HOW COMPANIES IN CHINA CAN USE GOODWILL ACCOUNTING IN EARNINGS

MANAGEMENT
This essay firstly defines the concept of earnings management and goodwill, and then analyzes how
companies in China can use goodwill accounting in earnings management.
Earnings management as defined by Healy and Wahlen (1999), results when managers use judgment in
financial reporting and in structuring transactions to alter financial reports to either mislead some
stakeholders about the underlying economic performance of the company or to influence contractual
outcomes that depend on reported accounting numbers.
Goodwill is the difference between the value of a business enterprise as a whole and the sum of the
current fair values of its identifiable tangible and intangible net assets, that is, an intangible asset that
arises as a result of the acquisition of one company by another for a premium value.
The Accounting Standards for Enterprises No. 20 on Business Combinations requires that any positive
balance of the cost of a business combination over the acquirers interest in the fair value of the acquirees
identifiable net assets shall be recognized as goodwill. The business reputation/goodwill upon initial
measurement shall be measured on the basis of its costs minus the accumulative impairment provisions
and cannot be amortised.
According to Accounting Standards for Enterprises No. 8 on Impairment of Assets, whether or not there
is any sign of possible assets impairment, the goodwill formed by the merger of enterprises and intangible
assets with uncertain service lives shall be subject to impairment test every year. Since goodwill is an
intangible asset, companies in China can use goodwill impairment in earnings management for the
reasons as outlined below.
For instance, before an IPO, the company to be listed on the Chinese stock exchange will want to have a
profit figure reported in its financial statements so as to have a high offering price for its shares. To
achieve this, management can purposely decide to reduce the value of goodwill resulting in higher
earnings. Since the impairment loss is not amortised, it will not affect the company earnings.
Goodwill accounting in earnings management can also be used by companies to avoid bankruptcy. By
manipulating the goodwill figure, a company can report positive earnings and avoid losses which may
have led to its bankruptcy.
For purposes of share price maximization, management can intentionally impair the goodwill value. This
results in better earnings for the financial period. As the share price is affected by the companys earnings,
a profit at the end of the financial period will increase the share price value.
Earnings management can also be used by companies to avoid being delisted from the Chinese stock
exchange. This usually results when a listed company reports consecutive losses for a number of years.
One of the tools used by companies to prevent reporting consecutive losses is to impair the goodwill
figure. With the impairment, companies are able to inflate their earnings.
The above are just a handful of the various means that companies can use goodwill accounting in earnings
management.