Accounting for Cisco and JDS Uniphase

As much as I like watching Cisco Systems (Nasdaq: CSCO) do its amazing growth thing, its pooling accounting bugs me.

The company should take a close look at fast-growing JDS Uniphase (Nasdaq: JDSU), whose treatment of acquisitions makes it plain for investors to see how much money the optical networking manufacturer spent in the last 18 months to become a market leader.

The bottom line is this: Eliminating the pooling of interests method for acquisitions is the right thing to do, since it allows investors to better track how much companies are spending on big acquisition deals.

Many corporations know it, but argue they can't take the final step since investors are too dumb to understand that those enormous amortization expenses are noncash charges that don't affect economic profitability.

That's just plain wrong.

There's boatloads of information supporting the position that investors don't penalize companies for noncash amortization charges. More on this in a bit. First, a little background for investors who burned their accounting textbooks years ago.

When a company makes an acquisition it can account for the transaction in one of two ways, purchase or pooling. You'll see this language in every press release involving an acquisition. Since the method chosen has a drastic impact on the acquiring company's financial statements, it's worth understanding the basic differences, especially here in the Rule Maker portfolio where we pay so much attention to the balance sheet.

In purchase accounting, the acquiring company records all assets and liabilities of the purchase at fair market value. The excess amount paid over net asset value gets recorded as goodwill on the balance sheet and is written down over as much as 40 years. These goodwill amortization charges are an expense that can drastically reduce earnings, even though they have no affect on the company's real profitability.

In pooling accounting, the two merging companies merely combine their assets and liabilities at historical cost, creating zero goodwill on the balance sheet and, therefore, zero goodwill amortization charges on the income statement. Earnings aren't impacted, and the wedded couple sails blissfully into the sunset of smooth accounting miracles.

Problem is, there's no track record of how much the acquiring company paid for the wedding, since everything was just combined at book value, as though the two became one without any capital costs for goodwill.

One of the chief problems with this is that it can create the wrong impression. For example, a company that records acquisitions using the purchase method could end up with lower returns on equity and assets relative to a company that uses pooling, even though economically there's no difference between the accounting treatments.

It's indisputable, therefore, that purchase accounting gives investors a better look at what a company has been doing with its capital, since goodwill appears, plain as day, on the balance sheet. This makes it easier to develop a clear financial picture of what's been happening.

Nevertheless, companies like our own Cisco Systems (Nasdaq: CSCO) spend more time in the pool than Mark Spitz, and are fighting against any changes the Financial Accounting Standards Board (FASB) has planned. (Currently, FASB has proposed a rule to eliminate pooling accounting as of January 1.)

"Elimination of pooling will derail the engine that is driving the strong economy of this country," Cisco Systems Controller Dennis Powell, said in a June 25 Washington Post story.

That's balderdash (a worthless mixture of liquors).

Optical component networking company JDS Uniphase (Nasdaq: JDSU) has been busily buying companies over the last year -- well over $50 billion worth, including the SDL (Nasdaq: SDLI) deal -- and all have been accounted for using the purchase method.

As of June 30, the end of JDS's fiscal year, the company reported a whopping $897 million worth of amortization charges on its income statement, more than enough to wipe out its $679 million of gross profit for the year. Turning to the balance sheet, we see that the bulk of JDS's assets -- more than $22 billion -- are intangible, largely the result of goodwill from acquisitions.

At least we know how the company has been spending its money. We've got our answer in black and white on the financial statements. As long as investors realize those assets may not be worth anything like the amount the company paid for them -- which is a risk in many acquisitions -- they're in good shape, fully informed about JDS's capital activities.

"It's easier to see," said Steve Moore, vice president of finance at JDS, in a phone interview. "You get to see the full impact of the deal on the balance sheet."

But, won't the investing public fail to realize that amortization charges won't damage the company's profitability? Let's see, JDS stock is up almost 40% this year. A company nobody heard of 18 months ago has a market value approaching $100 billion. "You have to give the investing public a little credit," Moore said. "The economics of the transactions are the same."

Bravo, and no more tears about investors being too dumb to understand anything but earnings per share. They're not only smart enough to back out amortization charges when it's appropriate, but they know earnings per share can be a fiction, that cash from operations and free cash flow are a much better measure of true profitability.

Cisco's balance sheet is another story. You won't find the billions of dollars worth of stock exchanged for acquisitions accounted for anywhere on its financial statements. Investors are virtually in the dark regarding how much capital Cisco has deployed to build its $446 billion business, or $33 billion asset base.

The networking giant should take a page out of JDS's handbook.

What do you think? Post your thoughts on the Rule Maker Strategy Board.

Have a great day.

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