New Accounting Rules for M&A
from
Summer 2001
by Ron Connaught
So maybe it wasn’t an out-and-out knockout, but at least someone
threw in the towel. As a result, many companies that depend on M&A
for growth were cheering.
Those dancing the winner’s jig include Cisco Systems, JDS Uniphase, and other outfits that have pegged much of their strategy to acquisitions. The loser: the Financial Accounting Standards Board (FASB), still looking groggy and wondering what happened to its determination to keep corporate America from getting a free ride on the back of goodwill.
Whatever the result, the bout was a humdinger. It lasted roughly five years, involved more than 60 public hearings, and drew some 500 letters of comment about FASB’s initiative to change the way goodwill is accounted for when companies merge or are acquired. FASB’s objective was to put an end to pooling-of-interest accounting. This permitted merging or acquiring companies to combine their balance sheets, enabling them to avoid the amortization of goodwill, potentially a huge benefit to the bottom line. According to Merrill Lynch, a full 55%—or $900 billion—of 1998’s mergers employed pooling accounting.
Instead, FASB wanted companies to use purchase accounting, which would mean they’d have to write off goodwill and take a hit to reported earnings. (The accounting rules don’t affect actual cash flow.) The regulatory board argued that purchase accounting makes bookkeeping more transparent for shareholders.
But what the FASB saw as a simplification, most corporations viewed as a problem. Cisco was a particularly vocal fan of pooling. Vice president and corporate controller Dennis Powell told the Senate Banking Committee: The purchase model “does not work for companies in the new economy, where most of the acquisition value cannot be attributed to hard assets. Forcing companies to report an arbitrary, artificial net income number is irrelevant and misleading.” He also said that elimination of pooling could stifle technology development and erode the competitive advantage the U.S. enjoys.
Lobbyists representing all kinds of companies got to work, twisting arms on Capitol Hill. Both the Senate Banking Committee and the House Commerce Committee held hearings on pooling. Its supporters cited America Online’s 1998 acquisition of Netscape as a prime example of the damage that would be wrought were this type of accounting eliminated. AOL used the pooling method to make the purchase. Had the deal been done under the purchase method of accounting, the company would have had to write off $688 million in goodwill the following year. That would have resulted in a $653 million loss instead of the $35 million profit that AOL actually reported.
For all the protests, FASB won the first round. Pooling-of-interest accounting is still set to end this summer, after which companies must use purchase accounting for acquisitions.
As of January 1, 2002, every company will have to establish that the goodwill that came with a merger has not been impaired. This means that the amount recorded on the books for goodwill does not exceed its fair value. If it does, the goodwill will be impaired and the company must write off the difference against earnings. Companies must conduct such impairment tests on an annual basis.
An annual test is not the only thing to worry about. Companies must also be on the watch for events that could happen any time between annual tests which could also impair goodwill. Examples: A feisty new competitor or the sudden loss of a key executive. If this happens, a company must do another impairment test.
All in all, FASB’s collapse has won mixed reviews. Even companies welcoming their escape from amortization question the expense and hassle of having to conduct annual impairment tests. Says Cisco’s Jenkins: “We have to determine if it’s reasonable to make businesses perform an expensive and complex calculation on an annual basis. That’s a debatable point.”
Among those taking the other tack is Barry Epstein, a partner at Gleason, Sklar, Sawyers & Cumpata, a Chicago accounting firm. “It’s a terrible decision. Impairment is in the eye of the beholder. Management will fight until it’s in their interest to take the write off.”
Still, the part of the M&A industry that had been fueled by pooling is likely to see prolonged life. Possible targets include a number of technology companies, where goodwill, inflated by such intangibles as customer loyalty and the value of patents, comes high. Many such companies have yet to recover from last year’s plunge in share prices. “There are still a lot of companies with failed business plans whose only hope is to be acquired and liquidated,” says Bruce Mann, senior managing director at W. R. Hambrecht, an investment banking firm. They will be looking good to larger companies that want to fill out their product lines or scoop up new technology.
Thrifts, which carry large amounts of goodwill, could also be beneficiaries of the changed amortization rules. Investment bank Friedman, Billings, Ramsey & Co. has issued a report stating that the change in accounting standards will likely boost the earnings per share of thrift stocks.
