Review of Quantitative Finance and Accounting (2021) 56:891–915

https://doi.org/10.1007/s11156-020-00912-x

ORIGINAL RESEARCH

Did SFAS 141/142 improve the market’s understanding of net

assets, goodwill, or other intangible assets?

Peter M. Johnson1 · Thomas J. Lopez1 · Trevor L. Sorensen2 

Published online: 11 July 2020

© Springer Science+Business Media, LLC, part of Springer Nature 2020

Abstract
Statement of Financial Accounting Standards nos. 141 and 142 eliminated the pooling
method of accounting for acquisitions and altered the accounting for intangible assets,
respectively. The Financial Accounting Standards Board (FASB) asserts that as a result
of these changes financial statement users (i.e., market participants) will be “better able
to understand the investments” made and have an improved “ability to assess the future
profitability and cash flows” derived from these assets. In this paper, we address whether
the FASB accomplished its goals with these new standards. We utilize an OLS regression
to assess investors’ ability to forecast a firms’ future performance and to determine whether
the information related to these accounting changes are impounded into market prices.
The overall evidence partially supports FASB’s assertion of providing better information.
While there is a significant improvement in market participants’ ability to assess the future
economic benefits associated with goodwill, there does not appear to be any improvement
in the market’s ability to understand the future implications of other intangible assets or net
assets in general.

Keywords  Goodwill · Intangible assets · SFAS 141 · SFAS 142 · Market efficiency

JEL Classification  G14 · M41 · M48

* Trevor L. Sorensen
trevor.sorensen@mail.wvu.edu
Peter M. Johnson
pjohnson@cba.ua.edu
Thomas J. Lopez
tjlopez@cba.ua.edu
1
Culverhouse School of Accountancy, Culverhouse College of Commerce, University of Alabama,
Tuscaloosa, AL 35487‑0220, USA
2
John Chambers College of Business and Economics, West Virginia University, Morgantown,
WV 26506‑6025, USA

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 892 P. M. Johnson et al.

1 Introduction

When issuing Statement of Financial Accounting Standards (SFAS) nos. 141 (Account-
ing for Business Combinations) and 142 (Goodwill and Other Intangible Assets) in 2002,
the FASB’s primary stated objective was to allow market participants (i.e., investors) to
better assess acquired assets, including the allocation of goodwill and the effects of any
subsequent changes in goodwill on the firms’ future performance and cash flows.1 In par‑
ticular, the FASB wrote that the new regulation “will improve financial reporting because
the financial statements of entities that acquire goodwill and other intangible assets will
better reflect the underlying economics of those assets” such that “financial statement users
will be better able to understand the investments made in those assets and the subsequent
performance of those investments” (FASB 2001a). In this study, we test whether the FASB
accomplished its objective to improve the information content of reported earnings so
that investors are “better able to understand” investments in goodwill and other intangible
assets.
With regard to the FASB’s assertion of providing better information about goodwill
and other intangible assets, the concept of “better information” is susceptible to multiple
interpretations. The majority of prior research operationalizes this concept using several
different measures related to goodwill impairment including: (1) timeliness of recognition
(Chen et al. 2008; Li and Sloan 2017); (2) earnings volatility (Li and Sloan 2017); (3) the
opportunistic use of discretion in the reporting of goodwill impairments (Beatty and Weber
2006; Ramanna 2008; Li et al. 2011; Ramanna and Watts 2012); and (4) analyst reaction to
the announcement of impairments (Bens et al. 2011; Li et al. 2011). To our knowledge, Lee
(2011) is the only study to investigate the effect of SFAS 142 on the information content
of goodwill and finds that the ability of goodwill to predict future cash flows has increased
since SFAS 142.2
While each of these studies assess the information content associated with the change in
accounting for goodwill, they fail to assess two key parts of the FASB’s objectives. First,
prior literature fails to analyze the amount of information that is actually understood by
market participants. Second, prior research has predominantly focused on goodwill impair‑
ment, and has failed to consider the investor’s assessment of the reliability of the balance
sheet accounts (i.e., goodwill and other intangible assets). Although impairment may be a
major concern with goodwill, other changes to goodwill through acquisitions or sales also
contain information for investors. Therefore, we define better in the context of whether the
market impounds more or less of the future earnings and cash flow implications of good‑
will and other intangible assets after the implementation of SFAS 142. This study differs
from prior research in that we focus on how SFAS 142 affects the market participant’s abil‑
ity to understand the predictable elements of these assets rather than the association with
future earnings and cash flows.
We ascertain whether the significant changes to accounting for goodwill at the time of
acquisition and in subsequent periods mandated in SFAS 142 achieves the intended results
for two main reasons. First, SFAS 141 requires the use of the purchase method in business
combinations that results in an increased amount of goodwill and other intangible assets

1
  In 2007, the FASB revised SFAS 141 (R). In 2009, the FASB renamed SFAS 141 (R) and SFAS 142 as
Accounting Standards Codification 805 and 350, respectively.
2
  Consistent with Lee (2011), we also find evidence that suggests a stronger association between goodwill
and future cash flows post-SFAS 142. We discuss those results in detail later in the text.

13
Did SFAS 141/142 improve the market’s understanding of net assets,… 893

being reported after acquisition. Second, goodwill was previously amortized over a period
of time not to exceed 40 years, and tested for impairment using undiscounted cash flows
after an event indicated a potential decline in value. This testing was done when an event
occurred that suggested a possible decline in the value of the asset group to which good‑
will was allocated. SFAS 142 instituted a major change in the accounting for goodwill and
other intangible assets by eliminating the systematic amortization of goodwill and requires
that goodwill be evaluated for impairment at least once a year using fair value estimates
(i.e., discounted future cash flows).3
With SFAS 142 relying on fair value estimates to determine the value of reported assets,
our study provides a unique testing environment to ascertain whether the shift to fair value
reporting allows market participants to better understand the future performance effects
following the enactment of SFAS 142. The FASB believes the shift to fair value report‑
ing allows financial statements to become more relevant. However, prior research provides
mixed results as to whether the FASB’s attempt to increase the relevance of asset values,
such as goodwill and subsequent impairment, comes at the expense of reduced reliability
(Ramanna and Watts 2012; Bens et  al. 2011; Jarva 2009; Beatty and Weber 2006). We
explore this tension between relevance and reliability by examining market participants’
ability to better understand the future performance implications of SFAS 142 with the new
reporting standards requiring the use of fair value estimates.
The two-equation Mishkin (1983) test has long been used to ascertain whether mar‑
ket participants better understand the earnings implications of these accounting changes
(Schmidt 2006; Ball and Bartov 1996; Bernard and Thomas 1990; Baez-Diaz and Alam
2013; Lopez, Sisneros, and Sorensen 2020). Kraft et al. (2007) provide additional insight
into this methodology and show that OLS yields the same results for large sample tests
while allowing more control for omitted variables and cross-sectional correlation. Follow‑
ing the OLS method from Kraft et al. (2007), we are able to test whether the changes in
accounting for goodwill and other intangible assets persist over time and impact investors’
ability to forecast a firm’s future performance. This allows us to assess whether the FASB
achieved its stated objective of providing better information with the regulation change.
In testing our hypotheses, we find no evidence that the market better understands other
intangible assets. However, our results indicate that investors are better able to understand
the future earnings and cash flow implications of goodwill after the implementation of
SFAS 142. Our results are robust to estimations in levels and changes as well as using
alternative pre- and post-SFAS 142 time periods.4 Overall, our evidence suggests that the
FASB did not fully accomplish its goal of improving financial information related to other
intangible assets after the issuance of SFAS 142. However, market participants’ ability to
impound future performance implications did improve with the accounting changes associ‑
ated with goodwill.
Our study makes two important contributions to prior research. First, we test directly
the FASB’s assertion that SFAS 142 would improve investors’ ability to understand future

3
  Other intangible assets that are still amortized continue to follow SFAS 121 (FASB 1995) and are tested
for impairment using undiscounted cash flows only when an event occurs indicating impairment may have
occurred. SFAS 144 (Accounting for the Impairment or Disposal of Long-Lived Assets) supersedes SFAS
121, and applies to intangible assets that are not amortized. The rules for testing for impairment are consist‑
ent with that of SFAS 121.
4
  We estimate 5, 3, and 10-year pre- and post- time periods surrounding the enactment of SFAS 141/142.
We also utilize a more recent sample in the post-period (2012–2016) and find consistent results for all tests.

13
 894 P. M. Johnson et al.

performance implications associated with the accounting changes for goodwill and other
intangibles assets. While prior research examines the associations of goodwill and good‑
will impairment with future financial expectations, it fails to test whether the information
is actually understood by market participants. We fill this void in the literature by using
the Kraft et  al. (2007) approach to assess whether investors understand the impact that
goodwill and other intangibles have on a firm’s future performance. Second, we analyze all
assets affected by SFAS 141/142. Prior research focuses only on goodwill given that it is
the largest and most identified intangible asset. However, SFAS 141 and SFAS 142 apply
to all intangible assets and the simultaneous accounting changes may impact investors’
ability to better understand future performance implications associated with these assets.
Overall, we find that investors have a better understanding of the future performance impli‑
cations associated with goodwill but not with other intangible assets or net assets.
The remainder of the paper proceeds as follows. Section  2 presents the background
and literature review. Section  3 explains the hypothesis development. Section  4 provides
an explanation of the sample selection and descriptive statistics. Section  5 presents the
research design and results, while Sect. 6 contains a brief summary and conclusions.

2 Background and literature review

2.1 SFAS 141

Prior to SFAS 141, an acquiring entity could choose between the purchase and pooling
method of accounting for a business combination. The purchase method requires that the
acquiring entity allocate the costs to the assets acquired and liabilities assumed based on
their estimated fair values at the date of acquisition. After the acquisition price is allocated
to all tangible and identifiable intangible assets and liabilities, any excess is recognized as
goodwill. Under the pooling method, the assets and liabilities acquired are recorded at the
carrying value of the entity acquired and there is no goodwill recognized in the exchange.
The accounting methods available for business combinations raised concern among ana‑
lysts and other financial statement users who indicated it was difficult to compare the finan‑
cial results of entities because different methods of accounting for business combinations
were used. Further, company managers indicated that the differences between the pooling
and purchase methods of accounting for business combinations adversely affected competi‑
tion in markets for mergers and acquisitions (FASB 2001b).5
To assist in the proper allocation of the acquisition price, SFAS 141 provides two cri‑
terion (the contractual-legal criterion and the separability criterion) to identify new intan‑
gible assets separate from goodwill.6 Prior to SFAS 141, there was very little guidance on
how to identify separate intangible assets, which afforded management discretion in how
to allocate the excess purchase price and typically resulted in excessive amounts recorded
as goodwill. Overall, SFAS 141 makes it more likely for firms to record goodwill (Frankel

5
  SFAS 141 was revised by the FASB in 2007 as SFAS 141(R). The revision provides additional guidance
for recognizing and reporting assets and liabilities that are acquired in a business combination. The revised
standard reinforces the FASB’s overall goal of providing financial statement users with better information
regarding business combinations.
6
  Only one of the two criterion needs to be met in order to identify a different intangible asset (FASB
2001a).

13
Did SFAS 141/142 improve the market’s understanding of net assets,… 895

et al. 2008), but the amount of goodwill is more likely to be lower due to the additional
intangible assets that are identified.

2.2 SFAS 142

Before the enactment of SFAS 142, there was little guidance on how to account for good‑
will or other intangible assets and subsequent impairment. Accounting Principles Board
Opinion No. 17, Intangible Assets (AICPA 1970) required that all intangible assets be
amortized over a period not to exceed 40 years. SFAS 121, Accounting for the Impairment
of Long-Lived Assets, required that management test for impairment when circumstances
indicated that the full recovery of goodwill or other intangibles was in doubt (FASB
1995).7 The impairment test compared estimated future undiscounted cash flows to the cur‑
rent book value of an asset group. If the undiscounted future cash flows were less than the
book value of the asset group then an impairment equivalent to the difference between the
estimated fair value and book value of goodwill was recognized.
Three major factors related to the accounting of goodwill and other intangibles were
altered with SFAS 142. First, certain intangible assets (i.e., goodwill, trademarks, etc.) are
now deemed to have indefinite lifespans and are no longer amortized. Henning and Shaw
(2003) find that, prior to SFAS 142, the amortization life of goodwill selected by man‑
agement is useful in predicting the success of the acquisition. However, once the life of
goodwill is selected, the annual charge is constant until goodwill is fully amortized. In dis‑
cussions with investors, the FASB found that amortization for indefinite-lived assets was
not a useful piece of information when analyzing an investment (Moehrle et al. 2001). This
is partially due to the recurring nature of amortization (i.e., the same amount each year),
which could easily be estimated by investors.
Second, goodwill and other indefinite-lived intangibles are required to be tested for
impairment at least once a year.8 In addition, SFAS 142 also requires that intangible assets
with an indefinite life (other than goodwill) be evaluated each year to determine if circum‑
stances still support an indefinite useful life. If the useful life is no longer determined to be
indefinite, then the asset is tested for impairment and the remaining carrying value is amor‑
tized over the newly estimated useful life. While major events may lead to a mass decline
in these assets, an annual test may be useful for investors to identify trends indicative of a
potential future economic decline. The annual tests are likely to increase the timeliness of
reported impairments.
Finally, SFAS 142 significantly altered the method of testing goodwill and other indef‑
inite-lived assets for impairment. Firms are required to use fair value (i.e., discounted
cash flows), rather than undiscounted cash flows to test for impairment at the reporting
unit level.9 The use of fair value results in a lower threshold for determining whether

7
  SFAS 144, Accounting for the Impairment or Disposal of Long-Lived Assets, was implemented in 2001
to replace SFAS 121 and does not apply to certain intangibles such as goodwill or intangibles with indef‑
inite useful lives (FASB 2001c). Under the new standard, the accounting for an impairment of a finite-
lived intangible is similar with three exceptions: (1) goodwill is no longer allocated to the long-lived assets
tested for impairment, (2) a probability-weighted cash flow model may be used, and (3) a “primary-asset”
approach is used to determine the cash flow estimation period.
8
  Intangible assets with a finite useful life are amortized over the estimated useful life of the asset. In addi‑
tion, when SFAS 142 was issued, the impairment tests for these assets still followed SFAS 121.
9
  SFAS 142 defines a reporting unit as “an operating segment or one level below an operating segment
(referred to as a component). A component of an operating segment is a reporting unit if the component

13
 896 P. M. Johnson et al.

impairment exists. In addition, the removal of the annual amortization of goodwill and
other indefinite-lived intangibles assets leads to a higher book value against which fair
value is evaluated. As a result, the dead book value of indefinite-lived assets (i.e., book
value in excess of fair value) that existed on the balance sheet prior to SFAS 142 should be
eliminated resulting in an asset with a stronger association with the future economic ben‑
efits that form the basis of the asset.

2.3 Literature review

Few studies examine the effect of SFAS 141 on companies or investors. From a lending
perspective, Frankel et al. (2008) find that as a borrower’s goodwill increases, lenders are
less likely to use a tangible net-worth covenant. However, they also find that the use of
tangible net-worth covenants has increased since the issuance of SFAS 141 and SFAS 142,
suggesting that the new standards decreased the contracting usefulness of goodwill in lend‑
ing decisions.
In contrast to SFAS 141, numerous studies examine the circumstances and consequences
of SFAS 142 specifically related to the impairment of goodwill. Henning et al. (2004) find
that firms delay writing off goodwill before SFAS 142. Hayn and Hughes (2006) apply
SFAS 142 standards to pre-SFAS 142 data and find that a reported goodwill impairment
lags behind economic impairment by 3 or 4 years. Using post SFAS-142 data, Jarva (2009)
reports that goodwill write-offs lag behind the economic impairment of goodwill. Li and
Sloan (2017) report that post-SFAS 142 goodwill impairments lag deteriorating operating
performance and stock returns by at least 2 years. Overall, these studies provide compelling
evidence that there is a significant lag between the economic impairment of goodwill and
when the impairment of goodwill is actually reported on the financial statements, suggest‑
ing a lack of transparency.
A number of other studies examine the discretion afforded to managers with SFAS 142.
Ramanna (2008) reports that lobbying support for SFAS 142 was increasing in a firm’s
discretion under the standard. He links that to the possibility that firms wanted to use dis‑
cretion to opportunistically recognize goodwill impairment. Consistent with that notion, Li
and Sloan (2017) conclude that management exploits the discretion afforded by SFAS 142
to delay goodwill impairment recognition, resulting in temporarily inflated goodwill bal‑
ances, earnings, and stock returns. Li et al. (2011) provides evidence to suggest that man‑
agers of firms with potentially impaired goodwill exercised their discretion within SFAS
142 to delay impairment recognition to avoid taking the loss. Finally, Ramanna and Watts
(2012) find evidence that managers use the discretion afforded by SFAS 142 consistent
with their individual incentives as predicted by agency theory. In addition, they find no
evidence that managers use their discretion within SFAS 142 to convey private information
regarding future cash flows.
Recent studies examine market and analyst reaction to the announcement of goodwill
impairments post-SFAS 142. Bens et  al. (2011) report a negative and significant market
reaction to the announcement of unexpected goodwill impairments post-SFAS 142. They
also report that the negative market reaction for high information asymmetry and larger

Footnote 9 (continued)
constitutes a business for which discrete financial information is available and segment management regu‑
larly reviews the operating results of that component” (FASB 2001a).

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Did SFAS 141/142 improve the market’s understanding of net assets,… 897

firms weakens following the enactment of SFAS 142. They conclude that this evidence is
consistent with SFAS 142 reducing the information content of goodwill impairments. In
contrast, Guler (2016) finds that unexpected write-offs are more correlated with returns
post-SFAS 142, suggesting an increase in the information content of goodwill impair‑
ments. Li et al. (2011) assess investor and analyst reaction to the announcement of good‑
will impairments. They report that both investors and analysts revise future estimates
downward after the announcement of an impairment loss; however, the downward revi‑
sions are lower post-SFAS 142 suggesting the nature of the information conveyed by good‑
will impairments has changed post-SFAS 142. While investigating acquired intangibles net
of goodwill, Makrominas (2017) finds a positive association with the market’s perception
of growth opportunities, indicating the usefulness of intangibles in an investor’s analysis of
a firm.
Finally, prior research examines the relationship of goodwill to future earnings and cash
flows. Tahat et  al. (2018) find that goodwill is positively related to future performance
(i.e., earnings per share, return on equity, and return on assets) for UK firms. Jarva (2009)
reports that goodwill impairments are associated with a decline in future expected cash
flows. Lee (2011) examines the ability of goodwill to predict future cash flows and finds
that it has improved subsequent to the enactment of SFAS 142. In contrast to the other
studies cited above, Lee (2011) reports finding no evidence that managers use their discre‑
tion within SFAS 142 to report opportunistically. Overall, Lee (2011) concludes that SFAS
142 improved the representational faithfulness of goodwill reporting and is associated to a
firm’s future performance. However, none of the prior studies ascertain whether SFAS 141
and 142 improve the information conveyed to financial statement users. We extend prior
research by assessing the extent to which investors understand the relationship between the
new accounting changes and future firm performance and determine whether the informa‑
tion related to these accounting changes are impounded into market prices.

3 Hypothesis development

3.1 Testable hypothesis of the perceived benefits associated with SFAS 142

The FASB’s main purpose in issuing SFAS 142 was to improve financial reporting related
to acquired goodwill and other intangible assets. In particular, the FASB stated:
The changes included in this statement will improve financial reporting because
the financial statements of entities that acquire goodwill and other intangible assets
will better reflect the underlying economics of those assets. As a result, financial
statement users will be better able to understand the investments made in those
assets and the subsequent performance of those investments. The enhanced dis‑
closures about goodwill and intangible assets subsequent to their acquisition also will
provide users with a better understanding of the expectations about and changes
in those assets over time, thereby improving their ability to assess future profit-
ability and cash flows (FASB 2001a).
With the necessity under SFAS 141 to identify and record intangible assets represent‑
ative of their economic substance, SFAS 142 was issued to improve financial reporting

13
 898 P. M. Johnson et al.

and provide guidance on the subsequent accounting for these assets.10 Prior to SFAS 142,
accounting for the impairment of intangibles with indefinite useful lives led to at least two
problems. First, the use of undiscounted cash flows as the impairment threshold results in
indefinite-lived intangible assets with dead book value (i.e., the book value of the intangi‑
ble asset exceeds its fair value). This inflated threshold reduced the likelihood of impair‑
ment recognition because no impairments are recognized unless the entire asset group is
deemed impaired (i.e., the undiscounted future cash flows are less than book value of the
asset group).
Second, under pre-SFAS 142 guidance, goodwill impairment may be recognized when
in fact goodwill is not impaired. For example, under SFAS 121 if goodwill was associated
with an asset group that was impaired, then the carrying value of goodwill was eliminated
before the value of any other asset was reduced. As a result, goodwill as well as other assets
may be misrepresented on the financial statements. Subsequent to SFAS 142, intangible
assets with indefinite lives are tested for impairment by comparing the book value to the
fair value of each asset based on the fair value of the reporting unit. Therefore, the FASB
believes it is less likely that indefinite-lived intangible assets will have dead book value and
it is more likely that the appropriate assets will be impaired subsequent to the enactment of
SFAS 142. However, there are concerns as to whether SFAS 142 will improve the financial
reporting of goodwill and other intangible assets.
Critics argue that fair value accounting negatively affects the quality of financial report‑
ing due to loss of verifiability and an increase in earnings volatility (Benston 2008; Dichev
2008; Lee 2011). Prior research suggests that managers have an incentive to delay or avoid
goodwill impairment because impairment recognition is associated with negative market
returns (Hirschey and Richardson 2002). In addition, there is compelling evidence that
managers use the discretion afforded in SFAS 142 to delay the recognition of goodwill
impairments (e.g., Ramanna 2008; Li and Sloan 2017; Li et al. 2011; Ramanna and Watts
2012). Finally, research suggests that opportunistic earnings management behavior is
potentially encouraged by SFAS 142 because the resulting financial statements are based
on unverifiable fair value estimates (Paugam et  al. 2015).11 In fact, Ramanna and Watts
(2012) state ‘‘agency theory predicts managers (all else equal) will, on average, use unveri‑
fiability in accounting judgment to opportunistically manage financial reports.”12
Given the potential for opportunistic reporting under SFAS 142, there is increased
uncertainty as market participants seek to evaluate the information content of goodwill
and other intangible assets and their association with firms’ future economic performance.
Additionally, managers have more discretion in using estimates for impairment testing and
in assigning goodwill to a reporting unit. The additional discretion and volatility in using
fair value estimates results in a more complex environment and challenges the potential
for market participants to better understand the future earnings and cash flow implications
with these assets after the regulatory change.

10
  As previously noted, SFAS 144 was also implemented a few months after SFAS 141 and SFAS 142.
While SFAS 142 focuses on the subsequent performance of intangible assets with indefinite useful lives
(FASB 2001a), SFAS 144 focuses on intangible assets with finite lives (FASB 2001c).
11
  Also see Hayn and Hughes (2006), Ramanna (2008), Ramanna, and Watts (2012).
12
  As discussed previously, prior research documents that managers use the discretion afforded in SFAS
142 to delay recognition of goodwill impairments all of which suggests uncertainty increased post-SFAS
142 (Ramanna 2008; Li and Sloan 2017; Li et al. 2011; and Ramanna and Watts 2012).

13
Did SFAS 141/142 improve the market’s understanding of net assets,… 899

With increased uncertainty and the complexity resulting from the unverifiable nature
of goodwill and other intangible assets, it is not entirely clear what impact SFAS 142 will
have on market participants’ ability to better understand the future performance implica‑
tions of these assets. Again, the underlying objective of SFAS 142 is to improve market
participants’ ability to impound the future earnings and cash flow implications of goodwill
and other intangible assets into market prices. Thus, our first and second set of hypotheses,
stated in the alternative form:

H1  Market participants more accurately impound the future earnings and cash flow impli‑
cations of goodwill subsequent to the enactment of SFAS 142.

H2  Market participants more accurately impound the future earnings and cash flow impli‑
cations of other intangible assets subsequent to the enactment of SFAS 142.

3.2 Testable hypothesis of the perceived benefits associated with SFAS 141

The main purpose of our study is to empirically test the FASB’s assertion that mar‑
ket participants’ better understand future performance implications subsequent to SFAS
142. However, SFAS 141, issued prior to SFAS 142, eliminated the pooling method of
accounting for business combinations. The previously allowed pooling method resulted in
the acquired assets being reported at their carrying value, which was not representative of
the economic substance of the acquisition. Thus, it was difficult to determine the future
economic benefits that would result from the assets acquired in the business combination.
The FASB and others believe that the net assets acquired using the purchase method better
reflect the underlying economic benefits associated with the assets acquired. Accordingly,
the FASB stated the following:
The changes to accounting for business combinations required by this Statement
improve financial reporting because the financial statements of entities that engage
in business combinations will better reflect the underlying economics of those trans‑
actions. In particular, application of this Statement will result in financial state‑
ments that: Better reflect the investment made in the acquired entity, improve
the comparability of reported financial information, and provide more com-
plete financial information… That additional information should, among other
things, provide users with a better understanding of the resources acquired and
improve their ability to assess future profitability and cash flows (FASB 2001b).
Based on these goals, we believe it is important to examine whether the use of the pur‑
chase method allows market participants to better understand the future performance impli‑
cations of acquired net assets following the issuance of SFAS 141. However, considering
that the pooling method did not result in additional intangible assets such as goodwill, the
question is whether the market understanding of assets as a whole has improved. This leads
to our third hypotheses, stated in the alternative form:

H3  Market participants more accurately impound the future earnings and cash flow impli‑
cations of net assets subsequent to the enactment of SFAS 141.

Prior research has not explored this aspect of SFAS 141. The changes associated with
SFAS 141 and 142 impact all assets including goodwill and other intangibles assets. Assets

13
 900 P. M. Johnson et al.

reflect the future economic benefits attributed to the firm. Therefore, it is imperative that
assets acquired subsequent to these accounting changes are examined to ascertain whether
the stated objectives of the FASB are realized. That is, do market participants better under‑
stand the future performance implications associated with these assets post-SFAS 141 and
142?

4 Research design and sample selection

4.1 Temporal market understanding of goodwill and other intangible assets

Hypotheses 1 and 2 predict that because of the expected impact of SFAS 142 on the report‑
ing quality of goodwill and other intangible assets, the market pricing of both goodwill and
other intangible assets improved subsequent to the enactment of SFAS 142. A long-stand‑
ing method used in prior research to address similar questions is the two-equation approach
developed by Mishkin (1983). One of the benefits of using the two-equation approach is
to ascertain whether the information related to these accounting changes are impounded
into market prices. Using this method, Ball and Bartov (1996) find that when current earn‑
ings are announced, investors react as if the predictable element of expected earnings have
not been fully impounded into market prices. Specifically, they find that current earn‑
ings are underestimated by 75%. Burgstahler et  al. (2002) expands on the predictability
of financial information by testing whether market participants fully impound a specific
component of earnings (i.e., special items) into market prices. Following the two-equation
approach, Burgstahler et al. find that market prices underestimate the effect of special items
by approximately 27%. Schmidt (2006) examines the tax change component of earnings
to ascertain whether the persistence and pricing implications are impounded into market
prices. Schmidt finds that the initial tax change component is more persistent for future
earnings than the revised tax change components, and that market prices underestimate the
persistence of the tax change component of earnings.
While the two-equation Mishkin (1983) test is insightful, it does have its limitations.
Kraft et al. (2007) note three main reasons to utilize OLS regression if possible. First, OLS
is easier to implement and understand and allows for including additional explanatory
variables.13 In their analysis, Kraft et  al. (2007) find that the coefficients are sensitive to
the exclusion of other explanatory variables and suggest including market-to-book, past
returns, and firm size as control variables. In addition to these, we include the standard
deviation of the prior year’s stock price and the US Gross Domestic Product to control
for firm risk and macroeconomic factors, respectively. Second, OLS is more comparable
across studies because the two-equation approach uses an iterative process with conver‑
gence criteria that can be modified for each study. Finally, in OLS it is easier to address
econometric issues. In their analysis, Kraft et al. compare the results of the two-equation
approach to those of an OLS regression and find that in using a large sample, such as ours,
the results are equivalent. An in-depth discussion of the comparability of the two-equation
approach to using an OLS regression is provided in “Appendix”.

13
  See Kraft et al. (2007) footnote #2, p. 1083 and section 6.2, pp. 1102–1106 for a detailed discussion of
this issue.

13
Did SFAS 141/142 improve the market’s understanding of net assets,… 901

As suggested by Kraft et al. (2007), we use an OLS regression to determine whether the
market better understands the future earnings and cash flow implications of goodwill and
other intangible assets after SFAS 142. PERFt represents the performance metric being
studied and is measured as INCt or CFt when testing the relationship with regard to earn‑
ings or cash flows, respectively. Considering the pre-/post-nature of our tests, we utilize
a fully interacted model, wherein we interact all the variables with PRE, an indicator for
observations prior to SFAS 142, and POST, an indicator for observations after SFAS 142.
We then test the difference between the coefficients of our variables of interest to determine
whether the market understanding has improved. The equation is as follows:
CARt+1 = 𝛽1 ∗ PRE + 𝛽2 ∗ PRE ∗ TAt + 𝛽3 ∗ PRE ∗ GWt + 𝛽4 ∗ PRE ∗ OIAt
+ 𝛽5 ∗ POST + 𝛽6 ∗ POST ∗ TAt + 𝛽7 ∗ POST ∗ GWt + 𝛽8 ∗ POST ∗ OIAt
+ 𝛽9 ∗ PRE ∗ PERFt + 𝛽10 ∗ PRE ∗ MBt + 𝛽11 ∗ PRE ∗ SIZEt
+ 𝛽12 ∗ PRE ∗ RTNt + 𝛽13 ∗ PRE ∗ GDPt + 𝛽14 ∗ PRE ∗ RISKt
+ 𝛽15 ∗ POST ∗ PERFt + 𝛽16 ∗ POST ∗ MBt + 𝛽17 ∗ POST ∗ SIZEt
+ 𝛽18 ∗ POST ∗ RTNt + 𝛽19 ∗ POST ∗ GDPt + 𝛽20 ∗ POST ∗ RISKt + et+4
(1)
Variable definitions are provided in Table 1. In this model, a significantly positive (nega‑
tive) coefficient indicates that the market underweighs (overweighs) the future earnings or
cash flow implications of that variable in the time period being tested. For H1 and H2
we are interested in the market’s ability to properly value the future earnings or cash flow
implications of GWt and OIAt, respectively. Evidence that the FASB was successful in pro‑
viding better information requires two things. First, β3 (β4) must be significantly different
from zero, indicating that the market does not correctly value the future implications of
GWt (OIAt) before SFAS 142. Second, the absolute value of β7 (β8) needs to be signifi‑
cantly less than the absolute value of β3 (β4).14 This indicates that the market improved in
its ability to incorporate the future earnings and cash flow implications of GWt (OIAt) after
the implementation of SFAS 142. The strongest evidence of improvement is present if β7
(β8) is not significantly different from zero, indicating that the market properly impounds
the future earnings or cash flow implications of GWt (OIAt) post-SFAS 142.

4.2 Temporal market understanding of net assets

H3 predicts that because of the expected impact of SFAS 141 on the quality of the net asset
reporting, the market pricing of net assets has improved subsequent to the enactment of
SFAS 141. Accordingly, we examine whether SFAS 141 influences the market understand‑
ing of net assets using an OLS regression similar to the one used to test goodwill and other
intangibles assets. The equation to test H3 is as follows:

14
  The purpose of this test is to determine whether the market becomes more accurate (i.e., does the over‑
all magnitude of the coefficient move toward zero). If one coefficient is negative and the other is positive,
this could result in a significant difference between the two time periods, but the market may simply have
changed from overweighting to underweighting the implication that the variable has on future earnings or
cash flows. Using the absolute value of both coefficients allows us to assess the change in magnitude, and
controls for this potential shift.

13
 902 P. M. Johnson et al.

Table 1  Variable definitions
Variable Definition

ASSETSt Total assets (AT) for firm i in year t

BVt Book value of equity (CEQ) for firm i in year t
CAR​t+1 The 12-month buy-and-hold security return for firm i beginning four months after the fiscal year
end for year t minus the value-weighted return of the benchmark size/book-to-market/prior year
return portfolio over the same 12-month period. (see Schmidt 2006 for description of portfolio
formations)
CFt Cash flows from operating activities (OANCF) for firm i in year t divided by total sales (SALE)
in year t
ΔCFt Change in CF from year t − 1 to year t
GDPt U.S. GDP (in trillions) in year t
ΔGDPt Change in GDP from year t − 1 to year t
GWILLt Goodwill (GDWL) for firm i in year t
GWt Goodwill (GDWL) for firm i in year t total sales (SALE) in year t
ΔGWt Change in GW from year t − 1 to year t
IBEt Income before extraordinary items (IB) for firm i in year t
INCt Earnings before extraordinary items (IB) for firm i in year t divided by total sales (SALE) in year
t
ΔINCt Change in INC from year t − 1 to year t
INTANt Intangible assets (INTAN) for firm i in year t
MBt MVAL divided BV for firm i in year t
ΔMBt Change in MB from year t − 1 to year t
MVALt Market value of equity for firm i in year t, calculated as the number of shares outstanding
(CSHO) multiplied by the fiscal year end closing stock price (PRCC_F)
NAt Net assets defined as book value of equity (CEQ) divided by total sales (SALE) in year t
OIAt Other intangible assets defined as intangible assets (INTAN) less goodwill (GDWL) divided by
total sales (SALE) in year t
ΔOIAt Change in OIA from year t − 1 to year t
PERFt Performance metric measured as earnings (INCt) or cash flows (CFt)
ΔPERFt Change in PERF from year t − 1 to year t
PRE 1 if the observations year is before SFAS 141/142 (1996–2000), 0 otherwise
POST 1 if the observations year is after SFAS 141/142 (2003–2007), 0 otherwise
RISKt Stock price volatility for firm i in year t − 1 measured as the standard deviation of the daily stock
price
ΔRISKt Change in RISK from year t − 1 to year t
RTNt Raw market return for firm i in year t measured as (­ PRCC_Ft –PRCC_Ft − 1)/PRCC_Ft − 1 where
PRCC_F is fiscal year end stock price
ΔRTNt Change in RTN from year t − 1 to year t
SIZEt Natural log of total assets (AT) for firm i in year t
ΔSIZEt Change in SIZE from year t − 1 to year t
TAt Tangible assets defined as book value of equity (CEQ) less intangible assets (INTAN) divided by
total sales (SALE) in year t
ΔTAt Change in TA from year t − 1 to year t

13
Did SFAS 141/142 improve the market’s understanding of net assets,… 903

Table 2  Sample description
Total

Panel A: Sample selection

All observations from with goodwill 1996–2007 139,638
Less:
 Missing data items from year t (43,922)
 Missing data items from years t − 1 or t + 1 (48,843)
 SFAS 141/142 adoption years (2001–2002) (7667)
 Missing final regression variables and trim at 1 and 99 percentiles (9223)
Final sample 29,983
Pre-SFAS 141/142 15,527
Post-SFAS 141/142 14,456
Fama–French Industry description All observations Pre-SFAS 141/142 Post-SFAS 141/142
industry code

Panel B: Proportion of top 10 Industries in the sample

35 Computer Hardware 9.92 9.43 10.44
37 Electronic Equipment 6.84 6.25 7.48
48 Trading 5.81 5.87 5.74
43 Retail 5.23 5.73 4.70
45 Banking 5.15 0.90 9.72
32 Communication 4.70 5.21 4.16
31 Utilities 4.12 4.26 3.97
36 Computer Software 3.92 4.19 3.63
46 Insurance 3.88 3.93 3.82
13 Pharmaceutical 3.66 3.52 3.81
Other 46.77 50.72 42.54
100.00 100.00 100.00

CARt+1 = 𝛽1 ∗ PRE + 𝛽2 ∗ PRE ∗ NAt + 𝛽3 ∗ POST + 𝛽4 ∗ POST ∗ NAt

+ 𝛽5 ∗ PRE ∗ PERFt + 𝛽6 ∗ PRE ∗ MBt + 𝛽7 ∗ PRE ∗ SIZEt
+ 𝛽8 ∗ PRE ∗ RTNt + 𝛽9 ∗ PRE ∗ GDPt + 𝛽10 ∗ PRE ∗ RISKt
+ 𝛽11 ∗ POST ∗ PERFt + 𝛽12 ∗ POST ∗ MBt + 𝛽13 ∗ POST ∗ SIZEt
+ 𝛽14 ∗ POST ∗ RTNt + 𝛽15 ∗ POST ∗ GDPt + 𝛽16 ∗ POST ∗ RISKt + et+4
(2)
All variable definitions are provided in Table 1. Consistent with the interpretation of the
coefficients in Eq. (1), evidence that the market better understands the future earnings and
cash flow implications of net assets (NAt) require that β2 be significantly different from zero
and that the absolute value of β4 be significantly less than the absolute value of β2. Again,
the strongest evidence of improvement is present if β4 is not significantly different from
zero, indicating that the market properly impounds the future earnings and cash flow impli‑
cations of NAt post-SFAS 141.

13
 904 P. M. Johnson et al.

4.3 Sample selection

Our sample consists of annual earnings data drawn from the Compustat annual data files
for two-time periods: (1) 1996 to 2000 and (2) 2003 to 2007. In additional testing, we
restrict the pre- and post-periods to 3 years (1998 to 2000 and 2003 to 2005) and expand
the pre- and post-periods to 10 years (1991 to 2000 and 2003 to 2012). For a more cur‑
rent test, we compare the original pre-period to a current post-period (1996–2000 and
2012–2016). The results are consistent for all of these variations.
We address the first time period as pre-SFAS 141/142 (1996 to 2000) and the second
time period as post-SFAS 141/142 (2003 to 2007). Sample selection criteria are sum‑
marized in Table 2, Panel A. For our primary empirical tests, we begin with a sample of
139,638 annual observations from 1996 to 2007. We eliminate 92,765 observations with
missing income before extraordinary items (IBE), operating cash flows (CFO), total assets
(ASSETS), fiscal year end stock price (PRCC_F), common shares outstanding (CSHO),
total intangible assets (INTAN), or goodwill (GWILL) in years t and t − 1 and returns data
on CRSP. We eliminate 7667 observations from the years 2001 and 2002, the period of the
SFAS 141/142 regulation change. Finally, we eliminate 9223 observations with missing
regression variables and by trimming at the 1 and 99 percent tails of all regression vari‑
ables. Our data requirements and sample selection criteria result in a test sample of 29,983
firm-year observations of which 15,527 (14,456) are in the pre- (post-) SFAS 141/142 time
period.
The industry breakdown of the final sample is provided in Table  2, Panel B. Overall,
the industry composition is consistent across time periods with the highest representation
being from the computer hardware, electronic equipment, and trading industries. Of note
is the change in the proportion of observations from the banking industry, which increases
from 0.90 to 9.72% from the pre- to the post-SFAS 141/412 time periods, respectively. All
results presented include the banking and other regulated industries. However, we also per‑
formed our analysis without these industries and the results are consistent.

5 Descriptive statistics and empirical results

5.1 Descriptive statistics

Descriptive statistics for the full sample are reported in Table 3. The sample firms in the
pre-SFAS time periods have mean (median) total assets (ASSETS) of approximately $1.7
billion ($55.7 million) and market value of equity (MVAL) of $2.1 billion ($44.8 mil‑
lion). Mean and median income before extraordinary items (IBE) is $82.2 million and
$0.4 million, respectively. For non-negative intangible assets (goodwill) observations,
the mean and median intangible assets (goodwill) is $156.7 ($134.1) and $2.7 ($3.4) mil‑
lion, respectively. The sample firms in the post-SFAS time periods have mean (median)
total assets (ASSETS) of approximately $5.2 billion ($153.2 million) and market value of
equity (MVAL) of $4.5 billion ($147.2 million). Mean and median income before extraordi‑
nary items (IBE) is $248.7 million and $2.1 million, respectively. For non-zero intangible

13
 Table 3  Descriptive statistics
Variable Pre-SFAS 141/142 (1996–2000; n = 15,527) Post-SFAS 141/142 (2003–2007; n = 14,456)
Mean SD Q1 Median Q3 Mean SD Q1 Median Q3

ASSETSt 1738.418 5045.081 4.112 55.687 219.259 5196.889 17,537.879 7.374 153.230 639.580
BVt 612.048 1765.351 0.719 28.583 106.148 1650.448 5561.048 1.535 75.363 257.515
MVALt 2054.782 10,669.277 0.938 44.804 193.448 4471.792 17,157.658 2.242 147.232 567.852
IBEt 82.226 351.268 − 3299.000 0.421 7.771 248.745 1175.404 − 3429.000 2.087 19.138
CAR​t+1 − 0.011 0.751 − 1.336 − 0.410 − 0.147 0.083 0.545 − 1.058 − 0.207 − 0.018
INCt 0.008 0.284 − 5.600 0.007 0.042 0.031 0.302 − 7.585 0.016 0.058
CFt 0.075 0.254 − 4.253 0.019 0.077 0.107 0.284 − 6.233 0.042 0.106
MBt 2.576 2.518 0.293 1.125 1.797 2.613 1.893 0.513 1.421 2.043
SIZEt 5.517 1.986 1.414 4.020 5.390 6.504 2.037 1.998 5.032 6.461
RTNt 0.090 0.596 − 0.840 − 0.278 − 0.017 0.190 0.537 − 0.671 − 0.127 0.086
RISKt 4.638 4.818 0.299 1.649 3.083 3.968 4.236 0.222 1.418 2.567
GDPt 9.105 0.761 8.100 8.609 9.089 13.040 1.054 11.511 12.275 13.094
TAt 0.715 0.941 0.026 0.237 0.430 0.805 1.008 0.023 0.268 0.533
Did SFAS 141/142 improve the market’s understanding of net assets,…

ΔTAt − 0.042 0.479 − 7.436 − 0.078 − 0.007 − 0.042 0.428 − 7.761 − 0.093 − 0.006
INTANat 156.710 561.848 0.001 2.737 14.363 496.923 1915.096 0.001 8.700 49.252
OIAt 0.042 0.087 0.000 0.000 0.003 0.049 0.085 0.000 0.002 0.017
ΔOIAt 0.004 0.041 − 0.179 − 0.002 0.000 0.000 0.044 − 0.343 − 0.007 0.000
GWILLat 134.102 428.408 0.005 3.424 16.070 406.896 1452.415 0.007 9.135 45.035
GWt 0.090 0.095 0.000 0.023 0.058 0.162 0.186 0.000 0.033 0.094
ΔGWt 0.008 0.050 − 0.178 − 0.010 − 0.001 0.007 0.076 − 0.301 − 0.014 − 0.001

Variable definitions provided in Table 1

a
 Statistics computed for non-zero observations only. For intangible assets (goodwill) in the pre- and post-period this is 8242 (5218) and 11,213 (9542) observations, respec‑
tively
905

13
 906 P. M. Johnson et al.

assets (goodwill) observations, the mean and median intangible assets (goodwill) is $496.9
($406.9) and $8.7 ($9.1) million, respectively.

5.2 Empirical results

We perform all of our empirical analyses on two future performance measures, earn‑
ings and cash flows, both in scaled levels (INCt and CFt) and scaled changes (ΔINCt and
ΔCFt).15 Thus, we have four separate tests for each hypothesis, levels and changes for two
different measures of future performance. We tabulate each of these analyses for our full
sample tests. However, we focus the discussion of the empirical results for the levels tests
with respect to INCt and CFt for two reasons. First, and most importantly, our results across
all tests are statistically consistent. That is, the levels and changes tests for INCt and CFt
lead to the same conclusions. Second, the additional manuscript length does not seem to
warrant additional explanation to discuss results that do not add to our understanding of the
hypothesized relationships.
To control for cross-sectional correlation, we cluster the standard errors at the firm and
year level in all of our regressions. In addition, we perform all of our analyses using the
Mishkin (1983) two-equation approach and find results that are consistent with the OLS
results presented in the tables.

5.2.1 Empirical tests of H1 and H2—full sample tests

H1 predicts that market participants more accurately price the future performance implica‑
tions (i.e., earnings and cash flows) of goodwill (GWt and ΔGWt) subsequent to the enact‑
ment of SFAS 142. Similarly, H2 predicts that market participants more accurately price
the future performance implications of other intangible assets (OIAt and ΔOIAt) subsequent
to the enactment of SFAS 142. The empirical tests of H1 and H2 are reported in Tables 4
(levels) and 5 (changes).
In Table 4, Panel A we report our test of goodwill and other intangibles. Looking at the
results for earnings, we find that the coefficient for PRE * GWt is − 0.367 and significant
while the coefficient for PRE  *  OIAt is not significant. This suggests that prior to SFAS
142, the market did not (did) fully understand the future earnings implications of goodwill
(other intangibles). Specifically, the market overweighted the future earnings implications
of goodwill. On the other hand, the coefficients for both POST * GWt and POST * OIAt are
not significant, suggesting that the market understands the future earnings implications of
goodwill and other intangibles after SFAS 142 was enacted.
In Table 4, Panel B we report the tests of the difference between the absolute value of
the pre-SFAS 142 coefficients and the absolute value of the post-SFAS 142 coefficients.
We find that the F-stat for the comparison of pre- to post-SFAS 142 coefficients for good‑
will (other intangibles) is 11.697 and significant (0.165 and not significant). This suggests

15
  Consistent with Lee (2011), we scale all of the variables in our main tests by sales. However, we note
that scaling by sales has its own problems, specifically for the earnings tests. Earnings divided by sales is
net margin, while net asset (goodwill) are the inverse of net asset (goodwill) turnover. Therefore, the predic‑
tion equation is testing if turnover influences the future net margin—not future profitability. Continuing this
scenario into the return regression, the analysis relates to whether the market understands the implications
of how NA/goodwill turnover influences net margin. Given this concern, we also run all tests using begin‑
ning stock price as the scalar and the results are consistent.

13
Did SFAS 141/142 improve the market’s understanding of net assets,… 907

Table 4  Empirical tests of H1 and H2 in levels

Variable INCt CFt

Panel A: OLS regression

PRE − 1.699*** − 1.698***
PRE * TAt − 0.006 − 0.007
PRE * GWt − 0.367*** − 0.360***
PRE * OIAt − 0.028 − 0.019
POST 0.463** 0.458**
POST * TAt − 0.002 − 0.003
POST * GWt − 0.053 − 0.055
POST * OIAt − 0.072 − 0.075
Controls
PRE * PERFt 0.038 0.080
PRE * MBt − 0.008 − 0.007
PRE * SIZEt 0.003 0.001
PRE * RTNt − 0.054* − 0.055*
PRE * GDPt 0.194*** 0.194***
PRE * RISKt − 0.004 − 0.004
POST * PERFt 0.055 0.075**
POST * MBt − 0.003 − 0.003
POST * SIZEt 0.012*** 0.011***
POST * RTNt − 0.013 − 0.013
POST * GDPt − 0.041*** − 0.040***
POST * RISKt 0.000 0.000
N 29,983 29,983
Adj. R-squared 0.06 0.06
INCt CFt
F-Stat F-Stat

Panel B: Inter-temporal difference test of absolute values

TAt 0.043 0.044
GWt 11.697*** 11.348***
OIAt 0.165 0.274

Variable definitions provided in Table 1

Standard Errors are clustered at the firm and year level
*, **, ***Statistical significance at the 0.01, 0.05 or 0.10 level, respectively

that the since the implementation of SFAS 142, the market has significantly improved (not
improved) in its ability to understand the future earnings implications of goodwill (other
intangibles). This supports H1, but does not support H2. Overall, this indicates that by
implementing SFAS 142 the FASB was successful in improving the information provided
regarding goodwill, but not other intangibles. However, given that our evidence suggests
the market accurately priced other intangible assets in the pre-SFAS 142 period (i.e.,
the coefficient on PRE * OIA is insignificant), it is not surprising we find no evidence of
improvement.

13
 908 P. M. Johnson et al.

Table 5  Empirical tests of H1 and H2 in changes

Variable ΔINCt ΔCFt

Panel A: OLS regression

PRE − 0.882*** − 0.884***
PRE * ΔTAt 0.007 0.008
PRE * PRE * ΔGWt − 0.427*** − 0.436***
PRE * ΔOIAt 0.116 0.108
POST 0.137 0.137
POST * ΔTAt − 0.007 − 0.008
POST * ΔGWt − 0.080 − 0.080
POST * ΔOIAt 0.054 0.054
Controls
PRE * ΔPERFt 0.054*** 0.059**
PRE * ΔMBt − 0.010 − 0.011
PRE * ΔSIZEt − 0.184*** − 0.180***
PRE * ΔRTNt 0.003 0.004
PRE * ΔGDPt 1.782*** 1.786***
PRE * ΔRISKt − 0.006* − 0.006*
POST * ΔPERFt − 0.004 − 0.008
POST * ΔMBt 0.002 0.002
POST * ΔSIZEt 0.005 0.006
POST * ΔRTNt − 0.026*** − 0.026***
POST * ΔGDPt − 0.204 − 0.204
POST * ΔRISKt 0.001 0.001
N 29,983 29,983
Adj. R-Squared 0.04 0.04
ΔINCt ΔCFt
F-Stat F-Stat

Panel B: Inter-temporal difference test of absolute values

ΔTAt 0.001 0.001
ΔGWt 4.848** 5.197**
ΔOIAt 0.035 0.026

Variable definitions provided in Table 1

Standard errors are clustered at the firm and year level
*, **, ***Significance at the 0.01, 0.05 or 0.10 level, respectively

In Table  4, we also report our test of goodwill and other intangibles with respect to
future cash flows. We find that the coefficient on PRE  *  GWt is − 0.360 and significant,
while the coefficient on PRE * OIAt is not significant. In contrast, we find that the coeffi‑
cients for POST * GWt and POST * OIAt are not significant. With regard to the future cash
flow implications of goodwill, these results indicate that the market did not fully under‑
stand the implications (i.e., overweighted) in the pre-SFAS 142 period, but does under‑
stand the implications in the post-SFAS 142 period. As for other intangibles, the results
indicate that the market understood the future cash flow implications in both time periods.

13
Did SFAS 141/142 improve the market’s understanding of net assets,… 909

Table 6  Empirical tests of H1 and H2 using purchase firms

Variable INCt CFt

Panel A: OLS regression

PRE − 1.730** − 1.724**
PRE * TAt − 0.003 − 0.005
PRE * GWt − 0.414*** − 0.420***
PRE * OIAt 0.203 0.223
POST 0.463*** 0.460***
POST * TAt 0.007 − 0.004
POST * GWt 0.053 0.047
POST * OIAt − 0.211 − 0.244*
Controls
PRE * PERFt − 0.089 0.088**
PRE * MBt − 0.024*** − 0.023***
PRE * SIZEt − 0.012 − 0.014
PRE * RTNt − 0.049 − 0.053*
PRE*GDPt 0.217*** 0.217***
PRE * RISKt − 0.006** − 0.006**
POST * PERFt 0.104 0.195**
POST * MBt − 0.007 − 0.008
POST * SIZEt 0.008*** 0.006***
POST * RTNt − 0.005 − 0.005
POST * GDPt − 0.038*** − 0.037***
POST * RISKt 0.002 0.002
N 8021 8021
Adj. R-Squared 0.09 0.09
INCt CFt
F-Stat F-Stat

Panel B: Inter-temporal difference test of absolute values

TAt 0.010 0.001
GWt 18.356*** 18.886***
OIAt 0.000 0.003

Variable definitions provided in Table 1

Standard Errors are clustered at the firm and year level
*,**,***Statistical significance at the 0.01, 0.05 or 0.10 level, respectively

Finally, in Panel B we find a significant improvement in the market’s understanding of

goodwill after SFAS 142 (F-stat = 11.348), but no improvement with regard to other intan‑
gibles (F-stat = 0.274). Again, this indicates that the FASB accomplished its goal of pro‑
viding better information with SFAS 142 with regard to goodwill (i.e., supports H1), but
not other intangibles (i.e., does not support H2). However, as above, we find no improve‑
ment post-SFAS 142 because the market accurately priced OIA in both time periods.
Table 5 presents the results of testing H1 and H2 using a changes model. The results of
the change tests in Table 5 are consistent in all respects with the results reported in Table 4.

13
 910 P. M. Johnson et al.

Overall, the evidence with respect to GW and ΔGW in Tables 4 and 5 suggests that market
participants better understand the future earnings and cash flow implications of goodwill
after the issuance of SFAS 142.

5.2.2 Empirical tests of H1 and H2—pre‑SFAS 141/142 purchase firms

One of the major changes with the implementation of SFAS 141 was the required use of
the purchase method for business combinations. Considering that some firms preferred
to use the pooling method but must now use the purchase method, it is possible that the
increased market understanding of goodwill is driven by the elimination of the pooling
method. Therefore, we re-estimate Eq.  (1) using a sample of firms that engaged in the
purchase method in both the pre- and post-SFAS 141/142 time periods.16 This provides
a direct test as to whether market participants’ ability to better understand future perfor‑
mance implication associated with the accounting change related to fair value assessments
required for goodwill under SFAS 142. The results are provided in Table 6 where the sub‑
sample is composed of 4015 firm-year observations in the pre-SFAS 141/142 period and
4006 firm-year observations in the post-SFAS 141/142 period. We limit our discussion to
the results with respect to the future INC tests because the CF tests yield consistent results.
In Panel A, the coefficient for PRE  *  GWt is − 0.414 and significant while the coef‑
ficient for OIAt is not significant in relation to earnings. The coefficients for POST * GWt
and POST * OIAt are not significant.17 Looking at the difference test in Panel B, the F-stat
for goodwill is 18.356 and significant and the F-stat for other intangibles is not significant.
In our analysis on cash flows we find consistent results with PRE  *  GWt having a sig‑
nificantly negative coefficient (− 0.420) and an insignificant coefficient for POST * GWt. In
testing the difference between periods, we again find a significant difference for goodwill
(F-stat = 18.886) and no difference for other intangibles. Overall, the evidence in Table 6
suggests that market participants better understand the future earnings and cash flow impli‑
cations of goodwill after SFAS 141/142.18
Even with the complexity of fair value estimates and the enhanced discretion that man‑
agement has to delay the reporting of goodwill impairment, the accounting change allows
market participants to impound more of the information associated with goodwill into mar‑
ket prices. These results support the notion that management discretion regarding fair value
does not impede market participants’ ability to understand complex transactions.

5.2.3 Empirical tests of H3—net assets—full sample tests

H3 predicts that market participants more accurately price the future earnings and cash
flow implications of net assets subsequent to the enactment of SFAS 141. The results for

16
 We identify these firms using Compustat data item ACQMETH. This data item provides codes that
allow us to determine whether the firm accounted for an acquisition of another entity using the pooling or
purchase method of accounting.
17
 Although the post-period coefficient for OIAt in the cash flow model is significant at the 0.10 level,
there is no intertemporal difference between the pre- and post-SFAS 141/142 coefficients. This indicates
no change in the information provided by the standards, yielding consistent results with those from the test
using income.
18
  We also utilized a changes model for the purchasing firms and find results (untabulated) that are consist‑
ent with the reported levels tests.

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Did SFAS 141/142 improve the market’s understanding of net assets,… 911

Table 7  Empirical tests of H3 in levels

Variable INCt CFt

Panel A: OLS regression

PRE − 1.689*** − 1.689***
PRE * NAt − 0.004 − 0.005
POST 0.467** 0.462**
POST * NAt − 0.003 − 0.004
Controls
PRE * PERFt 0.038 0.083
PRE * MBt − 0.007 − 0.007
PRE * SIZEt 0.001 0.000
PRE * RTNt − 0.053* − 0.054*
PRE * GDPt 0.192*** 0.192***
PRE * RISKt − 0.004 − 0.004
POST*PERFt 0.054 0.074**
POST * MBt − 0.003 − 0.003
POST * SIZEt 0.011*** 0.010***
POST * RTNt − 0.012 − 0.012
POST * GDPt − 0.041*** − 0.041***
POST * RISKt 0.000 0.000
N 29,983 29,983
Adj. R-squared 0.05 0.05
INCt CFt
F-Stat F-Stat

Panel B: Inter-temporal difference test of absolute values

NAt 0.002 0.002

Variable definitions provided in Table 1

Standard errors are clustered at the firm and year level
*,**,***Statistical significance at the 0.01, 0.05 or 0.10 level, respectively

the levels analysis are reported in Table 7. We also perform tests using a changes model,
but do not report the results because they are statistically identical to the levels results.
In Panel A, we find that the coefficient on PRE * NAt is − 0.004 and not significant and
the coefficient on POST  *  NAt is − 0.003 and not significant. This suggests that market
participants correctly price the predictable earnings implications of net assets before and
after SFAS 141. From the inter-temporal difference test in Panel B, we find that there is no
significant difference in the coefficients between the two time periods. However, as previ‑
ously noted, the lack of evidence of improvement is not informative with respect to SFAS
141 because we find the market accurately priced NA in both before and after SFAS 141.

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 912 P. M. Johnson et al.

5.2.4 Empirical tests of H3—net assets—pre‑SFAS 141 pooling firms

One of the major changes resulting from SFAS 141 was the elimination of the pooling
method of accounting for business acquisitions. If there is improvement in market partici‑
pants’ ability to better understand the future implications of these changes then the most
likely set of firms to find improvement are those that used the pooling method to account
for acquisitions in the pre-SFAS 141 period. To perform this test, we identify a subsample
of firms that used the pooling method to account for business acquisitions in the pre-SFAS
141 period and subsequently used the purchase method in the post-SFAS 141 period.19
This process yields 955 firm-year observations in the pre-period and 887 firm-year obser‑
vations in the post-period. Re-estimating Eq. (3) using this sub-sample of firms provides a
direct test of whether market participants impound the future earnings implications of net
assets of pooling firms subsequent to the enactment of SFAS 141.
We find (untabulated) that the coefficient on PRE * NAt is − 0.088 and significant and
the coefficient on POST * NAt is 0.032 and not significant. This suggests that SFAS 141
lead to an improvement in the ability of investors to price net assets. However, in test‑
ing the intertemporal difference we find no significant improvement of the market’s under‑
standing after the implementation of SFAS 141 (F-stat = 1.301). Although the evidence is
not conclusive, we provide some evidence that SFAS 141 was successful in making the
future performance implications of net assets easier to understand. In additional testing, we
utilize a changes model for the pooling firms and find results (untabulated) that are consist‑
ent with the levels tests.

5.3 Robustness tests

In addition to the empirical analyses noted previously, we performed multiple tests to

assess the robustness of our results. To control for the changing sample composition in our
primary analyses, we create a constant sample that requires a firm to be in both time peri‑
ods and re-estimate all of our analyses. We also eliminate observations from the two largest
industry segments in our test sample (Banking and Computer Hardware) and re-estimate
all of our analyses. In another test, we exclude observations from 1997 to 2000 to eliminate
the effect of the late 1990s dot-com bubble and re-estimate our analyses. Concerning our
sample window, we also test our hypotheses using a 3-year and a 10-year pre- and post-
SFAS 141/142 testing window. Finally, we also test the original pre-period (1996 to 2000)
against a current post-period sample (2012 to 2016). The untabulated results of all of these
additional tests are quantitatively and qualitatively consistent with our tabulated results.
As noted previously, Kraft et al. (2007) suggest that an OLS model can be used as an
alternative to the two-equation approach used by Mishkin (1983) and should yield quan‑
titatively and qualitatively similar results if properly specified. Accordingly, to assess the
sensitivity of our empirical results and conclusions in additional testing (untabulated), we
re-run all of our tests using the Mishkin (1983) approach. We find that each of our results
and conclusions are robust to this alternative method.

19
  We identify pooling firms using Compustat data item ACQMETH consistent with our method of identi‑
fying purchase firms (Table 7 tests).

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Did SFAS 141/142 improve the market’s understanding of net assets,… 913

6 Summary and conclusions

We extend the prior literature by examining the FASB’s assertion that the mandated
changes in SFAS 141/142 result in market participants being “better able to understand
the investments” made in assets (net assets, goodwill and other intangible assets) and
improve “their ability to assess the future profitability” that stem from these assets
(FASB 2001a, b). In so doing, we address whether market participants have a better
understanding of the future earnings and cash flow implications of goodwill, other
intangibles, and net assets from the pre- to the post-SFAS 141/142 time period.
Taken together, our evidence suggests that SFAS 141/142 had a significant effect on
market participants’ ability to understand better the future performance implications of
goodwill. On the other hand, we find little evidence that market participants have a bet‑
ter understanding of the future earnings or cash flow implications of net assets (SFAS
141) or other intangible assets (SFAS 142). In short, we find that the FASB accom‑
plished its goal of providing more information so that “…financial statement users will
be better able to understand the investments made in those assets and the subsequent
performance of those investments” (FASB 2001a), but only with respect to goodwill.

Acknowledgements We thank workshop participants at the University of Alabama, the 2013 BYU
Accounting Research Symposium, and the 2016 FARS Section Meeting for comments on early drafts of this
manuscript.

Appendix

The Mishkin (1983) test utilizes a two-equation approach to test whether the market
rationally prices accounting information. Following Kraft et al. (2007, pp. 1089–1091)
we can show that using an OLS regression will yield results that are equivalent to those
obtained with the Mishkin test. The first equation for the Mishkin test (or prediction
equation) assesses the impact that current information has on future earnings or cash
flows. The second equation (or pricing equation) tests the impact of current information
on future returns. In the context of our research question, we have the following set of
equations:
Prediction equation
PERFt+1 = 𝛾0 + 𝛾1 TAt + 𝛾2 GWt + 𝛾3 OIAt + 𝛾4 PERFt + 𝛾5 MBt
(3)
+ 𝛾6 SIZEt + 𝛾7 RTNt + 𝛾8 GDPt + 𝛾9 RISKt + vt+1

Pricing equation
CARt+1 = 𝛽(PERFt+1 −𝛾0 ∗ −𝛾1 ∗ TAt −𝛾2 ∗ GWt −𝛾3 ∗ OIAt −𝛾4 ∗ PERFt −𝛾5
(4)
∗ MBt −𝛾6 ∗ SIZEt −𝛾7 ∗ RTNt −𝛾8 ∗ GDPt −𝛾9 ∗ RISKt ) + et+4

To test whether the market rationally prices goodwill (other intangibles), we test whether
γ2 = γ2* (γ3 = γ3*). If they are not equal, then we conclude that the market is not efficient
with respect to goodwill (other intangibles).
To create a comparable OLS regression as in Kraft et  al. (2007), we can replace
PERFt+1 in equation (4) with the forecasting equation (3) so we have the following
model:

13
 914 P. M. Johnson et al.

CARt+1 = 𝛽(𝛾0 + 𝛾1 TAt + 𝛾2 GWt + 𝛾3 OIAt + 𝛾4 PERFt + 𝛾5 MBt

+ 𝛾6 SIZEt + 𝛾7 RTNt + 𝛾8 GDPt + 𝛾9 RISKt + vt+1
(5)
−𝛾0 ∗ −𝛾1 ∗ TAt −𝛾2 ∗ GWt −𝛾3 ∗ OIAt −𝛾4 ∗ PERFt −𝛾5 ∗ MBt
− 𝛾6 ∗ SIZEt −𝛾7 ∗ RTNt −𝛾8 ∗ GDPt −𝛾9 ∗ RISKt ) + et+4

Next, we combine the terms, so we now have:

( ) ( ) ( ) ( )
CARt+1 = 𝛽 𝛾0 −𝛾0 ∗ + 𝛽 𝛾1 −𝛾1 ∗ TAt + 𝛽 𝛾2 −𝛾2 ∗ GWt + 𝛽 𝛾3 −𝛾3 ∗ OIAt
( ) ( ) ( )
+ 𝛽 𝛾4 −𝛾4 ∗ PERFt + 𝛽 𝛾5 −𝛾5 ∗ MBt + 𝛽 𝛾6 −𝛾6 ∗ SIZEt
( ) ( ) ( )
+ 𝛽 𝛾7 −𝛾7 ∗ RTNt + 𝛽 𝛾8 −−𝛾8 ∗ GDPt + 𝛽 𝛾9 −𝛾9 ∗ RISKt + 𝛽vt+1 + et+4
(6)
This can then be rewritten as:
CARt+1 = 𝜑0 ∗ +𝜑1 ∗ TAt + 𝜑2 ∗ GWt + 𝜑3 ∗ OIAt + 𝜑4 ∗ PERFt + −𝜑5 ∗ MBt
(7)
+ 𝜑6 ∗ SIZEt + 𝜑7 ∗ RTNt + 𝜑8 ∗ GDPt + 𝜑9 ∗ RISKt + ut+4

where φ = β(γi − γi*).
Overall, this shows that estimating equation (7) is essentially equivalent to estimat‑
ing equations (3) and (4). Similar to Kraft et al. (2007) we note a few minor differences
between the two approaches. First, the omission of vt+1 potentially introduces some bias.
Considering that vt+1 is orthogonal to the other variables (i.e., they are included in the pre‑
diction equation) and due to the large sample size the bias is negligible. Second, the exclu‑
sion of vt+1 slightly increases the standard errors, which again is negligible due to the sam‑
ple size. Therefore, in an OLS regression like equation (7), testing whether a coefficient is
different from zero is equivalent to testing γi = γi* using the Mishkin test.

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