FOOL ON THE HILL
Accounting Fireworks

First, the Financial Accounting Standards Board proposes that companies needn't amortize goodwill, then it says its proposal should be retroactive. If this proposal becomes a rule, investors will see earnings soar. You should know what this means for calculating returns on equity and operating margins.

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By Richard McCaffery (TMF Gibson)
December 27, 2000

The Financial Accounting Standards Board (FASB), the folks who make U.S. accounting rules, are ending the year with a bang.

If you don't think accountants can make fireworks, make waves, or make noise, it's worth reading the FASB's latest proposals regarding purchase and pooling accounting, the two controversial methods of accounting for business combinations. Investors could be looking at major changes in the way companies report earnings and account for items on the balance sheet.

Accounting might not be your thing, but it's the language of business. If you can't speak it well enough to find an asset on a balance sheet, you're talking gibberish. Worse, you're prey for those who push stock-picking schemes based on anything other than fundamental analysis. That doesn't mean you have to be an accounting expert, no way. Just learn the basics.

Dip into a few accounting books, and you'll see an immediate payoff in your ability to understand financial statements. In fact, you might find the world of accounting strangely compelling -- a very old, very versatile, though very imperfect method of bookkeeping.

Here's some background taken from a recent article. U.S. Generally Accepted Accounting Principles (GAAP) permit two accounting methods for business combinations: purchase and pooling. Under the purchase method, any premium paid in excess of the acquired company's book value that can't be assigned to a category of intangible assets (such as patents) gets recorded as goodwill. Companies don't like this, since goodwill has to be amortized, which means its gets deducted from earnings.

Under the pooling method, the balance sheets of the two companies are combined, no goodwill is created, and net income isn't reduced by periodic amortization expenses. Lots of companies use the pooling method when allowable, for obvious reasons -- they don't want to see net income reduced as the byproduct of a big acquisition.

On Dec. 6, the FASB proposed allowing companies to keep goodwill unamortized on the balance sheet. Companies that used the pooling method cheered this tradeoff, of course, because FASB had already proposed eliminating pooling, and this new proposal would remove the aspect of purchase accounting companies loathe -- reducing earnings as a result of goodwill amortization.

As an encore, the FASB announced Dec. 20 that its proposal should be retroactive, meaning companies currently amortizing goodwill no longer have to do so. How big a deal is this? Look at optical components manufacturer JDS Uniphase (Nasdaq: JDSU). The San Jose, California company has spent more than $40 billion in the last 18 months buying up competitors. (This figure includes SDL (Nasdaq: SDLI), an acquisition still pending.)

Since it used the purchase method to account for most of these acquisitions, and most of the companies it bought had little in the way of tangible assets, JDS parked a massive amount of goodwill on its balance sheet. Turn to its latest 10-K and you'll see JDS has more than $22 billion in goodwill and intangible assets.

According to present accounting rules, that goodwill must be amortized over a maximum of 40 years, which is why fiscal 2000 earnings were reduced by an $897 million goodwill amortization charge. Now, if the FASB proposal goes through, JDS won't have to amortize that goodwill unless it becomes impaired, or loses value.

Suddenly, JDS would be reporting an additional $897 million in earnings -- which means rather than reporting a $907 million net loss last year, JDS pretty much broke even. In truth, most investors and managers already ignore these amortization charges when looking at the income statement. Amortization expenses are non-cash charges, thus they don't impact the amount of money a firm has at its disposal. Further, in a number of cases, goodwill actually increases in value. In these cases, it doesn't make economic sense to write down an asset that isn't spoiling.

Therefore, regarding JDS, most investors would understand adding back $897 million in amortization charges isn't a change in economic substance, but rather one of accounting form.

Whether goodwill is amortized is an important issue, but it's secondary to eliminating pooling, in my opinion, since pooling is an absolute scam. Why? Companies that use pooling don't have to record goodwill on the balance sheet or make proper changes to their equity base to reflect acquisition costs. This means there's virtually no financial track record of a critical financial transaction.

Let's say Company A exchanges $50 million in stock to acquire Company B in a pooling transaction. That $50 million is just as real as cash, perhaps even more real for investors that just experienced dilution in their ownership position. These investors are entitled to compensation for this transaction in the form of an adequate return on investment. How do they track this return?

Without any record on the balance sheet, it's much more difficult for investors to determine. Here's a simplified example of what return on equity (ROE) would look like for two firms, one that used pooling, the other purchase. Remember ROE is equal to net income divided by average shareholders' equity.

              Pooling     Purchase  
ROE           $50/$160    $48.7/$200
ROE             31.2%       24.3% 

Why the difference? The firm that used purchase accounting gets a double whammy. First, it has a much larger equity base to earn a return on, since the sale of stock boosts paid-in capital roughly by the market value of the stock exchanged. Second, net income is reduced due to goodwill amortization charges. That's the problem with having two different accounting methods for mergers and acquisitions -- you end up with very different results for the same transaction.

This is why it makes so much sense to eliminate pooling. The firm that uses purchase accounting is forced to earn a return on all that extra equity, and investors can see it happen. This is proper. The pricier the acquisition, the harder it is to earn a satisfactory return. The pooling firm gets off scot-free.

As mentioned in a story on this topic a few weeks ago, there are accountants and investors who strongly object to the new rule because it doesn't require companies to amortize goodwill. In their view, this proposal inflates earnings.

There are two points here to consider. First, any investor who bases his understanding of a company's financial position on looking at just the income statement is already sunk. The bottom line is pretty much worthless alone. Don't be surprised by this. Accountants break up financial statements into three (technically four) separate statements because you can't fit all the information on a single page.

On the other hand, I sympathize with those who want to see goodwill amortized for the sake of consistency on the income statement. Whether or not goodwill is a wasting asset, one that declines in value, goodwill is an expense. When incurred, it's part of a company's cost of doing business, and I'm a little sorry to see that no longer reflected on the income statement.

Let's use the JDS example. Currently, the $897 million goodwill charge shows up as an operating expense, which led to an operating loss. Without that charge, JDS would have reported an operating profit of $31.8 million. An investor trying to calculate the operating profit margin of a company that fails to amortize goodwill is looking at an inflated number, even though amortization is a non-cash charge.

How so? Remember the income statement matches revenues and expenses during a given period. Is it fair that a company gets to record revenues, presumably some of which are the benefit of acquired goodwill, without allocating the cost of acquiring the goodwill concurrently? I'd argue that if you want to know how much cash a company is producing, ignore amortization charges; but if you want to look at its operating margins, add them back in, at least when looking at companies with large blocks of unamortized goodwill. When a company pays a large premium for an acquisition, that expense is part of the cost of doing business, and whether allocating it over fixed periods is accurate or not, I always prefer a conservative estimate to one I know is too high.

Happy Holidays!