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ACCOUNTING REGULATION
By Joanne W. Rockness,
Howard O. Rockness and
Susan H. Ivancevich
It has finally happened: Twenty-five years after its first discus- sued its new statements, the deal would not have happened, ac-
sion memorandum on accounting for business combinations cording to Lehman Brothers. On the other hand, PepsiCo
and intangibles (Aug. 19, 1976), the Financial Accounting initiated a merger with Quaker Oats in April as a pooling, with
Standards Board has issued Statements 141 and 142, doing a professed concern about the consequences of the new rules.
away with pooling of interests. Apparently, it took an extremely This is only the beginning. The new rules are poised to change
volatile stock market to finally bring resolution to 1970 ac- the direction of domestic and international merger activity and
counting rules that frequently triggered a structuring of combi- to initially increase complexity and confusion in financial
nations inconsistent with economic reality or sound business reporting, while providing significant new opportunities for
practices. “earnings management.”
To gain the corporate community’s acceptance for the highly
controversial rule, the FASB in early spring softened the blow
by attaching the elimination of required goodwill amortization. Key Changes
The FASB’s justification for eliminating pooling is enhanced
The new FASB statements include several noteworthy changes
comparability and understandability for investors. Will this be
to current accounting. Statement 141 on Business Combina-
achieved? Or has it muddied the waters more? Acquired versus
tions: 1) requires the use of purchase accounting for all business
organic growth, complex goodwill impairment tests, intangible
combinations initiated after June 30, 2001; and 2) provides new
asset classification and cash-versus-stock acquisitions are but a
criteria for determining when intangible assets should be recog-
few of the issues that may, in fact, make the new acquisition ac-
nized separately from goodwill. Statement 142 on Goodwill and
counting less and not more comparable.
Intangible Assets requires that goodwill no longer be amortized,
What are the future economic consequences and implica-
but instead be subject to impairment testing at least annually.
tions?
Statement 142 goes into effect for companies with fiscal years
By its own rules, the FASB’s mission is to ensure neutrality
beginning after Dec. 15, 2001 and applies to all existing good-
of information resulting from its standards, without influencing
will and intangible assets. Early adoption is available for com-
behavior in any direction (FASB Rules of Procedure). The
panies with fiscal years beginning after March 15, 2001.
board has argued strongly that eliminating pooling will level the
playing field and provide more comparable and neutral infor-
mation. But, once again, accounting standards are not just re-
porting financial transactions, but are, in fact, driving them. On
Comparability Concerns
March 19, the $2.4 billion merger between AmeriSource Health The FASB asserts that the new business combination rules will
Corp. and Bergen Brunswig Corp. was the first deal structured benefit investors by spurring companies to provide better infor-
to align with the new FASB statements. If the FASB hadn’t is- mation on the true cost of both transactions and acquired intan-
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ANNUAL EDITIONS
2
Article 4. The M&A Game
when circumstances reduce the fair value below the carrying Securities Data reported that stock transactions comprised 32
value. percent of the total in 1999 and 44 percent in 2000. Now, indus-
Although many have heralded the non-amortization of good- tries such as technology and banking, where pooling-of-inter-
will as the saving grace in the new rules, the benefit is not ests acquisitions have dominated in recent years, will be ripe for
clear. According to Robert Willens, Lehman Brothers’ tax and a new wave of acquisitions using cash. This also may lead to
accounting analyst, “It is not so clear that if you did a purchase more cross-industry acquisitions and a new era of large con-
transaction that a substantial portion might be allocated to good- glomerate organizations.
will. A very large amount would be allocated to other intan- Earnings will be more volatile. The bottom line will be lower
gibles that may still have to be amortized.” If items such as for most companies previously utilizing pooling. New intan-
customer lists and supplier relationships get heavy allocations, gible asset classifications (amortized) and goodwill impairment
they will still have to be amortized. Companies will be taking a will ultimately lower ROA and EPS. Resulting P/E ratios will
lot more hits to earnings subsequent to the deal than if pooling be higher, which could hurt stock prices, depending on market
were allowed. conditions. At the same time, earnings may increase at compa-
Since many acquired intangible assets are difficult to measure, nies such as Tyco International that have predominantly used
and have frequently changing values, this additional classifica- the purchase method.
tion process is likely to add volatility to the financial reporting Eliminating goodwill amortization will be a bonus when
process and once again open the door for earnings management there is significant goodwill on the books. Dominion Resources
through asset-classification selection and the trade-off between Corp. stated earlier this year that earnings could increase by 34
intangible amortization and potential goodwill impairment cents per share simply by eliminating the amortization of good-
write-offs. Further, when goodwill is recorded, it is unlikely to will resulting from the acquisition of Consolidated Natural Gas
last forever. The resulting impairment will create still more Co. The result would be a lower P/E, which may, in turn, drive
earnings volatility. the stock price up.
The effects on financial results and ratios will be very signif- Acquisition prices will be lower. A J.P. Morgan Chase & Co.
icant in years of impairment, and it is hard to see how fair values study reported that in pooling transactions, acquirers paid a 35.4
for goodwill will be objectively determined. The new impair- percent premium over the target’s stock market value, while ac-
ment charges are prime candidates for movable expenses from quirers in purchase transactions paid a 28.2 percent premium.
one period to another to achieve desired earnings targets. Much While the differences in premiums may reflect real differences
like depreciation was in the 1920s, impairment may become the in value, it is far more likely that part of the premium reflected
key to making earnings estimates—not to mention the added perceived advantages in effecting a pooling. Average premiums
cost of annual impairment testing. paid should come down under the new rules, which once again
Further, the new rules apply only to purchased intangible as- shifts the advantage toward companies with the flexibility to do
sets and goodwill, not to internally developed intangibles. Thus, cash deals.
the standards still place acquiring companies at a competitive Losers will be disposed of. Eliminating pooling will end the
disadvantage to those that build their goodwill and other intan- artificial incentive to acquire or retain components of compa-
gibles internally. Interestingly, the same valuation models could nies that don’t fit well economically with the acquirer. A re-
easily apply to internally generated intangibles, but the FASB quirement for pooling was that acquirers buy and retain all
shows no apparent interest in doing so, despite obvious compa- significant components for up to two years. Purchase accounting
rability benefits. removes both the requirement and incentive. Deals are much
more likely to include only attractive components or include
Until the FASB can come up with a model in which all com-
explicit plans for disposal of segments that are a poor fit.
panies are treated similarly, regardless of growth, comparability
International acquisitions will increase. Most European
problems will not diminish. Looking ahead, there are predict-
companies already are required to use purchase accounting for
able economic consequences inherent in these rules.
acquisitions. Despite this perceived disadvantage, foreign pur-
chases of U.S. companies have been growing rapidly and are at
record levels. This may be partially due to more liberal rules in
Economic Consequences many countries for writing off goodwill, as well as different and
Cash will be king. Large, cash-rich companies like Microsoft often more advantageous tax laws. Nevertheless, elimination of
Corp., with $30 billion in cash (recently increasing at the rate of pooling for U.S. companies will level the playing field for for-
$1 billion a month), will enjoy a distinct advantage in the M&A eign companies, making them more competitive in the M&A
race. Cash purchases have been avoided in many cases because market. That is likely to accelerate the growth of foreign acqui-
of asset revaluation and goodwill. Now, the cash-rich will have sitions in the U.S.
a stronger market position with the freedom to make cash acqui- Management compensation plans will change. To the extent
sitions, thereby avoiding the excessive EPS dilution, goodwill that existing compensation plans are tied to EPS, P/E and other
amortization and additional issues raised by stock deals. “older” valuation methods, management compensation could
A Merrill Lynch & Co. study of 1998 mergers and acquisi- be impacted. The key is to revisit pay plans to ensure that the
tions indicated that “55 percent of the dollar volume of U.S. best measures of economic health are used. The old adage that
mergers employed the pooling method.” Thomson Financial you get what you measure applies here. If incentive plans are fo-
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ANNUAL EDITIONS
cused on specific performance measures, acquisition plans will As a result, comparability within and across companies will
reflect these. If alternative behavior is more desirable, plans be challenging, and financial reporting and disclosure will be
should be tied to less volatile measures. more complex. We may be stepping from relatively clear waters
into muddy ones, but regardless of accounting rules on business
combinations, a good deal will still be a good deal.
Conclusion
Under FASB 141 and 142, financial reporting should be mar-
ginally improved, with deals driven more by underlying eco-
nomic substance. Unfortunately, the pricing and structure of Joanne W. Rockness is Cameron Professor of Accounting, Howard O.
acquisitions will still be driven in part by accounting rules. Rockness is Professor of Accounting and Susan H. Ivancevich is As-
Earnings will be increasingly subject to possible enhancement sistant Professor of Accounting, all at the University of North Caroli-
through use of in-process R&D expense, intangible asset classi- na–Wilmington. Susan Ivancevich would like to thank Dixon & Odom,
fication and timing of goodwill impairment write-offs. LLP, for financial support for this project.
Reprinted with permission from Financial Executive, October 2001, pp. 22-25. © 2001 by Financial Executives International, 10 Madison Avenue,
Morristown, NJ 07962.