New accounting rules for business combinations could make many mergers and acquisitions look a lot less enticing than they do today if the rules that are expected to be proposed in June are adopted.
First, the Financial Accounting Standards Board has all but proposed the end of the popular pooling-of-interest merger accounting technique, which allows two companies to combine their businesses at historic cost rather than at the target's current value. The alternative-- purchase accounting--is likely to leave acquisitive companies holding a lot more "goodwill"--that is, the premium paid above the market value of all identifiable assets--on their books, which they have to amortize against earnings.
Second, FASB is expected to propose shortening the amortization period for goodwill from the current 40 years to as few as 10--a change that greatly heightens the impact on earnings.
These changes, say Wall Street advisers, could ground any number of potential mergers. "Deals die today all the time when they can't get pooling treatment, because managements demand that they be accretive to earnings immediately," says Robert Willens, a tax and accounting adviser at Lehman Brothers Inc., in New York. "With no pooling allowed, and a short life on goodwill, acquisitions are going to be a lot more expensive on an accounting basis. As a result, some deals won't get done."
That reality could produce a heated debate between corporate executives and FASB similar to previous ones over stock options and derivatives accounting. Some opponents are already warning they'll seek congressional intervention.
But not all finance executives are opposed. "Personally, I think this proposal makes a lot of sense," says Hal Rogero, assistant corporate controller of The Mead Corp., in Dayton, and a member of the task force that advised FASB on the new standard. In any case, Rogero adds, "Running off to Congress would be a mistake that would undermine the private standard-setting process."
The Opponents Within
In contrast to the dispute over stock options, this time FASB has a powerful ally firmly in its corner. The Securities and Exchange Commission has long loathed poolings because of the complex conditions that companies must meet--with SEC staff approval--to use pooling rules. And when expressing personal views, various commissioners and staff members have called for shortening the life of goodwill in purchase transactions in the name of both sound accounting and international harmonization.
Ever since FASB decided to address the issue (see "Goodwill Games," CFO, September 1997), most accounting observers and corporate reporting executives have felt that pooling was on the way out because of its obvious problems.
First, the method makes it extremely difficult to compare acquisitive companies both within the United States and across borders. While poolings create potential dilution because new stock is issued, there is no quarterly hit to earnings from amortizing purchased assets, including goodwill.
As a result, says Jack Ciesielski, an accounting analyst and an outside adviser to FASB, "Poolings leave the surviving management teams less accountable to shareholders for earning a return from the acquired operations, because shareholders never get to see what was paid for which asset, and never see the amortization of those purchased assets over time."
And because poolings are allowed only in the United States (except in rare cases in the United Kingdom and in a few other countries), U.S. companies that qualify for the method gain a bidding advantage over their foreign counterparts. While many executives want to deny it, pooling acquirers have been shown to pay generally higher premiums than purchase buyers for targets.
That's why pooling also has some powerful foreign enemies. Last fall, FASB took part in developing a discussion paper on methods of merger accounting. Other participants included the G4+1, the coordinating body of accounting-standard setters in Canada, the U.K., Australia, New Zealand, and the United States, as well as the International Accounting Standards Committee (IASC). The paper, a comparison of the pooling method, the purchase method, and some combination of the two, concluded that only one method of merger accounting should be used globally. And pooling lost out.
No wonder a huge amount of recent M&A activity has taken advantage of pooling rules. Four of the five biggest deals announced in 1998 were poolings--Exxon and Mobil, Citicorp and Travelers Group, SBC Communications and Ameritech, and Bell Atlantic and GTE--all of which were worth more than $70 billion. Other $10 billion-plus poolings last year included McKesson and HBO, Tyco International and AMP, and ATT and Teleport Communications Group. And since this option will remain available through at least this year, and likely through 2000, many more companies are apt to vie for one last dip in the pool.
But pooling's critics are less certain about the appropriate amortization period--or "life"--of the goodwill created in purchase transactions. As of now, five votes of seven on FASB support the proposal that an appropriate default life for goodwill is 10 years, with an allowance for companies to make the case for a life as long as 20 years. Companies that want to justify shorter lives for goodwill will be allowed to write the amount off over as little as two years.
That's a big change from an approach the board had considered last year. That approach would have allowed companies to identify different elements of goodwill--such as "operational synergies" or "customer loyalty"--and assign different lives, including the option of an indefinite life, if it could be justified. Some, if not much, goodwill would have been allowed to remain on the books of acquiring companies forever, unless an impairment test showed that the goodwill wasn't pulling its weight.
A similar indefinite life approach is now used in the U.K. (see table, page 93), which embraces finite lives for goodwill and other intangibles. But contemplating its new standard, FASB abandoned the indefinite-life approach. It did so not to increase international harmonization with the IASC and others, as much as to allay deep concerns over the leeway that it would give corporations to manage their earnings.
"To allow subjective decisions on useful life would probably be opening a Pandora's Box," says Gaylen Larson, the FASB member who heads the combinations project. That assertion is backed up by the result of FASB's field test of that abandoned approach in a dozen companies. "In theory, most agreed that a discernible-elements approach was the right answer, but in practice it was very subjective," Larson says.
Then there's the question, which was unanswered as we went to press, of all the existing goodwill on corporate books. If FASB proposes, and eventually requires, companies to write off existing goodwill based on the new, shorter amortization period, the impact on earnings per share at some companies could be very significant, even in the face of strong operating earnings.
In a worst-case scenario, with a 40-year life reduced to 10 years, The Walt Disney Co., for one, would see its noncash charge to earnings for intangibles increase from about $431 million in fiscal 1998 to more than $1 billion. That's mostly the result of the $16.5 million in goodwill from its $19 billion purchase of Cap Cities/ABC in 1996. On a per-share basis, that charge would total about 85 cents, as opposed to 21 cents currently.
Disney's CFO, Tom Staggs, was unavailable for comment. But ever since the ABC acquisition, Disney has taken pains to single out the intangibles charge in its annual and quarterly earnings releases. It contends that the stock should be valued against its operating income, not its earnings.
Other corporations, from Coca-Cola to Merck, could face similar hits to earnings if the new life on goodwill is imposed immediately. And if it is, FASB can expect opposition from the corporate community throughout the comment period.
Both FASB observers and task force members expect the board to allow deals announced before the effective date to be grandfathered in some way, but neither the board nor FASB staff members would comment on such speculation. For deals completed afterward, however, experts say, the board is likely to require certain disclosures that mitigate the effect (see "Much Ado About Little?" page 92).
However implemented, the proposed goodwill changes would bring the United States more closely into line with accounting standards in the G4 and the growing number of countries now using the IASC standards. These include such major U.S. trading partners as Germany, France, Switzerland, South Korea, and Taiwan. The glaring exception, of course, is the U.S. rule requiring companies here to immediately expense the value of acquired research and development rather than amortize it like goodwill. The issue is currently being considered separately by a panel of the American Institute of Certified Public Accountants.
Should that issue also be harmonized with the norm elsewhere, the playing field between U.S. and foreign companies would be far more level, whether competing for acquisitions or for global capital, says Patricia McConnell, senior managing director at Bear Stearns in New York and the current vice chairwoman of the IASC.
"Once FASB makes its preferences known, there will likely be a slowdown in M&A activity among U.S. companies until everyone is comfortable with the nuances of the new rules," says McConnell. "But longer term, there shouldn't be any permanent disadvantage for U.S. companies. After all, the economics of the deals are the same. The rules will just present the results of U.S. and foreign companies in a more consistent way."
Ian Springsteel is a freelance writer in Boston.
------------------------------------------------------------------------ Much Ado About Little?
To help companies make clear that their goodwill is a noncash charge, and to make the definition of amortization items comparable across companies, FASB is expected to propose changes in how companies disclose the information. For starters, it is considering a standard line item on the balance sheet for goodwill and another for other intangibles. FASB is also considering a requirement that companies define each item and its amortization life in a footnote. Finally, the board may also add a line item far down on the statement of income for the current amortization charge related to those assets.
If those disclosures are indeed required, institutional investors and analysts believe corporations would have less to fear from bigger goodwill charges than they think. "The shorter lives on goodwill are going to increase the size of the charges to the point where analysts are going to have to take goodwill into consideration," says Errol M. Cook, managing director at E.M. Warburg Pincus & Co. LLC, a venture capital firm in New York, and a member of a FASB task force on business combinations. "They'll be able to easily add it back into earnings to get an operating number, and think more about what the cash and stock paid out in acquisitions actually bought."
Hal Rogero, controller of The Mead Corp., in Dayton, agrees. "Analysts haven't been able to do this well for all companies, because so few corporations spike out their goodwill or their charges to earnings. Requiring this disclosure will allow analysts to more easily get to cash earnings from operations," says Rogero. "That's important, because most corporate managers don't feel analysts and investors rely on cash flow as much as they say they do, because of the comparability and disclosure problem. So requiring it across the board may mitigate some of the furor."
FASB still has to address the issue of impairment-testing methods for goodwill. FASB wants to tighten the allowable methods so that companies with long-lived values on the books don't inappropriately write them down during short-term earnings declines just to boost earnings in subsequent quarters. Plus, the board wants to end the use of questionable valuation methods, such as comparisons of corporate market values to competitors', used by some to justify write-offs. The most likely scenario is a stricter application of the rules governing impairment of long-lived assets.-- I.S.