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... University of Memphis August 1998 Share- Market Reaction to Tax Law Changes: Tax Amortization o f Purchased Goodwill Major Professor: John M Malloy, Ph.D This study examines the market response to the...Reproduced with permission of the copyright owner Further reproduction prohibited without permission SHARE- MARKET REACTION TO TAX LAW CHANGES TAX AMORTIZATION OF PURCHASED GOODWILL A Dissertation... permission To the Graduate Council: I am submitting herewith a dissertation written by Stephen C Gara entitled “ShareMarket Reaction to Tax Law Changes: Tax Amortization O f Purchased Goodwill. ”
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Further reproduction prohibited without permission. UMI Humber: 9905087 Copyright 1998 by Gara, Stephen C. All rights reserved. UMI Microform 9905087 Copyright 1998, by UMI Company. All rights reserved. This microform edition is protected against unauthorized copying under Title 17, United States Code. UMI 300 North Zeeb Road Ann Arbor, MI 48103 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. Copyright ° Stephen C. Gara. 1998 All rights reserved ii Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. To the Graduate Council: I am submitting herewith a dissertation written by Stephen C. Gara entitled “ShareMarket Reaction to Tax Law Changes: Tax Amortization O f Purchased Goodwill.” I have examined the final copy of this dissertation for form and content and recommend that it be accepted in partial fulfillment of the requirements for the degree of Doctor of Philosophy, with a major in Business Administration. Malloy, Ph.D. Major Professor We have read this dissertation and recommend its acceptance: Kenneth R. Lambert, Ph.D. ^ /r f /■ ^dam es M. Lukawitz, PhTST Lars Gustafsson, LL. Accepted for the Council: Linda L. Brii^ley, Ph.D. U Vice Provost for Research and Dean of the Graduate School Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. DEDICATION This dissertation is dedicated to my parents and my grandmother Mr. Donald J. Gara Mrs. Carol B. Gara And Mrs. Madeline Gara for their emotional, financial and spiritual support. iii Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. ACKNOWLEDGMENTS I would like to thank my major professor, Dr. John M. Malloy, for his invaluable guidance and assistance in completing this dissertation. I would also like to thank my other committee members: Dr. Kenneth R. Lambert, Dr. James M. Lukawitz, and Professor Lars Gustafsson, for their comments and suggestions that have helped bring this paper to fruition. I would also like to thank Dr. Larry DuCharme for his comments on an earlier version of this manuscript. I would also like to acknowledge the assistance and guidance I received from my colleagues in the Ph.D. program at The University of Memphis. Furthermore, I’d like to recognize the many helpful comments and suggestions that I received from workshop participants at: Appalachian State University, Eastern Kentucky University, University of Arkansas-Little Rock, and St. John-Fisher College. iv Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. ABSTRACT Gara, Stephen C. Ph.D. The University of Memphis. August 1998. Share-Market Reaction to Tax Law Changes: Tax Amortization o f Purchased Goodwill. Major Professor: John M. Malloy, Ph.D. This study examines the market response to the adoption of an allowance for tax amortization o f purchased goodwill. Specifically, the study tests whether affected firms experienced positive abnormal returns flowing from the market’s perception of the cash flow impact of the change. This provision was included in the overall Omnibus Budget Reconciliation Act o f 1993. which was enacted on August 10, 1993. The new code section also contained a retroactive taxpayer election for acquisitions undertaken after July 25, 1991, two years prior to enactment. An event study methodology is utilized to analyze the market reaction upon final passage of the OBRA’93 on August 6, 1993. Abnormal returns to asset-acquiring firms are examined both in absolute terms and in association with the tax benefit generated from amortization. Market price reaction is studied using not only the traditional market model analysis, but also a seemingly unrelated regression model derived from prior regulatory change studies. The sample consists of firms that engaged in taxable acquisitions during the retroactive election period, July 1991 to July 1993, broken down into asset and stock purchasers, as well as into high and low-goodwill asset acquirers. The results o f this study indicate that the market did react to learning of final passage of OBRA’93 and its goodwill amortization provision. The market reaction for asset-acquiring firms with high goodwill, relative to total assets, experienced positive abnormal returns. A positive reaction was also observed for the Supreme Court’s decision in Newark Morning Ledger and the vote in the House of Representatives on an V Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. earlier version of the legislation. However, none of the observed market reactions were found to be related to the type o f acquisition or the magnitude o f goodwill purchased. vi Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. TABLE OF CONTENTS CHAPTER PAGE I. INTRODUCTION 1 II. BACKGROUND 6 Accounting and Tax Treatment of Goodwill Omnibus Budget Reconciliation Act of 1993 Financial and Tax Accounting for Mergers and Acquisitions III. 6 9 11 LITERATURE REVIEW 16 Capital Market Studies Tax Studies Goodwill Studies 16 17 19 IV. HYPOTHESIS DEVELOPMENT 25 V. RESEARCH METHODOLOGY 28 Sample Methodology 28 32 RESULTS 39 Passage of OBRA'93 Other Event Dates Revised Sample Diagnostics 39 40 41 44 VII. DISCUSSION 46 VIII. CONCLUSION 49 VI. LIST OF REFERENCES 51 APPENDICES 57 A. B. Tables List of Sample Firms 58 94 VITA 97 vii Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. LIST OF TABLES TABLE A-I. PAGE International Accounting and Tax Treatment of Purchased Goodwill 59 A-2. Description of Event Dates 61 A-3. Descriptive Statistics-Original Sample 62 A-4. Abnormal Returns For High-Goodwill Asset Acquirers-Final Passage of OBRA'93 64 Results o f OLS Regression Estimation for Hypotheses Two and Three-Final Passage o f OBRA'93 65 Results o f SUR Parameter Estimation for Hypothesis One-Final Passage of OBRA'93 67 Results o f SUR Parameter Estimation for Hypotheses Two and Three-Final Passage o f OBRA'93 68 Abnormal Returns For High-Goodwill Asset Acquirers-Other Event Dates 70 Results o f OLS Regression Estimation for Hypotheses Two and Three-Other Event Dates 71 Results o f SUR Parameter Estimation for Hypothesis One-Other Event Dates 74 Results o f SUR Parameter Estimation for Hypotheses Two and Three-Other Event Dates 76 Descriptive Statistics-Revised Sample 79 A-5. A-6. A-7. A-8. A-9. A -10. A-11. A-12. A-13. A-14. Abnormal Returns For High-Goodwill Asset Acquirers-Final Passage of OBRA'93-Revised Sample Results o f OLS Regression Estimation for Hypotheses Two and Three-Final Passage o f OBRA'93-Revised Sample 81 82 viii Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. A-15. Results of SUR Parameter Estimation for Hypothesis One-Final Passage of OBRA'93-Revised Sample 84 A-16. Results of SUR Parameter Estimation for Hypotheses Two and Three-Final Passage of OBRA'93-Revised Sample 85 A-17. Abnormal Returns for High-Goodwill Asset Acquiring Firms-Other Event Dates-Revised Sample 86 A -18. Results of OLS Estimation for Hypotheses Two and Three-Other Event Dates-Revised Sample 87 A-19. Results of SUR Parameter Estimation for Hypothesis One-Other Event Dates-Revised Sample 90 A-20. Results of SUR Parameter Estimation for Hypotheses Two and Three-Other Event Dates-Revised Sample 92 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. CHAPTER I INTRODUCTION The President signed the Omnibus Budget Reconciliation Act of 1993 (OBRA '93) (OBRA 1993) on August 10, 1993. The primary change incorporated within the statute was an increase in both personal and corporate tax rates.1 Additionally, changes were made in other areas such as expense and loss deductibility, transfer pricing, and estimated tax payments. Many of these changes were across the board with differing impacts on various firms. Despite the number of changes imposed by OBRA’93, the statute had far fewer changes than many prior, and subsequent, tax acts, such as the Tax Reform Act of 1986 (TRA’86) and the Taxpayer Relief Act of 1997. Given the relatively few changes, OBRA’93 presents fewer confounding elements. As a result, this change in law makes an excellent setting to assess the capital market’s response to a tax law change. Particularly, there were very few specific changes imposed in the merger and acquisition environment other than the one studied here, goodwill amortization. As a final note, OBRA’93 was a highly contested statute and, unlike prior tax acts that have been studied such as TRA’86, there was still a great deal of uncertainty leading up to final passage. The final vote in the U.S. Senate on August 6, 1993 was 51-50, with the Vice-President casting the tie-breaking vote. At least one senator had not disclosed his position until the final hours (CNN 1993). Accordingly, the risk of leakage or preannouncement market reaction was minimal. As a result, OBRA'93 presents a rare 1The statute added two higher marginal rates, 36 and 39.6 percent, for individuals, estates and trusts. The 1 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. opportunity to treat a regulatory change as a relatively clean event, similar to an earnings announcement.2 Many of the changes imposed by the statute were transaction-specific and others were industry-specific. One such transaction-specific provision was the addition of Section 197 to the Internal Revenue Code (IRC). This provision allowed for the amortization of goodwill over a 15-year period arising from asset acquisitions, thus reversing a long-standing prohibition against such deductibility. Moreover, this provision allowed taxpayers to elect to retroactively apply goodwill amortization to asset acquisitions completed after July 25, 1991. The allowance for goodwill amortization is thus restricted to firms that engage in taxable asset acquisitions, as opposed to stock purchases or tax-free reorganizations. This study examines the impact of passage of the OBRA’93 on the capital market’s revaluation o f affected firms, specifically corporate acquirers. Attention is focused on the effect of an allowance of goodwill amortization for firms undertaking taxable acquisitions and on the option for retroactive application. Specifically, this study compares the market reaction between asset-acquiring firms with substantial purchased goodwill, which could most utilize this provision, and stock-acquiring firms, which could not benefit from this allowance, as well as firms with insubstantial purchased goodwill. Mergers and acquisitions constitute major corporate events and entail utilization of substantial resources. The majority of these transactions entail payments of merger premia that exceed not only target book value but market value as well. This excess top corporate marginal rate was also increased from 34 to 35 percent. All the rate increases were retroactive to January 1, 1993 (OBRA Section 13201(a) 1993). 2 Alternative dates that will be examined as well as a sensitivity measure, include the date of original 2 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. payment, in the case of taxable acquisitions, constitutes goodwill. Goodwill has constituted a large sum in recent acquisitions. For example, 80 percent of Warner’s $14 billion acquisition o f Time was allocated to goodwill as was 90 percent o f Philip Morris’ $13 billion acquisition of Kraft (Hammond 1995).3 This study contributes to the extant accounting literature in a number of ways. First, the present study is one of only a handful of market event studies involving tax law changes. Market reaction is of significant interest to tax policy makers in assessing the economic impact of tax rule changes. Tax law changes, unlike changes in GAAP, produce real cash flow consequences. Prior literature has shown that firm value is a function of present and discounted future cash flows from which dividends can be paid (Ohlson 1990). Accordingly, this study posits that the allowance of goodwill amortization generates positive cash flows for the affected firms, resulting in a significant market reaction. This study inquires into the market’s assessment of the cash flow impact of the goodwill amortization provision and how investors have altered their valuations of the affected firms. A related point is that this study also measures the market’s assessment of the revenue effect of passage of OBRA’93 and the incidence of that effect on various firms, asset and stock-acquiring. Second, this study is unique in that the focus is on the retroactive application of the rule change to previously completed transactions. The sample firms in the present study had completed taxable acquisitions as of the date of passage. This allows a more direct assessment of the cash flow impact of the rule change, as the underlying House passage, May 25, Senate passage, June 24 and the Supreme Court’s decision in Newark Morning Ledger on April 20. 3 It should be noted that both figures represent the amount of goodwill for financial reporting and do not 3 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. transaction itself had already taken place and the terms and conditions had been established. Firm characteristics that are posited to be related to the market’s response, such as the magnitude of goodwill acquired in the transaction, are therefore known before the event occurs. This allows for isolation of the market’s response to passage, as opposed to disclosure of firm acquisition information. A third contribution o f the present study is methodological. Prior tax event studies have examined provisions that were industry-specific. The sample firms were in identical industries and experienced the same event dates. As a result, there was a high degree of cross-sectional dependence among firm returns. Correspondingly, prior studies were unable to utilize a market model based estimate of abnormal returns, instead utilizing a seemingly unrelated regression (SUR) approach. SUR is utilized frequently in regulatory change studies in which sample firms are in the same industry and the event dates are clustered in calendar time. Since the tax provision under study here is transaction-specific, not industry-specific, the SUR approach is not necessarily required. However, as the event date is identical for all sample firms, across calendar time, the present study utilizes both SUR as well as a market model to test for the presence of a market response. As a result, a comparison of the results across both methods will be made. A final contribution lies in this study’s use of a control group that completed taxable stock acquisitions, and thus unable to utilize the amortization provision of Section 197. The test group comprises firms that had completed taxable asset acquisitions during the retroactive election window. Control and test group firms are matched by size and necessarily correspond to the amount of goodwill for tax reporting (Douglass 1994). 4 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. industry. Since both groups of firms used cash as the consideration for the acquisition, the transaction was accounted for as a purchase, not as a pooling. As a result, both groups of firms are required to amortize any purchased goodwill for financial reporting purposes, but only the test group is allowed to amortize purchased goodwill for tax reporting purposes. The impact of goodwill amortization on reported earnings will be the same for both groups. However, the asset-acquiring group will also experience a positive impact from goodwill amortization on cash flows as a result of the new tax deduction. The utilization of control and test groups will also isolate the effects of OBRA’93 on asset -acquiring firms vis-a-vis other firms. Non-relevant attributes of the statute are controlled for, including any provisions relating to mergers and acquisitions in general. The remainder of this paper is organized into eight chapters. The next chapter, Chapter II, provides background information on the tax and accounting treatment of acquired goodwill, as well as the provisions of IRC Section 197. The third chapter provides a review o f the related literature on capital market studies, specifically tax law change and goodwill studies. Chapter IV develops and presents the hypotheses to be tested in the present study. The sample and research methodology to be utilized, including the tested models, are discussed and illustrated in Chapter V. Chapters VI and VII present the results and a discussion of their significance and limitations, respectively. The conclusion is provided in the last chapter, Chapter VIII. 5 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. CHAPTER II BACKGROUND Accounting and Tax Treatm ent of Goodwill The tax and financial accounting treatment o f goodwill has been in controversy for most of this century. Goodwill is an intangible asset and, as such, does not possess a physical existence o f its own. Additionally, goodwill does not possess a definite economic useful life, as opposed to tangible assets like property (excluding land), plant and equipment. Furthermore, goodwill does not possess a life limited by statute or contract, such as patents or non-competition agreements. Given goodwill’s almost mystic existence, it is no wonder its treatment has been subjected to differing opinions and practices, not only over time but across jurisdictions as well. Accounting Treatment There are three generally accepted treatments for acquired goodwill: immediate write-off, capitalization with amortization and capitalization without amortization (Volmer 1997). It should be noted that internally generated goodwill is not recognized for financial or tax accounting purposes. Instead, both call for the immediate deduction of expenditures designed to create or strengthen internal goodwill, such as advertising and research and development (Brunovs and Kirsch 1991). The financial accounting treatment has focused on the first two options; only New Zealand, alone among industrialized nations, allows the capitalization of acquired goodwill without any systematic amortization (Nobes and Norton 1996). While tax accounting has focused on 6 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. the latter two options, neither the United States nor any other industrialized tax regime allows the immediate write-off of acquired goodwill (Nobes and Norton 1996). The accounting treatment of goodwill in the United States is regulated by APB Opinion 17 (APB 1970b). Acquired goodwill is required to be capitalized, followed by systematic amortization over a period not to exceed 40 years. Most U.S. firms utilize the maximum recovery period, thereby limiting the amount of reported amortization expense (Hall 1993). However, the 40-year recovery period is fairly generous compared to a number of other industrialized nations. Accounting standards in Australia, France, Belgium and Germany require amortization over a much shorter period, generally no more than 20 years, sometimes as short as 5 years (Brunovs and Kirsch 1991; Nobes and Norton 1996). Furthermore, the goodwill standard issued by the International Accounting Standards Committee, IAS 22, requires amortization over a period not to exceed 20 years (IASC 1993). The diversity in international treatment of goodwill is further exemplified by nations such as the United Kingdom, Ireland and the Netherlands, which allow the immediate write-off of acquired goodwill against equity (Nobes and Norton 1996; Volmer 1997).4 As a result, there is no income statement impact of purchased goodwill in those countries. Tax Treatment The tax treatment in the United States has historically been to disallow any amortization of not only goodwill, but any intangible asset closely resembling goodwill. Treasury regulations prohibiting goodwill amortization were first issued in 1927 and 4 The ASB in the U.K. recently issued FRS 10, effective for fiscal years ending after December 31,1998. This standard requires acquired goodwill to be amortized over a period of no more than twenty years (ASB 1997). This standard supercedes SSAP 22, allowing immediate write-off of acquired goodwill. 7 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. subsequently carried forward to 1993 (Douglass 1994). The courts have denied deductions for not only goodwill amortization, but frequently for other customer-based intangibles, such as customer lists, relying on the “mass market” rule, developed by the Court of Claims in Golden State Towel & Linen Service (1967). Taxpayers have frequently been stopped by the often insurmountable requirement that the taxpayer prove the intangible asset in question had not only a distinct ascertainable value, but also a limited useful life (Bokinsky 1994; Hammond 1995). The government’s argument was that goodwill had no definite existence of a limited duration. As a result, there was no period over which to recover any amortization (Hammond 1995). Since its value is kept indefinitely, goodwill was not considered to be a wasting asset; consequently no deduction was allowed. It was not until August 1993, when the OBRA’93 was enacted, that this was changed. The government’s justification for denying amortization was often the same as that used by accountants and corporate managers in arguing against amortization for financial reporting; goodwill is not a wasting asset (Nobes and Norton 1996). This treatment was in sharp contrast to many other nations, particularly those in continental Europe where the tax treatment of goodwill followed the accounting treatment, allowing for the amortization of acquired goodwill against taxable income (Nobes and Norton 1996). For an illustration of the varying tax and accounting treatments for acquired goodwill see Table A -l.5 5 All tables are located in Appendix A. 8 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. Omnibus Budget Reconciliation Act of 1993 As stated earlier, OBRA’93 included numerous provisions affecting tax liabilities of individuals, corporations and other entities. Among the changes imposed were increased tax rates, restrictions on numerous deductions and tightened passive loss and transfer pricing rules (RIA 1993). However, the focus of the present study is on only one provision, goodwill amortization. OBRA’93 added a new code section, Section 197. to the IRC. Section 197 defined a new class of amortizable intangible assets, referred to as Section 197 intangibles.6 The cost of these intangibles is to be ratably amortized over a period of 15 years, from month of acquisition.7 Furthermore, to qualify for amortization treatment, the intangible asset must be acquired as part of the purchase of the assets of an on-going trade or business. Hence, only goodwill acquired as part of an asset acquisition qualifies. The enactment of Section 197 was designed to be revenue neutral, not a reduction. This was accomplished by providing for a uniform amortization period for all Section 197 intangibles. This included goodwill, which was previously not amortizable at all, as well as patents, covenants-not-to-compete, and government issued licenses. Many of these latter assets were previously written-off over a much shorter period (Bokinsky 1994). The revenue loss due to goodwill amortization was expected to be offset by extended recovery periods for these other intangible assets (Mackles 1993). Another reason for the adoption of Section 197 was to settle the anticipated litigation explosion to follow the Supreme Court’s decision in Newark Morning Ledger 6 These assets include: going concern, trained work force, covenants-not-to-compete, bank core deposits, customer lists and patents as well as purchased goodwill. 7A number of intangible assets are excluded from Section 197. These assets include: interests in 9 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. (Hammond 1995). The Court in that case ruled that there was no per se rule prohibiting amortization of intangibles if the taxpayer could establish a limited useful life and distinct value (Newark 1993). The Court in Newark held that the taxpayer had passed this twoprong test with regard to current subscribers, termed “paid subscribers” in the case, acquired in a newspaper acquisition. This ruling was considered to be an open invitation for taxpayers to judicially challenge IRS denials of amortization for intangibles (Hammond 1995). Section 197 was added to the code as a means of resolving this dispute by statute and thereby avoiding litigation. While the enactment date of OBRA’93 was August 10, 1993, the effective dates for numerous provisions were retroactive. The most notable example was the retroactive application o f the increased tax rates to January 1, 1993. Added Section 197 was generally effective for acquisitions on or after August 10, 1993. However, the provision gave taxpayers the option to apply Section 197’s terms retroactively to acquisitions completed after July 25, 1991. As a result, a firm that completed an asset acquisition, generating goodwill, between July 1991 and August 1993 could file an amended return taking a deduction for goodwill amortization (Pollack 1997). Such a filing would lower the reported taxable income of the prior year, generating a refund claim. The enactment of Section 197, along with the accompanying retroactive election, had an expected positive cash flow impact on firms that engaged in qualifying asset acquisitions. The event dates for the present study are the dates corresponding to Congressional approval. Approval by the President was of little doubt, as he was the strongest supporter for the statute. However, Congressional approval remained highly uncertain until the corporations, partnerships, estates or trusts, land, debt instruments, receivables, off-the-shelf computer 10 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. final moments before passage (Bokinsky 1994). As a result, the event utilized is the period running from August 3, 1993 to August 9, 1993. August 3 corresponds to the release date for the Conference Report on the statute, outlining the final language. The House of Representatives approved the bill on August 5 by a vote of 218 to 216. The Senate approved the measure on Friday August 6 by a vote of 51 to 50, with the VicePresident casting the deciding vote. Since final passage in the Senate occurred late in the afternoon, the following trading day is also included. A listing o f the dates is provided in Table A-2. Final passage of OBRA’93 changed the merger and acquisition landscape, particularly with regard to the treatment of acquired goodwill. Financial and Tax Accounting for Mergers and Acquisitions Financial Reporting Treatment The accounting method and treatment utilized for a particular merger or acquisition plays a pivotal role in determining the existence of amortizable goodwill. There are two methods used for acquisition accounting in financial reporting: pooling and purchase (APB 1970a). The pooling method treats the new and old firms as if they were always together. The target firm is carried on the acquirer’s books at its book value. There is no market value adjustment made to target assets, hence no goodwill is generated using the pooling method. However, there are 12 requirements that must be met before an acquisition may be accounted for under the pooling method (Davis 1990). The most significant restriction requires that at least 90 percent of the target be acquired software, sports franchises, leases of tangible property and futures or foreign currency contracts. 11 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. n exchange for stock o f the acquiring firm (APB 1970a). If any of these 12 restrictions is not met, the acquisition must be accounted for using the purchase method. An acquisition accounted for using the purchase method results in an increase in the target’s book-to-market ratio. While the pooling method treats the two firms, parent and target, as having been one entity all along, the purchase method is more pragmatic. The method requires that the value of the consideration paid for the target be allocated among the target’s assets to equate book value to market value. Any excess consideration paid above the market value of the net assets is allocated to goodwill. While goodwill will not arise under a pooling, it will often arise under a purchase. This purchased goodwill is then subject to amortization under APB 17 (APB 1970b). Tax Accounting Treatment The tax treatment of acquisitions follows the financial reporting rules rather closely. Presently, acquisitions may be either tax-free or taxable. The requirements for a tax-free, actually tax-deferred, acquisition are contained in Section 368 of the IRC.8 These requirements are very similar to those required for a pooling. One notable exception is that while a pooling requires at least 90 percent of the target be acquired in exchange for acquiring firm stock, Section 368 generally requires only 80 percent (Melone 1994).9 The requirements for a pooling are generally more stringent than those for tax-free acquisition. As a result, a transaction accounted for as a pooling is almost * Section 368(a) identifies seven forms of reorganization that qualify for tax-deferral. Two types o f transactions that are included in this group include the exchange of target assets or stock for stock o f the acquiring firm, sections 368(aXlXB) and (C). 9 Section 368(C) defines control as ownership of 80 percent of the total combined voting power and 80 percent of the total number of shares outstanding. Note that a statutory merger or consolidation (Type A reorganization) for ruling purposes requires that at least SO percent of the consideration used in the transaction consist of voting equity (Rev. Proc. 77-37, 1977-2 C.B. 568.). However, APB 16 requires the acquisition of at least 90 percent of the target firm’s equity in the transaction to qualify as a pooling. 12 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. always tax-free. A tax-free acquisition results in no gain or loss to the target, acquirer or either firms’ shareholders. Instead the acquirer takes a carryover basis in the target’s shares or assets, and the target or target shareholders take a carryover basis in the acquirer’s shares. Essentially this postpones any built-in tax liability until a subsequent sale. A taxable acquisition results in gain or loss to the target or the target’s shareholders. A taxable acquisition may be structured as an asset or stock acquisition. If the transaction is an asset acquisition, the target firm will realize gain equal to the difference between its assets’ tax bases and their market value. The acquirer will take a market value, usually stepped-up, basis in those assets. While the target will recognize any potential gain upon the sale, the acquirer gets the benefit of a stepped-up basis with a corresponding increase in depreciation and amortization deductions. Furthermore, it is only within the context of an asset acquisition that tax goodwill will arise, as the difference between the consideration paid and the total market value of the acquired assets. A stock purchase entails the purchase of target shares in exchange for cash or other consideration. The target firm itself is not a party to the transaction. The target shareholders recognize gain to the extent that the market value of the consideration received exceeds their basis in the shares. As only stock is acquired in a stock purchase, assets are not revalued and goodwill is not recognized. Additionally, Section 197 does not apply to a straight stock purchase as the statute’s application is limited to the context of a taxable asset acquisition. 13 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. However, the acquiring firm may undertake an election under Section 338 to treat the stock purchase as an asset acquisition. If this election is made, the acquiring firm's basis in the target's assets is stepped-up to market value and any excess purchase price over market value of the net assets is classified as goodwill. Moreover, if the transaction is treated as an asset acquisition under Section 338, then Section 197 would be applicable for any goodwill acquired in the transaction. However, if a Section 338 election is made, a gain is recognized on the revaluation of the assets equal to the difference between the consideration paid and the assets’ tax basis. Given this immediate gain recognition, Section 338 elections are rarely utilized (Melone 1994). Computation o f Goodwill The computation of goodwill is conceptually identical for both financial reporting and tax purposes. A number of countries define goodwill somewhat differently, though the concern here is with the U.S. definition (Nobes and Norton 1996). Goodwill in the United States is defined as the excess of the purchase price over the fair market value of net assets. Accordingly, goodwill is computed as the residual that remains after allocating the purchase price to all the identifiable net assets and bringing their book values up to market. Despite the conceptual definition of goodwill as the residual purchase price in excess of fair market value of net assets, there has not been a statutory definition for tax goodwill until Section 197 was added to the IRC in 1993. Section 197 defines goodwill as the value o f a trade or business that is attributable to the expectancy o f continued patronage, whether due to the name of a trade or business, the reputation of a trade or business or any other factor (Beil 1995). 14 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. The calculation of goodwill for tax purposes is accomplished using the residual method under Section 1060 of the IRC.10 Section 1060 applies only to the acquisition o f ssets that constitute a trade or business in the hands of the buyer.11 Accordingly, piecemeal asset acquisitions do not qualify for Section 1060 treatment and no goodwill arises. At the time OBRA’93 was enacted, this method classified assets into four categories or classes: cash, cash-equivalents, other tangible and intangible assets and finally intangible assets in the nature of goodwill. The purchase price is allocated to assets in each class up to each asset’s market value. Purchase price allocation starts with Class One assets, cash, and proceeds through Classes Two and Three. Any excess purchase price remaining after allocation to the first three categories is classified as goodwill, Class Four. Essentially, tax and book goodwill are both computed as the residual remaining after allocating cost among the other target assets (Nobes and Norton 1996). 10The allocation method under Section 1060 was amended for acquisitions after February 13, 1997. Temporary regulations issued by the Treasury Department now require an allocation among five classes of assets. The first three classes are the same as under prior law. However, class four assets include all Section 197 intangibles excluding goodwill and going concern. Class five, the residual class, includes Section 197 goodwill and going concern value (Treasury 1997). 11 Section 1060(c). 15 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. CHAPTER III LITERATURE REVIEW Capital Market Studies Capital markets research has played a major role in the development o f the extant accounting literature (Brennan 1991). The seminal work by Ball and Brown (1968) set the stage for what was to follow. Market-based research tests for information content of various firm announcements and other disclosures or external events. Studies have been undertaken regarding: earnings announcements (Ball and Brown 1968; Beaver 1968; Cornell and Landsman 1989), dividend announcements (Asquith and Mullins 1983), merger announcements (Dennis and McConnell 1986), performance plan adoptions (Gaver et al. 1992), LIFO adoptions (Jennings et al. 1992), and regulatory changes (Prager 1989; Smith et al. 1986). This study likewise tests for the information content of an external event, passage o f OBRA’93. As discussed earlier, this dissertation contributes to the extant capital market literature by extending it further into the tax arena. All of these studies are based upon the underlying hypothesis of market efficiency. This underlying premise posits that given efficiency, the capital markets impound all relevant information immediately upon its release (Fama 1991). Given this hypothesis, when a disclosure is made to the market, market price immediately adjusts to incorporate the new information. An examination o f this adjustment process and its speed and timing provide evidence of information content, as well as dissemination. The 16 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. present study will examine the market’s reaction upon learning of passage of OBRA’93 on August 6,1993. Tax Studies While event studies have numbered in the thousands, only a handful have involved changes in the tax environment. Additionally, many studies have examined regulatory events, such as banking deregulation, antitrust laws, environmental regulations and even cable television regulation. Only four studies to date have examined the security market reaction to tax law changes: Schipper and Thompson (1983), Bathke, Rogers and Stem (1985), Madeo and Pincus (1985) and Manegold and Karlinsky (1988). The present study further extends this stream of literature into the tax environment. Schipper and Thompson (1983) analyzed the impact of selected merger related regulations on the returns to acquiring firms, using a SUR approach. The sample used in their study consisted of firms that had announced and subsequently carried out aggressive acquisition programs. The events under study were the Williams Amendments to the federal securities laws, the Tax Reform Act of 1969, APB Opinions 16 and 17, and the SEC’s segment disclosure rules. Note that these events all took place during the late 1960’s and early 1970’s. One of these events, APB 17, is related to the present study in that it dealt with the amortization of goodwill. However, APB 17 required amortization for financial reporting, while amortization was disallowed for taxation purposes. As a result, APB 17 was predicted to have a negative impact, as opposed to the positive impact expected on enactment of Section 197. The authors’ results indicated a significant 17 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. negative market reaction to the Williams amendments and the 1969 Tax Reform Act. No significant reaction was observed for either the APB opinions or the SEC rules. Bathke, Rogers, and Stem (1985) (BRS) analyzed the impact of a series of tax acts on the price of a specific asset, flower bonds, used in estate planning. Flower bonds were government issued securities that, when originally issued, could be redeemed as payment for federal estate taxes. The selected acts all contained provisions affecting the desirability of flower bonds, either positively or negatively. BRS, through their analysis, looked at the bond market reaction to changes in tax law. Their results indicated that taxinduced market reactions did occur. However, their results were hampered by the thinness of the bond market and their small sample size. BRS's study illustrated the potential for market reactions to changes in tax legislation, including the bond markets. Madeo and Pincus (1985) studied the market reaction to adoption of the disallowance of time deposit interest tax deductions for financial institutions. Using a SUR methodology similar to that used by Schipper and Thompson (1983), they tested for an expected negative reaction to the disallowance. The authors included in their model parameters representing changes in market expectations of legislative action, negative and positive. Sample firms' returns were regressed on these parameters, as well as firm specific control variables, to measure the market impact. Their results confirmed the expected negative reaction. Madeo and Pincus (1985) illustrated the use of the SUR methodology as a powerful tool for tax research, for industry-specific and time-clustered events. Manegold and Karlinsky (1988) tested the market reaction to adoption of possessions corporation (PC) tax law changes. The changes imposed added restrictions 18 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. for availability of the PC tax credit for corporations operating within Puerto Rico. Using the same methodology as Schipper and Thompson (1983) and Madeo and Pincus (1985), Manegold and Karlinsky studied the impact o f the tax changes on returns to PC firms. The model parameters represented events expected to alter the market's expectation of adoption of the provision under study. Additionally, the authors looked at the sensitivity o f the market reaction to each firm's prior use o f the PC tax credit and they derived an estimation of the revenue to be generated by the new provision. The results indicated a significant impact on firm returns for all the event parameters, in the expected direction. Goodwill Studies Studies have also looked at goodwill itself, testing its information content and the significance of differential treatment in explaining firm market value and returns. Chauvin and Hirschey (1994) investigated the information content of disclosed goodwill numbers in determining firm value. Their results indicated that reported accounting goodwill accurately recognizes the intangible value of the sample firms and positively contributes to overall market valuation. A larger magnitude of reported goodwill, ceteris paribus, resulted in a larger firm valuation. These results were supported by Jennings, Robinson, Thompson, and Duvall (1996) (JRTD) in which the authors examined how reported goodwill asset and expense numbers relate to market equity values. Their results indicated a strong positive association between firm market value and the magnitude of goodwill, after controlling for other components of net assets. Additionally, JRTD found a negative association between firm equity value and reported goodwill amortization, after controlling for other 19 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. components of expected earnings (1996). Similar results were also found by McCarthy and Schneider (1995) relating disclosed goodwill levels to firm market value. The association between stock prices and increases in goodwill following a purchase transaction was examined by Hethcox (1995). An increase in goodwill following a merger indicates the presence of future amortization expense deductions and lower reported earnings. Using a sample of 88 mergers, accounted for as purchases, the author relates the firms’ year-end stock price to the increase in reported goodwill resulting from the merger. Hethcox finds that there is a significantly negative association between the stock price and increase in reported goodwill (Hethcox 1995). These results, that increased goodwill results in lower firm valuation, contradict those by Chauvin and Hirschey (1994). Chauvin and Hirschey’s results indicated that increased goodwill resulted in higher firm valuation. There are apparently two dimensions to goodwill. One dimension concerns the positive aspect of goodwill as a measure of intangible value o f the firm. The other dimension focuses on the negative aspect of goodwill as a source of amortization expense and lower reported earnings. Stock price has consistently been found to be negatively associated with reported goodwill amortization, and increases in goodwill following a merger. This association persists despite the absence o f any real cash flow impact to affected firms, through required goodwill amortization.12 The present study examines a situation in which required amortization leads to a real and positive cash flow impact. A recent goodwill market study was undertaken by Day and Hartnett (1997) using Australian data. Day and Hartnett examined the market reaction to the mandated change 12 However, it should be noted that required goodwill amortization will have adverse cash flow effects on 20 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. in goodwill accounting announced by the Australian Accounting Standards Board. AASB 1013, in June 1996. The event in question was a change in required amortization method for goodwill, mandating uniform use of straight-line amortization. Day and Hartnett found no significant market reaction surrounding the issuance of the new rule. According to the authors, this indicates the lack of any economic substance to the change, as it was merely a change in form or treatment. The mandated change had an adverse impact on reported earnings, but generated no cash flow effects for the affected firms (Day and Hartnett 1997). Choi and Lee (1991) and Lee and Choi (1992) studied the differential treatment of goodwill on merger premia. Under prior law goodwill was treated differently under financial reporting and tax rules. The authors compared the merger premia paid by U.S. firms with that paid by British, Japanese and German firms. Great Britain allows the immediate write-off of acquired goodwill against reserves, but does not allow an amortization deduction for tax purposes (ASC 1989). Germany allows both goodwill amortization and immediate write-off for financial reporting, and allows tax amortization over 15 years (Coopers and Lybrand 1991). While Japan requires goodwill amortization for financial reporting, but also allows amortization for tax purposes as well (Coopers and Lybrand 1991). The authors hypothesized that the differential treatment allowed British, German and Japanese firms to offer higher merger premia, creating an advantage over U.S. firms. The results of their study supported this hypothesis. The favorable goodwill treatment was significantly associated with the premium offered (Choi and Lee 1991; Lee corporate managers, to the extent their compensation is tied to reported earnings. 21 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. and Choi 1992). These results were an impetus to the adoption of Section 197. increasing the competitiveness of U.S. firms in the merger and acquisition market (Collins 1994). Weaver (1997) is the first to examine the economic impact of OBRA’93’s goodwill provision. Weaver analyzed the association between the enactment of the goodwill provision and the tax structure of corporate acquisitions. The analysis was between tax-free and taxable acquisitions, as well as between stock purchases and asset purchases. Weaver tested hypotheses that the probability of taxable acquisition was positively related to enactment of Section 197 and that given a taxable acquisition, the probability of an asset acquisition was positively related to enactment of Section 197 (Weaver 1997). Using data on completed acquisitions before and after enactment of OBRA’93, Weaver found a strong association between potential goodwill amortization and the tax status of the acquisition. A significantly positive relationship was found between enactment o f Section 197 and the occurrence of a taxable, as opposed to nontaxable, acquisition. However, a significantly negative relationship was found between the occurrence of asset, as opposed to stock, acquisitions and enactment o f Section 197 (Weaver 1997). One rationale offered by the author for this result was the inclusion and dominance of pre-OBRA’93 transactions in her study. The present study differs from Weaver’s in a number of aspects. The present study examines the impact o f Section 197’s enactment on the market’s valuation of affected firms and the change in investor beliefs and expectations. Weaver examined not market behavior, but the behavior of firm management in structuring corporate acquisitions. The present study analyzes the impact of Section 197 on the aggregate decision making of market participants, while Weaver analyzed the impact of Section 22 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. 197 on the decision making of firm managers. Additionally, Weaver’s study was prospective, examining the impact of Section 197 on subsequent acquisitions. The present study examines the impact of Section 197 on acquisitions previously consummated. Dhaliwal and Erickson (1998) examined the market reaction to three court rulings addressing amortization of purchased intangibles. These rulings included the Tax Court's decision in Ithaca Industries (Ithaca 1991) as well as the Third Circuit’s and Supreme Court’s decisions in Newark Morning Ledger (Newark 1991, 1993). The rulings addressed the treatment o f non-goodwill intangible assets, such as customer lists and assembled work force (Dhaliwal and Erickson 1998). The authors used a sample of reverse LBO’s and a large diverse cross section of Compustat listed firms, all of which were reporting intangible asset amortization for other than goodwill. While the results for the Ithaca decision and the Third Circuit’s decision in Newark were generally insignificant, a significant positive reaction was reported following the Supreme Court’s decision in Newark allowing amortization of an intangible asset entitled “paid subscribers” (Dhaliwal and Erickson 1998). As discussed above, the Supreme Court in Newark ruled that intangible assets, other than goodwill, were not nonamortizable per se. The taxpayer could amortize acquired intangibles if he could prove both a limited useful life and an ascertainable value (.Newark 1993). This ruling led the Congress to enact Section 197 as a means to limit the predicted “litigation explosion” that would follow (Hammond 1995). It should be noted that unlike Dhaliwal and Erickson’s (1998) study, the present study examines goodwill 23 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. firms. The authors above explicitly analyzed the market reaction for firms with non goodwill intangibles, such as customer lists or assembled work force. 24 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. CHAPTER IV HYPOTHESIS DEVELOPMENT OBRA’93 possessed a number of provisions beyond goodwill amortization. While goodwill amortization is the dominant provision under study, the most substantial change was an increase in both individual and corporate tax rates. Additionally, many of the remaining provisions were designed to increase reported taxable income, and as a consequence, tax liability. As a result, the overall statute was labeled a revenue raiser (Beil 1995). However, firms that engaged in asset acquisitions generating substantial goodwill benefited from the enactment of Section 197. Such firms were presented with a previously unavailable tax deduction and resulting positive cash flows. Accordingly, asset-acquiring firms should have faired better than the overall market upon passage of OBRA’93. This leads to the first hypothesis. HI: Asset-acquiring firms with substantial purchased goodwill experienced positive abnormal returns, relative to the entire market, upon passage of the Omnibus Budget Reconciliation Act of 1993. As stated above, the sample firms in the present study will be divided into a test and a control group. The provisions of Section 197 apply only to firms that have engaged in taxable asset acquisitions with reported goodwill. Accordingly, a test group consisting of firms that have completed taxable asset acquisitions will be utilized. The test group will be limited to asset-acquiring firms with substantial purchased goodwill, relative to other non-goodwill intangible assets, to isolate the effects of Section 197 on non goodwill intangible assets. The control group will include firms that have engaged in 25 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. taxable stock purchases, with reported values for goodwill for book purposes. As both groups contain firms that have reported goodwill for book purposes arising from recent taxable acquisition activity, their only distinction is the tax classification of the transaction and the presence of tax amortizable goodwill. This distinction is the focus of the following hypothesis. H2: Asset-acquiring firms with substantial purchased goodwill experienced positive abnormal returns relative to stock-acquiring firms with substantial purchased goodwill upon passage of the Omnibus Budget Reconciliation Act of 1993. The election to apply Section 197 retroactively requires firms to file an amended return for the affected year, claiming a refund based upon the reduced tax liability.13 Moreover, many Section 197 intangibles enjoyed shorter recovery periods under prior law. For example, patents with a remaining legal and economic life of 10 years are now amortized over 15 years, not the prior law’s 10-year recovery period. To the extent that these intangible assets are recovered over a longer time period, their cash flow impact will be negative (Weaver 1997). The greater the magnitude of the acquired goodwill relative to other non-goodwill intangibles, the greater the tax benefit and resulting positive cash flow. Accordingly, a comparison is made between asset-acquiring firms with proportionately greater acquired goodwill, relative to total intangibles acquired, and firms with proportionately less goodwill acquired. Firms with proportionately greater goodwill will receive greater benefit from enactment of Section 197. This magnitude effect leads to the third hypothesis. 13 Additionally, Temp. Tres. Reg. Section 1.197-1T requires that a notice of the election be filed with the acquirer’s tax return for the tax year that includes August 10, 1993, accompanied by any amended returns for affected prior years. 26 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. H3: Asset-acquiring firms with substantial purchased goodwill experienced positive abnormal returns relative to asset-acquiring firms with nonsubstantial purchased goodwill upon passage of the Omnibus Budget Reconciliation Act of 1993. Purchased goodwill is considered substantial relative to total purchased intangibles. The ratio of purchased goodwill to total assets of the acquiring firm is another measure that is also utilized. Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. CHAPTER V RESEARCH METHODOLOGY Sample The sample firms used in this study consist of firms that completed taxable acquisitions during the period July 26, 1991 to June 30, 1993.14 The retroactive election window covers the period July 26, 1991 to August 9, 1993. The decision to cut off the sample on June 30 (second quarter 1993) is to ensure that the acquisition is completed, and all terms disclosed, well before the statute is passed. This increases the likelihood that any observed market reaction is due to passage of the statute, not the disclosure of information related to the acquisition. The taxable asset acquisition sample includes acquisitions that fall under the jurisdiction of Section 1060. Only transactions that involve the acquisition of assets that constitute a trade or business are included. This would include both acquisitions of stand-alone firms as well as asset acquisitions following divestitures of ongoing businesses (i.e. selling off a corporate division) {Mergers and Acquisitions 1993). Finally, the sample selection process excludes financial firms (SIC codes 60-67). These firms generally experienced negative abnormal returns during this period as well as possess an unusual composition of intangible assets, such as core deposits (Adkins 1997). 14 Alternative event dates corresponding to congressional approval of the original version of the statute will be examined as well, April 20, May 24 and June 25, 1993. The sample period for these alternative date will end on March 31, April 30 and May 31, 1993 respectively. 28 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. The full sample is first divided into two sub-samples. The first sub-sample consists of firms that made asset acquisitions (test group). The second group is comprised of firms that completed stock purchases (control group). Section 197 only applies to goodwill acquired as part of an asset purchase. The control and test groups are further matched according to size and industry membership. Therefore, the only difference between the two groups is the tax treatment of the purchased goodwill. The asset and stock-acquiring firms are further broken down into two sub-groups according to the relative magnitude of acquired goodwill, compared to total intangibles acquired. Asset and stock acquirers are ranked according to the proportion of total intangibles acquired consisting of goodwill. Firms in the top forty-percent comprise the high- goodwill group. Firms in the bottom forty-percent will comprise the low-goodwill group. As the first hypothesis focuses on high-goodwill asset acquirers and the second and third hypotheses compare that group to high-goodwill stock acquirers and lowgoodwill asset acquirers respectively, low-goodwill stock acquirers are not utilized in this study. Prior literature has indicated that the prevalence of Section 338 elections has significantly dropped off after 1986 as a result of TRA’86’s repeal o f the General Utilities doctrine (Melone 1994). While an election under Section 338 allows a step-up in basis and qualifies a transaction to fall under Section 197, it comes with substantial cost, namely immediate gain recognition on the assets, unless the target possesses a NOL to offset the recognized gain. It is assumed that none of the stock-acquiring firms made a Section 338 election. 29 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. Sample firms were identified from a listing of acquisitions obtained from IDDUS/NEXIS, MergerStat, Mergers and Acquisitions and footnotes to firm financial statements (NAARS/NEXIS). The time period, as stated above, is July 26, 1991 through June 30, 1993 for the original event date. The sample was limited to acquisitions in which cash was clearly identified as the consideration used for payment, not the acquiring firm's stock. This last step ensures that only taxable acquisitions are included. Only firms in which the type of acquisition was clearly specified are included in the sample. A result of this limitation is a smaller sample size, but with a clear distinction as to type of acquisition (asset or stock purchase). Three earlier event dates are also examined. As a result, firms with acquisition dates after or close to these event dates are dropped as well. This resulted in a small reduction of firms for those earlier event dates. Financial data is obtained from Compustat. News announcement dates are obtained from the Wall Street Journal Index. Stock return data is obtained from CRSP (Center for Research on Securities Prices) tapes. Firms without data available on Compustat and CRSP for the years in question are dropped from the sample. The resulting sample size is 45 firms for the original event date, passage of OBRA’93. These firms are broken down into three groups: stock acquirers, highgoodwill asset acquirers and low-goodwill asset acquirers. Each group contains fifteen firms. As discussed in the next chapter, a second, and larger, sample is used as well, consisting of 61 firms. This second sample is also broken down into three groups. Table A-3 discloses the descriptive statistics for the original sample of 45 firms, broken down by category. A list of the sample firms is included in Appendix B. All 30 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. three groups are of approximately equal size, based on total assets. Additionally, the measure used to categorize the firms (goodwill/intangibles) differs between the low and high-goodwill asset acquirers (M = 100% for high and 41% for low) and does not substantially differ between the high-goodwill asset acquirers and the stock acquirers (.1/ = 98%). However, the stock-acquiring firms do possess substantially more total goodwill than either group of asset acquirers, almost three times as much. Given the relatively equal asset size, a ratio of goodwill over total assets (not shown) places the stock group fairly high and the asset acquirers fairly low, with the low-goodwill group actually ranking slightly higher. As a result, an enlarged sample of firms using a different measure, purchased goodwill over total assets of the acquiring firm, is used to categorize the firms and measure the relative magnitude of goodwill. Note that while most measures o f financial performance and leverage were approximately the same, the stock acquirers had a larger 1993 federal tax liability (A/= $43.5 million versus $10.3 million and $23.1 million for high and low-goodwill asset acquirers respectively). The descriptive statistics for the expanded sample is illustrated in Table A-12. For this sample, the ratio of purchased goodwill to total assets of the acquiring firm was used as the goodwill measure and as the basis for categorizing firms. First note that the ratio of goodwill to total assets is larger for the high-goodwill versus the low-goodwill group (Af= 5% and .6%, respectively). Additionally, the high-goodwill firms had substantially more goodwill on their books than the low-goodwill firms (A/= $59.8 million and $3.3 million). As a result of this categorization, both groups o f asset acquirers have similar size, based on total sales, and financial performance. As with the original sample, the stock acquirers paid more in federal taxes in 1993 as well (M= 31 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. $40.5 million versus $12.5 million and $22.3 million for high and low-goodwill asset acquirers respectively). Methodology The traditional event study entails the use of a market model regression to generate expected returns (Peterson 1989; Sharpe 1963). The difference between the expected returns and the firm’s actual returns is defined as the abnormal return arising from the event under study. However, prior tax event studies have not utilized this model, instead utilizing seemingly unrelated regression, in which the abnormal returns are parameterized into the model (Peterson 1989; Madeo and Pincus 1985). The focus in the SUR approach is on the model coefficients, not the model’s residuals (Binder 1997). A discussion of the SUR based model is below, preceded by an discussion of the market model based approach. Market Model Approach The event date under study, t=0, is August 6, 1993.IS That was the date of final Senate passage of the statute. The test period, for computing abnormal returns, is from t3 to t+1.16 The estimation period, for computing model coefficients, is the 100 days preceding the test period, t-4 back to t-103. A 100-day estimation period is used frequently in market event studies (Peterson 1989). The market model below is utilized to develop estimated returns: 13 Alternative event dates corresponding to congressional passage o f the original version of the statute will be examined as well as the Supreme Court’s decision in Newark Morning Ledger. However, the focus of the present study is on final passage of the conference report by the Senate on August 6,1993. 32 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. R 't a ( 1) + ffi^ r r t where R« is the stock return for firm on date t and Rm, is the return for the market index on date t as well. Abnormal returns are then defined as the difference between actual returns, R , and estimated returns, R , using the equation below: AR^R.-R,, (2) where AR is the abnormal return for firm i on date t. The cumulative abnormal return, CAR, for firm / is computed below for the event period (i.e. from August 3 through August 9, 1993). Note that August 7 and 8, 1993 were not trading days: i CAR, = £ AR, I (3) /= .-3 These cumulative returns are then averaged across the n firms, as well as separately for asset and stock purchasers, as: ACAR = - Y C A R i (4) where ACAR is the average cumulative abnormal return for the sample firms. The first hypothesis will entail computing the average cumulative abnormal returns for the asset-acquiring firms. The test statistic for the first hypothesis is computed 33 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. by dividing the value of ACAR by its standard error, thereby generating a test statistic that follows a r-distribution (Peterson 1989). ACARS = - CAR SE (5) where ACARS is the standardized cumulative abnormal return and SE is the standard error of the ACAR. The second hypothesis is tested by regressing the CAR for each firm on a dummy variable (TYPE) corresponding to the firm’s classification as either high-goodwill stock acquirer (TYPE=\) or high-goodwill asset acquirer (7TP£=0), equation 7 below. As predicted for hypothesis two, the CAR for the high-goodwill stock acquirers is expected to be lower than the CAR value for the asset acquirers. Accordingly, the coefficient on TYPE is expected to be significantly negative. The tax benefit from amortization is a function of the magnitude o f purchased goodwill. The greater the goodwill acquired in the acquisition relative to the total intangible acquired, the greater the annual Section 197 amortization and corresponding tax benefit. The third hypothesis is tested by the addition of another binary variable in equation 7 (GW). GW will equal one for low-goodwill asset acquirers and zero for highgoodwill asset acquirers. As predicted for hypothesis three, the CAR for the lowgoodwill asset acquirers is expected to be lower than the CAR for the high-goodwill asset acquirers. Accordingly, the coefficient on GW is also predicted to be negative. 34 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. The categorization of the firms into high and low relative goodwill is accomplished by computing the ratio of purchased goodwill to total purchased intangible assets for each firm. As stated during the development o f hypothesis three, firms with high levels of purchased goodwill benefited from enactment of Section 197, while firms with high levels o f other intangibles (i.e. patents) were made worse off by Section I97's longer recovery period. Firms were ranked according to this ratio. Only the top and bottom 40 percent were retained in the sample. The middle 20 percent was dropped. Firms in the top group had a value of 0 assigned for GW; the bottom group assigned a value of 1 for GW. The elimination of the middle 20 percent produced a final sample size of 45 firms. The level o f purchased goodwill was computed using the following formula, which is similar to the formula used for computing purchased intangibles (Schisler, McCarthy, and Schneider 1994): GWP = GW, - GW0 + AM, (6) where GWP is the amount of goodwill purchased in acquisition, GW, is goodwill reported after the acquisition, GW0 is goodwill reported before the acquisition, and AM, is the amount of goodwill amortization for the year of acquisition. Firms’ abnormal returns during the event period will also be affected by any news or other announcements related to the firm or the firm’s industry. Accordingly, a control variable, NEWS, is included to control for any news announcements or firm disclosures 35 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. during the event period (NEWS=l). There is no predicted sign for this variable's effect as the news or disclosures may have varying influences on each firm. CAR, = a 0 + a {TYPE, + a 2GWr + a }NEWS, (7) SUR Approach Traditional capital market research in accounting has utilized the methodology described above (Ball and Brown 1968; Peterson 1989; Binder 1997). This has involved the use of a market model to generate estimated or ‘‘normal” returns, with which abnormal returns are calculated. The standard approach in event studies involves the aggregation of unexpected security returns, estimated as the residuals from the linear market model, which is equation 1 (Manegold and Karlinsky 1988). However, one of the underlying assumptions of the market model regression is cross-sectional independence o f firm returns. When the event under study occurs at the same time for all firms in the same industry, potential dependencies between unexpected returns make aggregating abnormal returns problematic (Peterson 1989). As a result, prior capital market event studies in tax have utilized a seemingly unrelated regression (SUR) approach to estimate the market reaction to the event, tax law change (Madeo and Pincus 1985; Manegold and Karlinsky 1988). The SUR methodology obviates this problem by explicitly incorporating cross-sectional interdependencies among firm returns when the time period is identical for all firms. The necessity of using SUR in the present study is not settled. While this study entails an examination of an event date that is identical in calendar time across all firms, 36 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. the firms are not restricted to one or two industries, as in prior tax studies. The firms in the present study represent over twenty industries. According to Binder (1997) as well as Brown and Warner (1985), the use of a market model compensates for any crosssectional dependence, in the absence of either event date orjindustry clustering. Accordingly, a market model based test of the hypotheses is also carried out, as discussed earlier. The contribution from this two-prong test is the opportunity to compare results between methods. Two SUR models are utilized in the present study. The first model, SUR 1, consists of only returns for the high-goodwill asset acquirers, to test hypothesis one (equation 8a). The second model, SUR 2, consists of returns for the full sample of firms, both asset and stock acquirers, to test hypotheses two and three (equation 8b). An EVENT variable will be used in SUR 1 to capture the effect of passage of OBRA’93 on firm returns. Dichotomous variables (TYPE and GW) are used, similar to equation 7, to measure whether the firm is a high-goodwill asset or stock acquirer and whether the firm is a high-goodwill asset acquirer or low-goodwill asset acquirer. Both variables are interactive with EVENT. Unlike the traditional market model approach, the SUR method combines estimation and testing into a single run. Additionally, abnormal returns and residual variances are allowed to differ across firms in the sample (Madeo and Pincus 1985). Essentially, the SUR approach uses an equation that parameterizes the abnormal return measure, by including event day dummy variables in a modified market model regression, E VENT (Peterson 1989; Binder 1997). The focus of the tests is on the estimated coefficients for the event date variables, not on the model’s residuals. The 37 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. coefficient estimates reflect the market effects related to passage o f the OBRA'93, specifically the introduction of Section 197. The estimated coefficient on the event day variable actually approximates the cumulative abnormal return over the event interval (Binder 1997). The model will also incorporate variables to isolate the influence o f extraneous factors that may impact the firms’ returns. Variables that have been determined in prior studies to affect firm returns include size, industry and unexpected earnings. The influence of these factors is addressed through the application of a matched-pair design and the addition o f a control variable for unexpected news events. Additionally, the NEWS variable, used in equation 7, is utilized in equations 8a and 8b as well. The SUR approach thus allows for a test of hypotheses two and three in a single model. Both the estimation and test periods are combined in the SUR model. The regressions are run for the 105-day period from t-103 to t+1. Based on the discussion above, the following models are tested: R„ = a Q+ a l Rml + a 2EVENT, +ai NEWSi (8a) R,, = a 0 + a xRm + a 2EVENT, * TYPE, + a ^EVENT, *G W ,+ a 4NEWS, (8b) 38 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. CHAPTER VI RESULTS The results are presented according to event date and methodology used. Results for tests of the three hypotheses for the August 1993 event date using the market model are presented first, followed by the results for the same event date using seemingly unrelated regression (SUR). The same sequence is followed for the other event dates as well. An enlarged sample, using a different measure for the goodwill variable (GW) was utilized as well. The results using that sample and revised measure follow, in the same sequence. Passage of OBRA’93 Market Model The results for tests of hypothesis one are presented in Table A-4. Abnormal returns and cumulative abnormal returns are shown for the date of passage, trading day immediately following passage as well as for two, three and five day windows surrounding and leading up to passage. The event days are described in Table A-2. According to these results, there is no evidence o f a significant market reaction to passage of OBRA’93. None o f the measures are statistically significant. The analysis of the impact o f type o f acquisition and relative goodwill acquired is presented in Table A-5. As evidenced, none of the model coefficients are significant. As with the abnormal returns presented in Table A-4, the parameters o f interest are in the 39 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. opposite direction. As stated earlier, the original goodwill measure utilized does not address the overall magnitude of goodwill purchased with respect to firm size. It only addresses the level of purchased goodwill relative to total intangibles. An analysis using a new measure is presented later in this chapter. The categorization of firms as high or low-goodwill also changes with the new goodwill measure. SUR Table A-6 presents the results for testing the first hypothesis, that high-goodwill asset-acquiring firms experienced positive abnormal returns. The EVENT coefficients are all insignificant, as well as of the wrong sign. However, as explained in the preceding paragraph, the categorization of firms as high or low-goodwill was based on the level of purchased goodwill relative to intangibles, not to firm size. The negative coefficients on EVENT supports an indication that the model is capturing the impact of the magnitude of purchased goodwill, not the relative amount. The SUR parameter estimates for tests of hypotheses two and three are presented in Table A-7. None o f the parameters of interest are significantly negative, as predicted. The type of acquisition (stock versus asset) also appears to have no significant impact. Other Event Dates Market Model The above analysis was repeated for alternative event dates: Senate and House passage of an earlier version of the statute and the Supreme Court’s decision in Newark Morning Ledger. As illustrated in Table A-8, none of the abnormal returns are significantly positive. The abnormal returns surrounding earlier Senate passage (June 25) 40 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. are negative. The abnormal returns surrounding the two other dates are statistically insignificant. The second and third hypotheses are also tested for the alternative event dates. Table A-9 reveals that none o f the parameters are significant. Accordingly, hypotheses two and three are not supported for these alternative dates, using the market model based test. SUR SUR parameter estimates for hypothesis one are illustrated in Table A -10. While none of the estimates are significantly positive, as predicted, the estimates for dates surrounding earlier Senate passage are the strongest. The estimates for the two other dates are insignificant, thus not supporting hypothesis one. Hypotheses two and three were tested as well for these three dates using SUR as well. The SUR estimates are presented in Table A-l 1. Consistent with the market model results none of the key parameter estimates are significantly less than zero, as predicted. Overall, the results do not support hypotheses two or three. Revised Sample OBRA’93 market model The results for the expanded sample, using an alternative goodwill measure (purchased goodwill/total assets) are presented in Table A -13. A significantly positive abnormal return is evidenced on August 9, the trading day immediately following passage of OBRA’93 (AR - .0129, t-value = 2.650). One other window indicates a 41 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. significant reaction: the two day window ending on the ninth (CAR = .0093, t-value = 1.607). The reaction on the ninth, as opposed to the sixth, is due to the late Senate passage of the statute. The other dates indicate no significant reaction. The Senate vote was not concluded until late in the afternoon on the sixth, thereby limiting the time the market had to react. Overall, these results do support the first hypothesis, that assetacquiring firms with substantial goodwill experienced positive abnormal returns following passage o f OBRA’93. The second and third hypotheses were tested using this new measure as well. These results are presented in Table A-14. Note that NEWS was dropped from this model, as well as all revised sample models, due to its lack of significance. The results for these tests fail to support H2 or H3. Unlike the tests using the original goodwill measure (GW = purchased goodwill/purchased intangibles), the predicted signs for the new GW variable (purchased goodwill/total assets of the acquiring firm) as well as EVENT*GW are positive. None o f the coefficients are significant. Accordingly, H2 and H3 are not supported. SUR The SUR estimates for tests o f HI are illustrated in Table A-15. Consistent with the market model tests, the coefficient for EVENT is significantly positive on August 9 (.0130, t-value = 1.667). Accordingly, with respect to the trading day following passage, there is support for a positive market reaction to passage of OBRA’93. None of the earlier windows are significant. As a result, there appears to have no significant reaction until after final passage and the removal of all uncertainty. 42 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. Likewise, the results for the SUR tests for the second and third hypotheses are also consistent with the market model tests. None of the parameters of interest are significant. However, unlike the market model tests, the coefficients for EVENT*GW are all positive, as predicted. Unfortunately, the estimates for EVENT*TYPE are generally positive as well, while the predicted sign is negative. Accordingly, there is no support for H2 or H3. Other Event Dates market model The results of the tests for hypothesis one for the earlier event dates are presented in Table A-17. With three exceptions, none of the abnormal returns are statistically significant at conventional levels. The abnormal return on April 20, the date of the Supreme Court’s decision in Newark Morning Ledger, is significantly positive (AR = .0108, t-value = 1.881), thus providing some support HI for that event, though a strong offsetting negative abnormal return is observed for the preceding day. This result is also consistent with the findings of Dhaliwal and Erickson (1998), in their study of the market reaction to various court rulings, including Newark Morning Ledger. Furthermore, significant positive abnormal returns are observed on both May 21 (AR = .0101, t-value = 1.414) and May 25 (AR = .0179, t-value - 1.588), the two days surrounding House passage of an earlier version of OBRA’93. There is, however, an insignificant negative reaction observed on May 24 itself (AR = -.0042, t-value = -.657). Accordingly, some support is found for H I on these two earlier event dates. The results for market model-based tests of H2 and H3 are shown in Table A-18. Except for the June 24-28 three-day window, none of the coefficients o f interest are 43 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. significant in the predicted direction. The coefficient on TYPE for the June 24-28 window (earlier Senate vote) is marginally significant (-.0126, t-value = -1.872). However, no significant reaction is observed for any of the individual days within that period or for GW. As a result, there is no strong support found for H2 or H3. SUR The SUR parameter estimates for a test of HI, Table A-19, support a finding of a significant positive reaction for only one of the event dates. All but two of the coefficients of interest are insignificant. Significant reactions are found during the threeday period May 21-25 (earlier House vote) (.0079, t-value - 1.423) and on May 25 (.0179, t-value = 1.879). A strong, though not significant, reaction is found on April 20 as well (Newark Morning Ledger) (.0103, t-value = 1.000), preceded by a strong negative reaction on April 19 (-.0114, t-value = -1.112), consistent with the results for the analysis presented in Table A-17. The SUR estimates for tests of H2 and H3 for these same three earlier dates, shown in Table A-20, are consistent with the results presented in Table A-18 (marketmodel based tests). None o f the key parameters are significant, though they are generally of the correct sign. Accordingly, the results fail to support H2 or H3. Diagnostics Various diagnostic tests were also performed to test for the presence of multicollinearity, autocorrelation or hetroscedasticity. Plots of the data over time as well as residual plots (not shown) do not indicate the significant presence of either hetroscedasticity or autocorrelation. Additionally, a correlation matrix (not shown) of the 44 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. independent variables do not indicate the presence of muiticollinearity. The variance inflation factor ( VIF) was computed for each regression model used. A VIF o f ten or greater indicates the likelihood of muiticollinearity among the independent variables (Berenson and Levine 1992, 708). However, the highest VIF score was 2.8, well below the limit. Finally, a Durbin-Watson test (DW) was run for the SUR models to test for autocorrelation among the observations (returns). The DW scores were likewise well below the threshold for concern, values significantly different from two (Greene 1993. 423). Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. CHAPTER VII DISCUSSION The discussion of the results of this study addresses three questions: (1) What support is there for the three hypotheses presented? (2) What are the implications of the findings in this study? (3) What limitations are contained within this study? The first hypothesis posits that asset-acquiring firms experienced positive abnormal returns surrounding final passage of OBRA’93, as well as surrounding three earlier events leading up to passage. The results using the original grouping of firms, based on the ratio of purchased goodwill to tangibles, do not support this first hypothesis. However, the results using the alternative measure, ratio o f purchased goodwill to total assets does support the first hypothesis. Notably, as illustrated in Tables A -13 and A-15, the group of asset-acquiring firms with substantial goodwill (based on the new measure) experienced significantly positive abnormal returns on August 9, 1993. This was the first trading day (Monday) following final passage of the statute. Given the late timing of the Senate’s vote, this finding indicates that the market waited until all uncertainty regarding passage was resolved and reacted positively upon learning of the favorable vote. Additionally, there is some support for a similar finding that the market reacted favorably upon learning o f the pro-taxpayer ruling by the Supreme Court on April 20 in Newark Morning Ledger (Table A-l 7). This result is consistent with Dhaliwal and Erickson’s (1998) study of the market reaction to tax-related court rulings. However, no significant reaction is found during the three-day period surrounding the ruling and a 46 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. strong negative abnormal return is observed on the preceding day. A similar reaction is shown during the May 21-25 period coinciding with the original vote in the House of Representatives (Table A-19). Furthermore, while no significant reaction shown on May 24 itself, a significant positive reaction is observed on May 25. The second and third hypotheses posited that the market reaction was related to the magnitude of goodwill acquired in the acquisition as well as the type of acquisition (stock versus asset purchase). However, none of the results support this relationship. The estimated coefficients for both type of acquisition and goodwill were insignificant in all tests. This provides some indication that the market did not assess the relationship posited to exist between the type of acquisition, goodwill acquired, and the level of abnormal returns. The implications of this study are that the reaction to a change in tax law does serve as a useful measure of the market’s assessment of the economic impact of the change. This assessment is useful to policymakers in determining how statutory change impacts capital markets; including investor behavior, capital allocation, and firm cash flows. Additionally, the potential market reaction to a change in law is a factor that policymakers and legislators need to be cognizant of during their deliberations. This study adds to the extant accounting and finance literature on market reaction and impact from regulatory changes. This study also has methodological implications as well. Specifically, the results using both the SUR and traditional market model based event study methodologies produce the same conclusion. As stated in the introduction and the methodology sections, the benefits of using SUR may not be significant in this study. The results using 47 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. both methods support this conclusion. The SUR models produced the same qualitative conclusions as the market models. There are however limitations inherent in this study. First, while the event in question was "clean” relative to other regulatory and tax changes, there were still a number of other provisions contained within the statute (i.e. rate increases and business expense deduction limitations). Additionally, while the statute did pass by a close margin, the probability of eventual passage was quite high. Accordingly, market participants were not completely surprised by passage and undoubtedly experienced small revisions to their prior expectations following the Senate vote. Another limitation is this study’s use of book goodwill as a proxy for tax goodwill, which is not publicly reported. Firms were ranked and categorized based on the changes in (financial statement) reported goodwill following the acquisition. While the values for book and tax goodwill will differ, they are conceptually identical based on IRC Section 1060 and APB Opinion 17 (APB 1970b). As a result, the relative rankings of the firms, by goodwill, should not be impacted by the measure used. Other limitations in this study include the measurement of the “substantial goodwill” used in categorizing the sample firms and in assessing the magnitude of the market reaction. As stated above, this measure was changed, as the first measure did not account for the magnitude of the purchased goodwill relative to the size o f the firm. 48 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. CHAPTER VIII CONCLUSION This study examines the market response to the adoption of an allowance for tax amortization of purchased goodwill through a taxable asset acquisition. Specifically, the study tests whether affected firms experienced abnormal returns flowing from the market’s perception of the cash flow impact of the change. This provision was included in the overall Omnibus Budget Reconciliation Act o f 1993, which was enacted on August 10, 1993. The adoption o f this provision reversed a long-standing prohibition against amortization of not only goodwill, but of any intangible asset closely resembling goodwill. Moreover, the new code section contained a retroactive taxpayer election for acquisitions undertaken after July 25, 1991, two years prior to enactment. An event study methodology is utilized to analyze the market reaction upon final passage o f OBRA’93 on August 6, 1993. Abnormal returns to asset-acquiring firms are examined both in absolute terms and in association with the tax benefit generated from amortization. Additionally, market price reaction is studied using not only the traditional market model analysis, but also a seemingly unrelated regression approach derived from prior regulatory change studies. The study sample consists o f firms that have engaged in taxable acquisitions during the retroactive election period, July 1991 to July 1993, broken down into asset and stock purchasers, as well as into high-good will and low-goodwill asset acquirers. 49 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. The results of this study indicate that the market did react to learning of final passage of OBRA’93 and its goodwill amortization provision, with the corresponding retroactive election. Asset-acquiring firms with substantial goodwill, relative to total assets, experienced positive abnormal returns. Additionally, a positive reaction was also found for the Supreme Court’s decision in Newark Morning Ledger, though preceded by a strong negative abnormal return, as well as the House vote on an earlier version of the legislation. However, the magnitude of the reaction was not found to be related to the type of acquisition or the magnitude of goodwill purchased. Opportunities for further research include assessments of the market reaction to other tax law changes, including the Taxpayer Relief Act o f 1997, as well as judicial and administrative pronouncements. Regarding the present provision, Section 197, further research could explore the taxpayer decision concerning the retroactive election and the factors impacting on the decision whether to apply Section 197 retroactively. Furthermore, the prospective impact of the provision on acquisition activity, transaction terms, and purchase price allocations among acquired assets could be investigated. 50 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. LIST OF REFERENCES 51 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. LIST OF REFERENCES APB. 1970. Opinion 16: Business Combinations. New York, NY: American Institute of Certified Public Accountants. APB. 1970. Opinion 17: Intangible Assets. New York, NY: American Institute of Certified Public Accountants. ASB. 1997. F R S 10: Accountingfor Goodwill and Other Intangibles. London, UIC: Accounting Standards Board. ASC. 1989. SSAP 22: Accountingfor Goodwill. London, UK: Accounting Standards Committee. Adkins, N. 1997. The Security Market Impact o f Judicial Decisions Affecting the Amortization of Financial Institutions’ Core Deposit Intangibles. Working Paper. University of Houston. Asquith, P. and D.W. Mullins. 1983. The Impact of Initiating Dividend Payments on Shareholder Wealth. Journal o f Business 56: 77-96. Ball, R. and P. Brown. 1968. An Empirical Evaluation of Accounting Income Numbers. Journal o f Accounting Research 6 (Fall): 159-78. Bathke, A., R. Rogers and J. Stem. 1985. The Security Market Reaction to Tax Legislation as Reflected in Bond Price Adjustments. 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Using Daily Stock Returns: The Case of Event Studies. Journal o f Financial Economics 14: 3-31. Brunovs, R. and R.J. Kirsch. 1991. Goodwill Accounting in Selected Countries and the Harmonization of International Accounting Standards. ABACUS 27: 135-61. Cable News Network. 1993. Transcript # 391-4 (August 6). Chauvin, K.W. and M. Hirschey. 1994. Goodwill, Profitability, and the Market Value of the Firm. Journal o f Accounting and Public Policy 13: 159-80. Choi, F.D.S. and C. Lee. 1991. Merger Premia and National Differences in Accounting for Goodwill. Journal o f International Financial Management and Accounting 3: 219-40. Collins, M.C. 1994. New Section 197 of the Internal Revenue Code: Simplifying the Amortization of Intangibles in the Wake of Newark Morning Ledger Co. v. United States. University o f Toledo Law Review 25: 815-45. Coopers and Lybrand. 1990. International Accounting Summaries: A Guide for Interpretation and Comparison. New York, NY: John Wiley and Sons. Cornell, B. and W.R. Landsman. 1989. Security Price Response to Quarterly Earnings Announcements and Analysts’ Forecast Revisions. The Accounting Review 64: 68-92. Davis, M.L. 1990. Differential Market Reaction to Pooling and Purchase Methods. The Accounting Review 65: 696-709. Day, R. and N. Hartnett. 1997. Sharemarket Reaction to Mandated Changes in Goodwill Amortisation Methods: Australian Evidence. Working paper, University of Newcastle, Newcastle, Australia. De Bos, A. and F. Krens. 1996. The Goodwill Dilemma: A Political Issue. Working paper, Erasmus University Rotterdam, Rotterdam, The Netherlands. Dennis, D.K. and J.J. McConnell. 1986. Corporate Mergers and Security Returns. Journal o f Financial Economics 16: 143-87. Dhaliwal D.S. and M.M. Erickson. 1998. Wealth Effects o f Tax-Related Court Rulings. Journal o f the American Taxation Association (Spring): 21-48. 53 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. Dimson. E. 1979. Risk Measurement When Shares are Subject to Infrequent Trading. Journal o f Financial Economics 7: 197-226. Douglass, M. 1994. Tangible Results For Intangible Assets: An Analysis of New Code Section 197. Tax Lawyer 47 (Spring): 713-62. Fama. E.F. 1991. Efficient Capital Markets II. Journal o f Finance 46 (December): 15751617. Gaver. J., K. Gaver and G. Battistel. 1992. The Stock Market Reaction to Performance Plan Adoptions. The Accounting Review 67: 172-82. Golden State Towel & Linen Service v. U.S., 179 Ct. Cl. 300, 373 F.2d 938 (1967). Greene, W.H. 1993. Econometric Analysis. New York, NY: Macmillian. Griffiths. W.E., R.C. Hill and G.G. Judge. 1993. Learning and Practicing Econometrics. New York, NY: John Wiley and Sons. Hall, S.C. 1993. Determinants o f Goodwill Amortization Period. Journal o f Business Finance and Accounting 20: 613-21. Hammond, C. 1995. The Amortization of Intangible Assets: §197 of the Internal Revenue Code Settles the Confusion. Connecticut Law Review 27: 915-41. Hethcox, K.B. 1995. Security Price Response Associated With the Accounting Regulation of Purchased Combinations Increasing Goodwill. Research in Accounting Regulation 9: 49-62. IASC. 1993. IAS 22 (Revised): Accounting for Business Combinations. London, UK: International Accounting Standards Committee. Ithaca Industries Inc. v. Commissioner, 97 TC 16(1991) Jennings, R., D. Mest and R. Thompson. 1992. Investor Reactions to Disclosure of 197475 LIFO Adoption Decisions. The Accounting Review 67: 337-54. Jennings, R., J. Robinson, R.T. Thompson II and L. Duvall. 1996. The Relation Between Accounting Goodwill Numbers and Equity Values. Journal o f Business Finance and Accounting 23: 513-33. Lee, C. and F.D.S. Choi. 1992. Effects o f Alternative Goodwill Treatments on Merger Premia: Further Empirical Evidence. Journal o f International Financial Management and Accounting 4: 220-36. 54 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. Mackles, G.F. 1993. 15-Year Amortization of Purchased Intangible Assets-Some Winners, Some Losers. Journal o f Taxation (December): 332-37. Madeo, S.A. and M. Pincus. 1985. Stock Market Behavior and Tax Rule Changes: The Case of the Disallowance of Certain Interest Deductions Claimed by Banks. The Accounting Review 60 (July): 407-29. Manegold, J.G. and S.S. Karlinsky. 1988. The Security Market Impact of a Tax Law Change: Possessions Corporation Revisions. Journal o f the American Taxation Association (Spring): 65-83. McCarthy, M.G. and D.K. Schneider. 1995. Market Perception of Goodwill: Some Empirical Evidence. Accounting and Business Research 26: 69-81. Melone, M. 1994. Taxable Corporate Acquisitions: A Primer For Business and the NonSpecialist. University o f Toledo Law Review 25: 673-711. Mergers and Acquisitions. 1993. A Key Breakthrough on Intangible Assets. (September/October): 9-10. Newark Morning Ledger Co. v. U.S., 945 F.2d555 (3rdCir., 1991) Newark Morning Ledger Co. v. U.S., 507 U.S. 546 (1993). Nobes, C. and J. Norton. 1996. International Variations in the Accounting and Tax Treatments of Goodwill and the Implications for Research. Journal o f International Accounting, Auditing and Taxation 5: 179-96. Ohlson, J.A. 1990. A Synthesis of Security Valuation Theory and The Role of Dividends, Cash Flows and Earnings. Contemporary Accounting Research 6: 648-76. Omnibus Budget Reconciliation Act o f 1993, [P.L. 103-66], 103rd Cong., 1st Sess. (August 10, 1993). Peterson, P.P. 1989. Event Studies: A Review of Issues and Methodology. University of Nebraska-Lincoln: 36-66. Pollack, S.D. 1997. Amortization of Intangible Assets in a Business Acquisition. Taxation for Accountants (June): 336-42. Prager, R.A. 1989. Using Stock Price Data to Measure the Effects of Regulation: The Interstate Commerce Act and the Railroad Industry. Rand Journal o f Economics 20 (Summer): 280-90. Rev. Proc. 77-37, 1977-2 C.B. 568. 55 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. RIA. 1993. The RL4 Complete Analysis o f the Revenue Reconciliation Act o f 1993. New York, NY: Research Institute of America. Schipper, K. and R. Thompson. 1983. The Impact of Merger-Related Regulations on the Shareholders of Acquiring Firms. Journal o f Accounting Research (Spring): 184220 . Schisler, D., M.G. McCarthy, and D.K.. Schneider. 1994. Cash Flow Impact of Tax Amortization of Goodwill Smiles on Acquisitions. Journal o f Corporate Accounting and Finance (Summer): 501-11. Treasury Regulation 1.1060-lT(d) (1997). Volmer, F.G. 1997. Goodwill and the Balance Sheet: A New Solution for a Dilemma: Some Dutch Experiences and Ideas. Working paper, University of Limburg, Maastricht, The Netherlands. Weaver, C.D. 1997. The Effect of a Tax Law Change on the Structure of Corporate Acquisitions. Ph.D. dissertation, Arizona State University. Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. APPENDICES 57 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. APPENDIX A TABLES 58 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. TABLE A-l International Accounting and Tax Treatment of Purchased Goodwill Country Australia Canada France Germany Ireland Japan Netherlands New Zealand United Kingdom United States IASC Financial Accounting Treatment Amortize over useful life, but no more than 20 years Amortize over useful life, but no more than 40 years Amortize over useful life or, in exceptional cases, immediate write off to retained earnings Amortize over 4 years or immediate write-off to retained earnings Amortize over useful life, or immediate write-off to retained earnings. Ireland uses same standards as the UK. Amortize over useful iife, but usually 5 years Amortize over useful life, or immediate write-off to retained earnings Capitalize as asset, but no amortization required Amortize over useful life, or immediate write-off to retained earnings Amortize over useful life, but no more than 40 years Amortize over useful life, but no more than 5 years. Exceptional cases may allow amortization over 20 years Tax Accounting Treatment No deduction allowed 75% of cost is amortizable at maximum rate of 7% per year No deduction allowed Amortize over exactly 15 years No deduction allowed Amortize over useful life, usually same as financial No deduction allowed No deduction allowed No deduction allowed Amortize over 15 years Not Applicable 59 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. TABLE A-l (continued) Sources: Brunovs, R. and R.J. Kirsch. 1991. Goodwill Accounting in Selected Countries and the Harmonization of International Accounting Standards. ABACUS 27: 135-61. De Bos. A. and F. Krens. 1996. The Goodwill Dilemma: A Political Issue. Working paper, Erasmus University Rotterdam, Rotterdam, The Netherlands. Lee, C. and F.D.S. Choi. 1992. Effects of Alternative Goodwill Treatments on Merger Premia: Further Empirical Evidence. Journal o f International Financial Management and Accounting 4: 220-36. Nobes, C. and J. Norton. 1996. International Variations in the Accounting and Tax Treatments of Goodwill and the Implications for Research. Journal o f International Accounting, Auditing and Taxation 5: 179-96. Notes: Table A-l reports treatment for positive goodwill arising from a corporate consolidation or acquisition. The UK Accounting Standards Board issued FRS 10 in December 1997, effective for fiscal years ending after December 31, 1998. FRS 10 requires that acquired goodwill be capitalized and amortized over a period not exceeding twenty years (ASB. 1997. FRS 10: Accountingfo r Goodwill and Other Intangibles. London, UK: Accounting Standards Board). 60 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. TABLE A-2 Description of Event Dates Date August 3, 1993 August 5,1993 August 6, 1993 June 25, 1993 May 24, 1993 April 20, 1993 Description Conference committee issues Conference Report on OBRA’93 House of Representatives passes Conference Report by vote of 218 to 216 Senate passes Conference Report by vote o f 51 to 50. Vice-President casts tie-breaking vote. Senate passes original version o f bill by a single vote, the Vice President’s House of Representatives passes original version of bill. U.S. Supreme Court issues decision in Newark Morning Ledger. Source: Bokinsky, A.J. 1994. Section 197: Taxpayer Relief and Questions of Asymmetry. Virginia Tax Review 14: 211-53. RIA. 1993. The RIA Complete Analysis o f the Revenue Reconciliation Act o f 1993. New York, NY: Research Institute of America. 61 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. TABLE A-3 Descriptive Statistics Original Sample All Firms Goodwill/ Intangibles: Mean Median S.D. N Total Assets: Mean Median S.D. N Sales: Mean Median S.D. N Goodwill: Mean Median S.D. N ROA: Mean Median S.D. N ROE: Mean Median S.D. N Asset Acquiring Firms With High Relative Goodwill Asset Acquiring Firms Low Relative Goodwill 80% 100% 3% 45 100% 100% 3% 15 41% 50% 30% 15 98% 100% 5% 15 1,245,900,000 506,100,000 1,769,300,000 45 1,156,360,000 430,000,000 1,508,170,000 15 1,209,000,000 99,000,000 1,762,000,000 15 1,372,240,000 573,900,000 2,104,600,000 15 1,454,600,000 506,300,000 2,070,200,000 45 1,292,210,000 506,310,000 1,782,180,000 15 1,515,430,000 187,000,000 2,215,680,000 15 1,556,050,000 645,300,000 2,311,000,000 15 62,800,000 8,700,000 152,000,000 45 37,490,000 2,800,000 88,700,000 15 36,060,000 5,700,000 73,350,000 15 114,730,000 15,000,000 235,000,000 15 4.3 4.5 7.5 45 3.79 4.02 3.99 15 3.06 4.80 10.32 15 6.18 5.40 7.10 15 8.5 9.9 14.6 45 8.32 9.70 8.40 15 8.29 8.80 19.10 15 8.89 12.20 15.20 15 62 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. Stock Acquiring Firms TABLE A-3 (continued) All Firms Debt/Equity: Mean Median S.D. N Federal Taxes Paid: Mean Median S.D. N Asset Acquiring Firms With High Relative Goodwill Asset Acquiring Firms Low Relative Goodwill 56.7 54.1 43.4 45 59.67 63.50 31.64 15 60.04 54.90 50.65 15 50.30 38.80 47.80 15 25,600,000 6,600,000 53,800,000 40 10,350,000 6,240,000 40,590,000 13 23,100,000 5,170,000 37,460,000 14 43,560,000 12,000,000 75,000,000 13 Stock Acquiring Firms Notes: Firms are grouped by type of acquisition (stock or asset) and relative goodwill (goodwill/intangibles). 63 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. TABLE A-4 Abnormal Returns For High Goodwill Asset Acquiring Firms: Final Passage Of OBRA’93 Event Window August 3-9, 1993 August 5-9, 1993 August 6-9, 1993 August 6, 1993 August 9, 1993 Mean AR/CAR -.0062 -.0074 -.0033 -.0029 -.0004 Predicted Sign + + + + + t-value -.509 -.947 -.488 -.545 -.079 * Significant at the 10% level (one tailed); ** Significant at the 5% level (one tailed); *** Significant at the 1% level (one tailed); Notes: AR = market model abnormal return for event period in question; CAR = market model cumulative abnormal return for multi-day event period in question; Estimation period for market model is 100 days prior to beginning of event period; Predicted sign = predicted sign of (cumulative) abnormal return based on hypothesis one. Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. N 15 15 15 15 15 TABLE A-5 Results O f OLS Regression Estimation For Hypotheses Two And Three: Final Passage O f OBRA’93 CAR, = a 0 + a lTYPEi + a 2GW, -ha,NEWS, Independent Event Window Predicted Coefficient Estimate Variable Sign Intercept August 3-9, 1993 -0.0006 TYPE 0.0222 GW 0.0284 NEWS -0.0166 R2 0.0885 Adj R1 0.0218 Intercept August 5-9, 1993 -0.0028 TYPE 0.0167 GW 0.0344 NEWS -0.0138 R2 0.1167 Adj R1 0.0520 Intercept August 6-9, 1993 0.00137 TYPE 0.0082 GW 0.0380 NEWS -0.0140 R1 0.1424 Adj R2 0.0796 Intercept 0.0002 August 6, 1993 TYPE 0.0068 GW 0.0092 NEWS -0.0096 Ri 0.0773 Adj R2 0.0098 Intercept 0.0011 August 9, 1993 0.0014 TYPE GW 0.0288 NEWS -0.0043 R2 0.1055 Adj Rz 0.0400 65 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. t-value -0.046 1.208 1.536 -0.972 F-value 1.327 -0.216 0.994 2.028 -0.882 F-value 0.161 0.104 0.438 2.216 -0.887 F-value 2.269* 0.044 0.839 1.131 -1.285 F-value 1.145 0.094 0.094 1.887 -0.309 F-value 1.612 TABLE A-5 (continued) * Significant at the 10% level; ** Significant at the 5% level; *** Significant at the 1% level; Significance levels are 1-tailed if coefficient has a predicted sign, otherwise 2-tailed; N = 45 firms. Notes: CAR = market model cumulative abnormal return for event period in question, CAR = AR if 1-day period; TYPE = 1 if stock acquisition, 0 if asset acquisition; CfV= 1 if low relative goodwill firm (goodwill/intangibles), 0 otherwise; NEWS = 1 if firm had news announcement during event period, 0 otherwise; Estimation period for market model is 100 days prior to beginning of event period. 66 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. TABLE A-6 Results O f SUR Parameter Estimation For Hypothesis One: Final Passage O f OBRA’93 R„ = a0 +- or, R„ir + a 2EVENT, + a}NEWS, Event Window Independent Predicted Coefficient Estimate Sign Variable August 3-9, 1993 Intercept .0004 .5341 Rm + EVENT -.0012 NEWS -.0002 August 5-9, 1993 Intercept .0003 .5367 Rm + EVENT -.0025 .0004 NEWS August 6-9, 1993 Intercept .0004 .5357 Rm + EVENT -.0016 NEWS -.0002 August 6, 1993 Intercept .0003 .5336 Rm + -.0029 EVENT .0004 NEWS August 9, 1993 Intercept .0003 .5325 Rm + EVENT -.0003 NEWS .0004 * Significant at the 10% level; ** Significant at the 5% level; *•* Significant at the 1% level; Significance levels are I•tailed if coefficient has a predicted sign, otherwise 2-tailed; N = 15 firms. Notes: Rj = firm i return on day r, Rm 3 market index on day r, EVENT = 1 if during event period, otherwise = 0; NEWS = 1 if firm had news announcement during event period, 0 otherwise; Returns are computed over 105-day period, including 100 days prior to event period. 67 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. t-value .697 5.333 -.544 -.186 .670 5.576*" -.857 .220 .657 _ • . .«n 3.354 -.462 -.186 .591 5.550’” -.588 .220 .541 5.517*” -.060 .220 TABLE A-7 Results O f SUR Parameter Estimation For Hypotheses Two And Three: Final Passage O f OBRA’93 R„ = a0 + a, Rm, + a-.EVENT, * TYPE, + a,EVENT, *GW + a,NEWS, Event Window August 3-9, 1993 Independent Variable Intercept August 5-9, 1993 EVENT*TYPE EVENT*GW NEWS Intercept August 6-9, 1993 EVENT*TYPE EVENT*GW NEWS Intercept Predicted Sign Rm - Rm - Rm August 6, 1993 EVENT*TYPE EVENT*GW NEWS Intercept - Rn, August 9, 1993 - EVENT*TYPE EVENT*GW NEWS Intercept Rm EVENT*TYPE EVENT*GW NEWS - Coefficient Estimate .0009 .5859 .0034 .0051 -.0012 .0006 .5824 .0034 .0099 .0001 .0009 .5742 .0029 .0186 -.0012 .0007 .5887 .0043 .0078 .0001 .0006 .5728 .0013 .0295 .0007 68 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. t-value 1.588 6.102'” .878 1.329 -1.136 1.181 6.063'” .678 2.003 .033 1.596 5.972'" .475 3.061 -1.126 1.371 6.131 .507 .911 .005 1.254 5.956 .148 3.426 .023 TABLE A-7 (continued) * Significant at the 10% level; * * Significant at the 5% level; *** Significant at the 1% level; Significance levels are 1-tailed if coefficient has a predicted sign, otherwise 2-tailed; N = 45 firms. Notes: /?/ = firm i return on day t; Rm = market index on day r; EVENT = 1 if during event period, otherwise = 0; TYPE = 1 if stock acquisition, 0 if asset acquisition; GW = 1 if low relative goodwill firm (goodwill/intangibles), 0 otherwise; NEWS = 1 if firm had news announcement during event period, 0 otherwise; Returns are computed over 105-day period, including 100 days prior to event period. 69 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. TABLE A-8 Abnormal Returns For High Goodwill Asset Acquiring Firms: Other Event Dates Event Window June 24-28, 1993 June 24, 1993 June 25, 1993 June 28, 1993 May 21-25, 1993 May 21, 1993 May 24, 1993 May 25,1993 April 19-21, 1993 April 19, 1993 April 20, 1993 April 21, 1993 Mean AR/CAR -.0151 -.0066 -.0080 -.0005 .0142 .0121 .0001 .0019 .0153 -.0023 -.0003 .0179 Predicted Sign + + + + + + + + + + + + t-value -2.478 -1.749 -2.131 -.113 1.060 1.476* .056 .438 1.112 -.335 -.041 1.752* * Significant at the 10% level (one tailed); ** Significant at the 5% level (one tailed); *** Significant at the 1% level (one tailed); Notes: AR = market model abnormal return for event period in question; CAR = market model cumulative abnormal return for multi-day event period in question; Estimation period for market model is 100 days prior to beginning of event period; P-value = probability that the coefficient [...]... write-off of acquired goodwill against equity (Nobes and Norton 1996; Volmer 1997).4 As a result, there is no income statement impact of purchased goodwill in those countries Tax Treatment The tax treatment in the United States has historically been to disallow any amortization of not only goodwill, but any intangible asset closely resembling goodwill Treasury regulations prohibiting goodwill amortization. .. allowance of goodwill amortization generates positive cash flows for the affected firms, resulting in a significant market reaction This study inquires into the market s assessment of the cash flow impact of the goodwill amortization provision and how investors have altered their valuations of the affected firms A related point is that this study also measures the market s assessment of the revenue effect of. .. First, the present study is one of only a handful of market event studies involving tax law changes Market reaction is of significant interest to tax policy makers in assessing the economic impact of tax rule changes Tax law changes, unlike changes in GAAP, produce real cash flow consequences Prior literature has shown that firm value is a function of present and discounted future cash flows from which... illustrated the potential for market reactions to changes in tax legislation, including the bond markets Madeo and Pincus (1985) studied the market reaction to adoption of the disallowance of time deposit interest tax deductions for financial institutions Using a SUR methodology similar to that used by Schipper and Thompson (1983), they tested for an expected negative reaction to the disallowance The authors... apparently two dimensions to goodwill One dimension concerns the positive aspect of goodwill as a measure of intangible value o f the firm The other dimension focuses on the negative aspect of goodwill as a source of amortization expense and lower reported earnings Stock price has consistently been found to be negatively associated with reported goodwill amortization, and increases in goodwill following a... referred to as Section 197 intangibles.6 The cost of these intangibles is to be ratably amortized over a period of 15 years, from month of acquisition.7 Furthermore, to qualify for amortization treatment, the intangible asset must be acquired as part of the purchase of the assets of an on-going trade or business Hence, only goodwill acquired as part of an asset acquisition qualifies The enactment of Section... goodwill While goodwill will not arise under a pooling, it will often arise under a purchase This purchased goodwill is then subject to amortization under APB 17 (APB 1970b) Tax Accounting Treatment The tax treatment of acquisitions follows the financial reporting rules rather closely Presently, acquisitions may be either tax- free or taxable The requirements for a tax- free, actually tax- deferred, acquisition... seven forms of reorganization that qualify for tax- deferral Two types o f transactions that are included in this group include the exchange of target assets or stock for stock o f the acquiring firm, sections 368(aXlXB) and (C) 9 Section 368(C) defines control as ownership of 80 percent of the total combined voting power and 80 percent of the total number of shares outstanding Note that a statutory merger... recognize gain to the extent that the market value of the consideration received exceeds their basis in the shares As only stock is acquired in a stock purchase, assets are not revalued and goodwill is not recognized Additionally, Section 197 does not apply to a straight stock purchase as the statute’s application is limited to the context of a taxable asset acquisition 13 Reproduced with permission of the... group is allowed to amortize purchased goodwill for tax reporting purposes The impact of goodwill amortization on reported earnings will be the same for both groups However, the asset-acquiring group will also experience a positive impact from goodwill amortization on cash flows as a result of the new tax deduction The utilization of control and test groups will also isolate the effects of OBRA’93 on