fool.com: Fool On the Hill: Showdown at the Accounting Corral

FOOL ON THE HILL
An Investment Opinion

Showdown at the Accounting Corral

By Yi-Hsin Chang (TMF Puck)
September 13, 1999

A showdown is imminent between U.S. companies and the Financial Accounting Standards Board (FASB). "Yawn," you say? Not so fast. The issue has to do with something that often captures newspaper and magazine headlines, not to mention our imaginations -- mergers and acquisitions ("M&A" in financial lingo). Hundreds of billions of dollars are at stake here, and some believe that if the FASB gets its way, there actually will be fewer mergers and acquisitions in this country as a result.

The FASB last week proposed to ban the pooling-of-interests method of accounting for business combinations. Instead, the FASB would like to see firms account for mergers using the purchase method. "In a pooling, an investor can't tell what price was actually paid for the companies to merge nor can they track the acquisition's subsequent performance," says FASB Chairman Edmund Jenkins. The board is seeking public comment on the proposal and plans to hold hearings on the matter early next year in New York and San Francisco.

The pooling-of-interests method of accounting, the preferred choice of many companies today, simply combines the assets and liabilities on the balance sheets of the combined entities without regard to the fair market value of the acquired company. In other words, even though a company might pay $800 million in stock for another company, the company being acquired might have a book value of just $500 million. Thus, the $300 million difference would be left unaccounted for.

Under the purchase method of accounting, the acquiring company records the price of the merger as it would the cost of any asset. In short, this method reflects the current cost of the acquired company's assets and liabilities, including intangible assets -- that is, assets that can't be quantified. So in the example above, the $300 million would be accounted for and would reflect the difference between current cost and historical cost of individual assets and liabilities as well as what is called goodwill, which accounts for additional value that might not be readily apparent on the balance sheet, such as a company's stellar brand or tremendous workforce.

Also, under pooling, sales and expenses reported by the two companies are combined as if the acquisition had taken place at the beginning of the year. In fact, even for historical periods of three, five, or ten years or longer, pooling accounting assumes that the two firms have been together forever, from the very beginning. The combined company not only avoids the recognition of substantial goodwill at the time of the transaction, it also dodges future income charges from depreciation of the unaccounted for assets plus the amortization of goodwill.

In other words, the pooling method makes earnings look better than they actually are, hence its popularity among companies. According to The Wall Street Journal, the total dollar value of pooling deals last year reached a record $850 billion, more than half of the $1.6 trillion value of all U.S. mergers.

Under the FASB's proposal, companies also would have a shorter period over which to write off goodwill -- 20 years instead of the current 40 years -- thus tightening another loophole.

The end to pooling likely would mean more transparency for investors, which is always good. In addition, studies have shown that companies that use the pooling method tend to overpay for acquisitions, so the purchase method might make company executives more cost-conscious.

One consequence of the rule change could be a decline in M&A activity, which, if nothing else, would certainly hurt the investment banks that have thrived on the hefty commissions they earn from these transactions. In all likelihood, companies will adapt to the new rules and continue to seek smart business combinations regardless of the accounting change.

Still, don't write off pooling just yet. If the past is any indication, the FASB may very well back off from its proposal if companies balk too much. In 1995, the FASB wanted companies to put a fair market value on employee stock options, but the board bowed to political pressure and stopped short of making it a mandatory practice.

A similar fate could befall this current proposal to end pooling. Already, the FASB has said it would allow companies to use an extra earnings-per-share figure that doesn't include goodwill.