Accounting for Goodwill and Incentive to Invest in Intangible Assets

Abstract

I examine management’s investment decision under the traditional amortization rules for intangible assets and that under the new rules such as IAS 36, IAS 38, and SFAS 142 where costs of purchased goodwill are subject to periodic impairment tests. I find that under the amortization rules, the manager’s hurdle rate to invest in the internally generated asset (IGA) is greater than that of the shareholder. Under the impairment rules, the manager hurdle rate to invest in the IGA is even greater than that under the amortization rules. However, the manager employs another hurdle rate for a partial investment in the IGA. This is because the IGA may serve as a “cushion” and help reduce the impairment charges on the purchased goodwill. I provide the conditions under which optimal (and suboptimal) investment decisions occur. The results overall suggest that firms and standard setters consider the incentive side of the standards in addition to the valuation side which is currently the sole focus.

Keywords: Intangible Asset, Goodwill Impairment, Management Incentive, Investment Decision

JEL Classification: M40, M41