The Accounting Treatment of Goodwill, Idiosyncratic Risk, and Market Pricing

We study the relationship between goodwill and future returns by considering how the information content of goodwill before and after Statement of Financial Accounting Standards (SFAS) 142 affects idiosyncratic return volatility (IVOL). Contrary to expectations, previous research has documented that stocks with high IVOL have low future returns (IVOL anomaly). We build on research that shows that high IVOL is a function of low information on future earnings and define goodwill as a growth option that could be priced through IVOL. Our results show that, during the goodwill amortization period, IVOL is high and the IVOL anomaly is strong. In contrast, nonamortized and tested for impairment goodwill is informative and corrects the IVOL anomaly. We find evidence that SFAS 142's recognition of goodwill as an asset with indefinite useful life results in value-relevant information about firm growth options and future earnings, thus reducing IVOL, eliminating the IVOL anomaly, and creating an environment of more efficient market pricing of risk.