Moody's: Goodwill impairments lag economic indicators of heightened credit risk

As policymakers revisit the accounting for goodwill, a key question is whether an impairment model provides valuable information to investors, or other users of financial statements. To provide more clarity around the issue, Moody's Investors Service analyzed whether goodwill impairments are a leading indicator of heightened credit risk.

In a report that reviewed rating trends between 2006 and 2015, Moody's found that companies' ratings actually start deteriorating more than two years prior to a goodwill impairment, indicating that impairments validate, rather than predict, increasing credit risk.

"A lack of consistency in valuation and subjective assumptions, combined with little to no warning of impairments from limited disclosure, provide challenges to financial statement users," said David Chan, a Vice President, Senior Accounting Analyst at Moody's. "The subjectivity embedded in goodwill impairment accounting in the US limits its effectiveness and timeliness."

Speculative grade companies are generally more credit sensitive to impairment events than investment grade companies, Moody's found. The speculative grade companies demonstrated more overall ratings deterioration, starting earlier, and with a sharper decline at the time of impairment. Conversely, investment grade companies showed more credit deterioration after the impairment event than before, evidence of their higher tolerance to deteriorating credit conditions.

Moody's report also noted that the higher the impairment, the higher the credit risk. Companies that recorded significant goodwill impairments, on average, had lower credit ratings than companies that did not. Moody's also found that the size of the impairment correlates to the level and pace of ratings deterioration.

Moody's also observed that rating outlooks are, on average, negative more than a year prior to the impairment event. This illustrates that negative factors exist well before any impairment signifying a heightened credit risk.