4%,

of those firms which have booked an impairment, impair more than 10% of goodwill at the

time. Further, the table shows between 13.4% to 26.7% of the sampled observations impair less

than 1% of total lagged goodwill.

Table 2: Descriptive statistics per year

From both Table 1 and Table 2 it can be seen there are some extreme values. In order to run

our statistical tests we, therefore, winsorize each continuous variable at its 1st and 99th

percentiles to avoid extreme observations in accordance with previous studies (see Chen, Shroff

& Zhang, 2014; Cohen, Dey & Lys, 2008; Filip, Jeanjean & Paugam, 2015; Lee, 2011; Li &

Sloan, 2017; Paugam & Ramond, 2015; Zang, 2012).

5.2 Test results

Using the first method to identify suspect firms, where firms without a booked impairment are

matched with firms which have booked an impairment within the same sector and year, enables

this study to identify 298 suspect firm-years from the total matched sample of 411 observations.

The corresponding number for control firms is 113. In Table 3, Panel A the result shows there

is a significant difference (at less than 1%, two-tailed) between suspect and control firms

regarding ∆𝑆𝑎𝑙𝑒𝑠𝑡, a proxy for growth opportunities and firm size (𝑙𝑛𝑆𝑖𝑧𝑒𝑡−1).. There is a

29

significant difference (at less than 5%, two-tailed) between the groups for analysts' coverage.

Furthermore, the t-test shows no significant difference between the groups regarding price-to-

book which indicates the market value of the current year's equity is in line with lagged price-

to-book ratio, used in the matching process.

Table 3. T-test and multiple regression for suspect and control firms

The result presented in Table 3, Panel B shows there is no statistically significant evidence

which indicates firms which have not booked an impairment manage their cash flows upwards,

succeeding the control for the ability and desire to manage cash flows. On the other hand, the

variable price-to-book is positive and significant (at less than 1%, two-tailed) regarding

operational cash flow management (OCFM) and for free cash flow management (FCFM). In

addition, the result shows a negative and significant (at less than 1%, two-tailed) effect for the

control variable ∆𝑆𝑎𝑙𝑒𝑠𝑡, proxy for growth opportunities, for cash flow management through

real activities (RAM). Growth opportunity is also the variable in which influences all of the

three dependent variables the most.

5.2.1 Economic impairment

Price-to-book ratios have been used in previous studies as a market indicator for economic

impairment (see André, Filip & Paugam, 2016; Filip, Jeanjean & Paugam, 2015; Francis, Hanna

& Vincent, 1996; Ramanna & Watts, 2012). Therefore, this study extends the investigation with

an additional requirement in order to identify suspect firms. The present study considers price-

30

to-book below one for two consecutive years as used by Ramanna & Watts (2012) to identify

such firms. The additional test shows an improvement in the coefficient of determination in all

of the three tests. This indicates the additional requirement allows the independent variables to

explain the variance in the dependent variable in a larger extent than before.

The addition of this requirement reduces the suspect group from 298 to 33 firm-year

observations. The procedure entails more significant results and the results presented in Table

4, Panel A shows a significant (at less than 5%, two-tailed) difference for ∆𝑆𝑎𝑙𝑒𝑠𝑡 between

suspect and control firms. Further, a significant difference (at less than 1%, two-tailed) for the

variable price-to-book, lnSize and Coverage were found between the two groups. After

controlling for factors affecting the ability and willingness to manage cash flows and adjusted

for sector and year effects the result still shows current years' price-to-book ratio has a positive

and significant (at less than 1%, two-tailed) impact on both operational cash flow management

(OCFM) and free cash flow management (FCFM). Unlike the first test, the additional

requirements show 𝑆𝑢𝑠𝑝𝑒𝑐𝑡𝐴𝑐𝑐𝐸𝑐𝑜 is significantly positive (at less than 5%, two-tailed) for

FCFM. With the additional requirement, the variable Coverage shows a negative and significant

(less than 5%, two-tailed) impact on cash flow management through real activities (RAM).

Table 4. T-test and multiple regression for suspect and control firms with P/B < 1 for 2 years

31

5.2.2 Summary hypotheses result

The results from the regressions show the study has supporting evidence for hypotheses H3, H4

(significant at less than 5%) and H5 (significant at less than 1%) as can be seen in Table 4,

Panel B. The evidence shows suspect firms have a significant impact on abnormal current free

cash flows, used as a proxy for earnings management. Also, both analysts' coverage and firms'

growth opportunities have a significant impact on abnormal cash flows from real activities,

used a proxy for earnings management through manipulation R&D, advertising, SG&A

expenditures, COGS or inventory. Thus, the result shows no statistical evidence for the

hypotheses H1 and H2, which means the study lacks supportive evidence that investigated

suspect firms experience abnormal current cash flows from real activities or from operating

activities.

32

6. Discussion

Chapter six presents an analysis of this study's results. The chapter begins with an analysis of

the dispersion of the sample and proceeds with a broader perspective where the mentioned

theories are included.

6.1 Dispersion of the sample

The data in this study shows that approximately 59% of those firm with indications of economic

impairment have not booked an impairment. These observed values are in line with the result

in Ramanna and Watts' (2012) study which found a 69% frequency of non-impairment of

goodwill in the analysis of a firm sample which had market indications of goodwill impairment.

The study result also corresponds to the low goodwill impairment frequency showed in prior

studies due to the average goodwill impairment of 3.9% of total goodwill in the sample (Caruso,

Ferrari & Pisano, 2016; Hamberg, Paananen & Novak, 2009).

As can be seen in table 1, there are only a few observations undertaking goodwill impairments

larger than 5% which indicates goodwill tends to be sticky. The decision to postpone goodwill

impairment, even though the asset faces economic impairment, can be considered as a breach

of faithful reporting and question the timeliness of financial reporting (Ramanna & Watts, 2012;

Riedl, 2004). Previous studies argue the managerial reluctance to impair goodwill is grounded

in managerial pride (Li & Sloan, 2017; Roychowdhury & Martin, 2013) and managers which

impair goodwill do it to reflect future performance or as a management strategy (Filip, Jeanjean

& Paugam, 2015; Healy & Wahlen, 1999). The dispersion of the non-impairing firms could be

explained by the argument managers are reluctant to admit to overpaying for previous

acquisitions due to the possible unfavorable effects for company value (Chen, Shroff & Zhang,

2014; Li & Sloan, 2017; Roychowdhury & Martin, 2013). Another explanation which the

present study elaborate is that the given discretion given from the IFRS framework has

presented managers with an opportunity to evade impairments and artificially boost cash flows

to support the calculations conducted in the DCF model. This elaboration corroborates with the

findings in Cohen and Zarowin (2010) and Huang and Sun (2017).

Further, as seen in table 1, Salest and price-to-book ratio discloses that some observations are

high even after the winsorizing procedure, which could be explained by the markets high

expectations of future growth prospects, thus leading to higher firm valuations. As argued by

(Chen, Shroff & Zhang, 2014; Li & Sloan, 2017) investors do not understand the intentions of

non-impairment and the untimeliness of financial reporting is contributing to a systematic

overvaluation of the firm. The argument is corroborated by the sample and that outsiders seem

to interpret the non-impairment as beneficial.

From the data presented in Table 2, it can be seen goodwill accounts for a larger amount of total

assets during the later years. This indicates Swedish firms either pay larger acquisition

premiums or engage more in transaction activities, and therefore allocates more goodwill in

their balance sheets toward the latter part of the investigated period. This is in line with Duff

and Phelps (2018) who argue the magnitude of goodwill impairment has become larger and

33

therefore more important for investors to understand. An explanation for the increased

allocation of goodwill could be the increased discretion and abolishment of goodwill

amortization stemming from the transition to the IFRS framework, thus making it more

beneficial for companies to acquire goodwill. The abolishment of mandatory amortization of

goodwill can, ceteris paribus, result in higher reported earnings due to that assets are not

frequently impaired and thus appears to be higher than they de facto are, leading to

overstatements and overvaluation by outsiders.

Further, the rising price-to-book ratio could be interpreted as the market's expectations on firms'

future performance and that earnings have increased. The evidence shows that higher market

value of equity will have a positive impact on managers engagement in cash flow management.

These results are in line with previous evidence (see André, Filip, Paugam, 2016; Filip, Jeanjean

& Paugam, 2015, Ramanna & Watts, 2012) which have shown price-to-book to be an important

proxy for economic impairment. Firms with lower price-to-book ratio are interpreted by the

market as firms facing economic impairment which makes it more difficult for such firms to

mislead investors, auditors and gatekeepers. The increased difficulty stems from gatekeepers

questioning future prospects and high cash flows when current cash flows are low (Kothari,

Wysocki & Shu, 2009).

As can be seen in Table 3, Panel A the results from the first t-test indicate suspect firms in this

study have a smaller amount of total assets, exhibit greater growth opportunities and have fewer

analysts following in comparison to control firms. As Burgstahler and Dichev (1997) reported,

earnings management activities and practices are more common among large and medium-sized

firms rather than within small firms. Such a statement is in accordance with the result from the

present study who identified that suspect firms have a smaller amount of lagged total assets in

comparison with control firms. Different from the first t-test, the second t-test in Table 4, Panel

A had an additional requirement which required firms to have a price-to-book ratio below one

for at least two consecutive years. The second t-test shows the average suspect firm experiences

negative growth which is in line with previous study results (see André, Filip & Paugam, 2016;

Ramanna & Watts, 2012). An argument for the result is that when firms experience negative

sales growth and fewer growth opportunities the market will take this into account when the

companies' prospects are being valued. Henceforth, leading to a lower price-to-book ratio and

thereby strengthening the indications regarding economic impairment.

6.2 Earnings management through cash flow manipulation

Unlike previous studies (see Filip, Jeanjean & Paugam; Ramanna & Watts, 2012;

Roychowdhury, 2006) which found that manipulation of real activities and operating activities

are conducted in order to delay goodwill impairment this study finds no evidence to support the

hypotheses H1 and H2. Consequently, this study has no statistical supporting evidence that

suspect firms experience abnormal current cash flows from real activities or operating activities.

However, this study's result shows supporting evidence for hypothesis H3, which means suspect

firms experience abnormal current levels of free cash flows which in turn could be interpreted

as managers manage free cash flows upwards. In the DCF-model, used by auditors in

impairment tests, future free cash flows are discounted (Lander & Reinstein, 2003). Managers

34

could thereby lower capital expenditures in order to increase current free cash flows and mislead

financial gatekeepers, such as auditors and investors, in order to postpone economic impaired

goodwill. This, in combination with the difficulties in detecting such activities (Cohen, Dey &

Lyz, 2008; Cohen & Zarowin, 2010; Huang & Sun, 2017) could be the reason why firms engage

in earnings management by manipulating free cash flows. Furthermore, as reducing R&D

expenditures to increase earnings in the short term can harm firm value in the long run (Canace,

Jackson & Ma, 2018; Graham, Harvey & Rajgopal, 2005) the result indicate firms will manage

capital expenditures instead. This result is in accordance with Kothari, Languerre and Leone

(2002) which argued capital expenditures are associated with higher future stock returns and

lower variability in earnings. Also, Fama (1980) argues managers' willingness to shift expenses

is controlled by job security and reputation which in turn depends on the firm's long-term

performance. Thus, managers willingness to manage free cash flows in order to postpone or

avoid goodwill impairment may originate from their willingness not to deteriorate the

company's long-term value, performance and earnings variability.

6.2.1 Analysts coverage and growth opportunities

The literature highlights real activities manipulation as something costly and difficult for

auditors and gatekeepers to detect (Cohen, Dey & Lyz, 2008; Cohen & Zarowin, 2010; Huang

& Sun, 2017; Roychowdhury, 2006) which present a low risk of scrutinization (Roychowdhury,

2006). As both auditors and financial analysts following the firms can be seen as financial

gatekeepers the significant difference between suspect and control firms regarding growth

opportunities and analysts' coverage is in line with the literature (see Ali & Zhang, 2015; Yu,

2008). The presented evidence supports hypotheses H4 and H5, which indicates firms engage

in fewer earnings management activities when analysts are following firms' performance and

when firms experience growth opportunities.

Burgstahler and Dichev (1997) together with Graham, Harvey and Rajgopal (2005) argue

earnings management is used to avoid earnings decline and reporting losses in order to meet

certain earnings thresholds, defined by Roychowdhury (2006) as real earnings management.

This study's evidence points in the opposite direction. The result shows that real activities

management activities decrease when at least one analyst following, which could be interpreted

from several perspectives. Seen from the perspective that analysts can be considered as financial

gatekeepers, the result is in line with Graham, Harvey and Rajgopal (2005) which argue that

analysts can reduce managers opportunities to manipulate earnings because they are able to

detect such unethical behavior. Also, it is in line with previous study results where firms with

high monitoring and analyst coverage exhibit lower earnings overstatement (Ali & Zang, 2014).

Yu (2008) argues analysts, choose to cover firms with a better information environment which

should result in less earnings management. From this point of view, the result from the present

study indicates Swedish firms operate within a financial market with high disclosure of

information. On the other hand, if analysts are perceived by the market as information

providers, in addition to corporate disclosure, more earnings management (less corporate

disclosure) will generate increased demand for information resulting in more analysts (Hong,

Huseynov & Zhang, 2014). Unlike the result in Yu (2008), this would instead indicate that

analysts are driven by the demand to choose firms with lower disclosures which therefore

35

should have a positive effect on earnings management. The last perspective is in line with the

conclusion from Abarbanell and Lehavy (2003) that firms receiving unfavorable ratings or

recommendations exhibits reduced incentives to manipulate earnings through real activities.

Based on previous studies and presented literature firms experiencing growth will most likely

have experienced lower scrutiny, by both auditors and analysts, and therefore been able to avoid

impairment of goodwill. In addition, Skinner and Sloan (2002) show listed companies with

growth opportunities are penalized more by the market when earnings thresholds are not

fulfilled. Therefore, Roychowdhury (2006) argues one of the reason firms with growth

opportunities engage in earnings management activities could be because they experience this

pressure to fulfill earnings thresholds. As current growth could be used as an argument to make

the future estimate more reliable (Filip, Jeanjean & Paugam, 2015) one could argue auditors

would not scrutinize such firms in the same extent. Therefore, the significant difference in

growth opportunities between the control and suspect firms, which can be seen in both Table 3

and 4, is in line with previous study results.

The result from the multiple regression (Table 4, Panel B) shows growth opportunities have a

significant negative impact on real activities management. The result is interpreted as firms

experiencing growth use their situation as a reliable base for improved future cash flows instead

of manipulating the current cash flows in order to postpone the impairment process. Because

of this, auditors will not scrutinize or question that firms delay goodwill impairments even

though there are indications they should go through with it immediately. Also, as decreased

growth should be reflected in reduced market expectation through lower price-to-book ratios,

thus higher risk of scrutinization, firms which experience growth have less need to manipulate

cash flows in order to increase market expectations. However, the result is in line with Filip,

Jeanjean and Paugam (2015) which found that managers are less likely to manage real activities

in times of increasing sales. Although, the result of the present study conflicts with the evidence

provided by Cohen and Zarowin (2010) together with Huang and Sun (2017) who find that real

activities are more attractive for managers to undertake due to a low probability of

scrutinization. The result also contradicts the study result, presented by Ali & Zhang (2015),

where CEO tenure has a negative impact on earnings overstatement. With the argument that

sales growth can easier be accomplished in younger firms, consequently more commonly with

CEOs with less tenure, growth opportunities would have a positive impact on earnings

management activities.

6.2.2 Timeliness of goodwill impairment

André, Filip & Paugam (2016) highlight timeliness of goodwill impairments as a widely

researched subject post the abolishment of goodwill amortization. In accordance, the present

study uses the definition of timeliness as the relationship between economic indicators

suggesting impaired assets and the actual accounting impairment. The study result provides

evidence that Swedish managers undertaking earnings management activities, which is

influential for the timeliness of goodwill impairments. For impairments to be considered as

timely and faithfully represented the information should be complete, neutral and free from

error (Nobes & Stadler, 2015). The present study argues the postponement of goodwill is

36

contradicting to the qualitative characteristics, faithful representation and relevance, of the

IFRS framework (IFRS, 2018). When impairment of assets facing economic impairment are

postponed the predictive value and capability of altering outsiders decision making diminishes

(Beaver, 1968; Nobes & Stadler, 2015), due to asset overstatement in the balance sheet. When

assets are overstated it can lead to incorrect estimations of future benefits pertaining to the assets

and of the future prospects for the company which can be detrimental for both investors and

firms (Li & Sloan, 2017). The results from the present study show suspect firms manage free

cash flows in order to support the postponement of goodwill impairment, thus breaching the

timeliness aspect of financial reporting.

In the context of information asymmetry, goodwill impairments are argued to send signals about

future cash flows to investors (Schatt, Doukakis, Bessieux-Ollier & Walliser, 2016). When

assets are impaired, the future cash flows stemming from the asset is certainly going to be lower,

in comparison to the estimated cash flow when goodwill was recognized in the balance sheet

(ibid.). This aspect can explain why managers are reluctant to impair goodwill due to that lower

future cash flows can have negative consequences both for the manager and the stock price

(André, Filip & Paugam, 2016; Li & Sloan, 2017; Roychowdhury & Martin, 2013). When

goodwill is impaired, managers admit to overpaying for past acquisitions and if the stock prices

decline as a consequence, the managerial abilities can be questioned by both insiders and

outsiders of the firm (Li & Sloan, 2017). The results from the present study corroborate with

the argument and real activities management seems to be decreasing when growth opportunities

are present and when analysts covering the firm. The evidence indicates cash flow management

is present for suspect firms and the present study argue managers are inclined to increase cash

flows to avoid the unfavorable effects stemming from goodwill impairment.

Thus, as the objective of financial reporting is to provide useful decision-making information

to financial users (IFRS, 2018a) a postponement will result in untimely goodwill disclosure.

Thus, the disclosures will contain less valuable information and make it more difficult for users

to make the best outcome from their decisions. Also, as standard setters expect managers to

mediate private information in disclosures (Filip, Jeanjean & Paugam, 2015) the asymmetric

aspect of information distribution should be mitigated. Therefore, if the impairment of goodwill

is disclosed by managers whenever the firms experience indication of economic impairment it

should contain an information value to investors regarding managers' additional information of

the firms' prospects. Consequently, manipulating current free cash flows in order to delay or

avoid goodwill impairment will result in larger information gap between managers in suspect

firms and the users of the disclosed financial information.

The evidence from the study is also in accordance with the predictions of the agency theory that

managers take advantage of the unsecured elements of goodwill impairments (Filip, Jeanjean

& Paugam, 2015) to maximize their own utility and make choices which fit their own agenda.

The study by Ramana and Watts (2012) found CEO compensation, reputation to be positively

correlated with non-impairment of goodwill which could explain the increased cash flows in

the present study. Caruso, Ferrari and Pisano (2016) show a growing acquisition rate post-IFRS

implementation, associated with increased goodwill recognition, but no increment in goodwill

37

impairments. The evidence from the present study aligns with the statement and the increased

cash flows act as a convincing mechanism to justify non-impairment to gatekeepers as

mentioned by Kothari, Wysocki and Shu (2009). The evidence indicates that the possibilities

and opportunities presented by the IFRS framework have been adopted by managers in Swedish

firms and cash flow manipulations are used to keep the assets intact on the balance sheet, hence

breaching the qualitative characteristics of financial reporting and ultimately misleads outsiders

of the firm.

38

7. Conclusion

Chapter seven concludes the analysis and reflections of the study. Furthermore, the study result

and contribution are presented, both academic and practical, and the chapter ends with a

proposal for future research.

The purpose of the study was to investigate how postponement of goodwill impairment is

conducted and if managers thereby contribute to a distortion of the underlying qualitative

characteristics in financial reporting. The present study has, with support of proxies for earnings

management, investigated how managers separate economic impairment from accounting

impairment, thus disrupting timeliness of financial reporting. Previous studies have shown

goodwill impairment lag behind the entity's operating performance from at least two years

which indicate managers are able to separate accounting and economic impairment of goodwill.

This study presents evidence that firms carrying impaired goodwill, without booking an

impairment, experience abnormal current free cash flows in comparison with this study's

sampled control firms. Thus, this study finds evidence that managers in suspect firms are able

to disrupt the timeliness of financial reporting by managing current free cash flows upwards in

order to postpone goodwill impairment. This is aligned with previous research showing that

managers engage in earnings management activities to delay goodwill impairment.

Previous studies have shown analysts following companies will have an impact on managers

and their behavior towards earnings management, but the result differentiates regarding the

direction of the effect. However, the findings of the present study show a decrease in abnormal

current cash flows from real activities management when at least one analyst is covering the

firm. The findings indicate gatekeepers have a mitigating effect for earnings overstatement

which is in accordance with previous study results. However, in the presence of analyst

coverage firms are argued to be pressured to meet earnings thresholds, due to the adverse

reactions if not met, which might inspire earnings management. In line with this, the study's

result, that firms exhibiting growth opportunities manage real activities less, indicates managers

manage current earnings in order to improve future estimates. The evidence that growth

opportunities have a negative effect on engagement in real activities manipulation is in

accordance with the idea that firms which are experiencing growth opportunities engage less in

earnings management, due to the adverse effects on future performance. Furthermore, the

evident increase in free cash flow management is aligned with the idea that free cash flows,

used in impairment tests, are managed when current cash flows and growth opportunities are

not enough to convince auditors. Thus, the research question is answered and the presented

evidence contradicts the timeliness of financial reporting, by the separation of economic and

accounting impairment, through cash flow manipulation, which justifies postponement of

goodwill impairment.

7.1 Contribution

The findings in the study can have an impact on future practitioners, academics and investors.

The study result adds on to the IFRS debate and concludes the timeliness of goodwill reporting

is suffering from the abolishment of mandatory goodwill amortization. The findings can,

39

therefore, be used as guidance on how standard setters will form the regulations of goodwill

impairment so it is more in agreement with the objectives of financial reporting. Also, it adds

on to the analyst coverage literature due to the presence of gatekeepers indicates a limiting

effect for real activities management behavior. The manipulation of free cash flows can

contribute to practitioners and provide knowledge to financial gatekeepers about the

opportunistic justification attempts of future estimations given by managers. The result will

especially be of importance to auditors in order to detect manipulation of free cash flows before

impairment tests. Regardless of the delimitation towards Swedish firms, which can inhibit the

generalizability to different geographic regions and demographic settings, the results can aid

practitioners in detecting earnings management activities. In addition, the study can have an

impact on the decision made by users of financial information because the findings highlight

that the usefulness can be deteriorated by untimely financial reporting originating from the

postponement of goodwill impairment.

7.2 Limitations and future research

A limitation with this study's findings is the generalisability regarding the interpretation of how

abnormal current cash flows implies cash flow management. Also, since earnings management

is difficult to measure there are different measurement proxies which could be used in order to

find indications of earnings management, the result in this study could differ if it would be

replicated with the use of other proxies. Thus, the findings only show indications of cash flow

manipulations, based on statistical supporting evidence of abnormal current cash flows for

suspect firms, and can not with certainty state that managers in such firms actually engage in

unethical behavior.

Since real activities earnings management is difficult to measure and to detect for auditors the

present study identifies a need for further research. An avenue for future research should be to

investigate how cash flow management pertains to managerial incentives tied to goodwill

impairment, due to the subjective measures used in the impairment tests. Since goodwill is

materialized through mergers and acquisitions an interesting area to examine would be the

market reactions and attitudes of the acquiring firm regarding impairment decisions. This

research avenue could enhance and accumulate to the existing knowledge and aid in identifying

the underlying factors for managerial decision making regarding goodwill impairments.

Furthermore, this study found no supporting evidence of managers manipulating current cash

flows from real and operating activities. Thus, a suggestion would be a more comprehensive

study with a focus on different measurement proxies for earnings management that might

explain the occurrence of this phenomenon which this study lacks supporting evidence to prove.

40

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9. Appendix