Editor's note: The following was first published as a Fool on the Hill column on April 22, 1999.
ALEXANDRIA, VA (Sept. 27, 1999) -- Non-fans of poolings of interests knew their day would come. And it did. Last April 21st, the Financial Accounting Standards Board made its announcement: "The Financial Accounting Standards Board announced today that it would eliminate pooling of interests as a method of accounting for business combinations. In a unanimous vote, the Board tentatively decided that using the purchase method is preferable to allowing more than one method to be used when businesses combine. The change will be effective for business combinations initiated after the FASB issues a final standard on the issues, which is expected to be late in 2000." The only problem with that is that it doesn't come soon enough.
Let's get to the heart of the matter. Rather, let's let FASB Chairman Edmund L. Jenkins do that: "The Board decided that it is hard for investors to make sound decisions about combining companies when two different accounting treatments exist for what is essentially the same transaction. We believe that the purchase method of accounting gives investors a better idea of the initial cost of a transaction and the investment's performance over time than does the pooling of interests method.''
You go, Ed. Exactly. There is no difference in the two methods except that many companies jump through ridiculous hoops that kill long-term value and restrict capital management alternatives when they decide that they must absolutely use the pooling-of-interests transaction accounting instead of the purchase method.
A little history, courtesy of my former Boring colleague Alex Schay, who is even more of an accounting geek than I am:
"Ironically, pooling accounting gained currency as a result of abuses that were occurring under the purchase method. According to Tony Cope of FASB, back in the days when utility companies could pretty much receive a steady, guaranteed return on their asset bases -- thanks to sympathetic regulators who would help hike rates if returns were not growing with assets -- there was a strong incentive to boost assets by means of acquisition (and the subsequent goodwill that was created in the purchase). Rate boards began to catch on to the abuse, hence the pooling methodology began to wend its way through corporate America -- resulting in the skein that we see today."
The big worry for some CFOs and CEOs is that they'll now have to contend with goodwill amortization cluttering up the income statement and goodwill cluttering up the balance sheet. Here's the news flash on that: The market already discounts merged entities as if they were effected under the purchase method. How in the world, if it doesn't, does the market figure out when a roll-up company isn't generating the return on capital necessary to add economic value to that capital? The market's not dumb -- Ben Graham wrote that and Warren Buffett believes that, as well. The market might be bi-polar, but its episodes are more rare and are not the norm.
The market equates poolings versus purchases by marking up "unrecorded goodwill" on the combined balance sheet of the pooled entity. Say, for instance, that Company A had book value of $60 and acquires Company B for $61.60 in stock. Company B has an appraised net asset value of $40 before the transaction. Before the transaction, Company A was earning $9.60 and company B was earning $5.60.
Under the purchase method, the pro-forma earnings of the combined equity would be $14.66. That's $9.60 + $5.60 minus goodwill amortization of $0.54 (1/40th of the $21.60 premium to appraised net asset value of Company B). Under the pooling-of-interests method, the company's net income would be $15.20. All these are under current Generally Accepted Accounting Principles, not prospective GAAP.
Leaving off the vital, but complicating, issues of accretion/dilution (it's not as vital, by the way, if it's just bookkeeping accretion), the market's going to put two companies on the same footing. Personally, I used to take all the goodwill off the combined company's balance sheet and look at return on assets and return on equity using earnings before goodwill amortization. In that vein, we would have the following:
Equity, including goodwill: $121.60
Goodwill brought on through purchase: $21.60
Pre-purchase book value of Company A: $60
Pre-purchase book value of Company B: $40
Tangible book value of combined entity = Book value - goodwill = $100
1. Return on tangible equity before goodwill amortization would be 15.2%.
2. Return on equity before goodwill amortization, leaving goodwill in book value = 12.5%
The poolings CEO might want you to look at the first example, because that's what their balance sheet and income statement would yield, but that's not the real economic earnings of the company. The purchase CEO would tell you to look at the second, because goodwill amortization means nothing unless that goodwill is an asset that declines in value and continually needs to be replaced at the 2.5% yearly rate.
The proper way to adjust the two is not to deduct goodwill from the purchase method company and look at return on tangible book equity before goodwill amortization. The proper way is to look at the poolings method company as having gone out and sold $61.60 in equity and then used that cash to acquire company B. In that case, book equity would be the same as the purchase company's owners' equity: $121.60. We would then look at return on deployed equity without including the arbitrary 2.5% goodwill charge or any other arbitrarily selected goodwill expense. Again, the expense means nothing if the asset does not have to be replaced.
The market is going to award a higher multiple to the artificially depressed earnings and a lower multiple to the goodwill-free earnings under the two GAAP methods now in place. In addition, the goodwill-free company will get a higher multiple to book and the company with goodwill will have a lower multiple to book, all else about the companies' prospects being equal.
I'll say right now that I've been taken in by the poolings game. For instance, First Union (NYSE: FTU) and BankAmerica (NYSE: BAC) have done tons of poolings over the years, which pump up return on equity (ROE) because the companies have gained tremendous platforms that have very low average costs per dollar of income. But their book equity tells nothing about their deployed equity. That's to say that it would be much more economically accurate to look at their ROE based on the value of equity actually deployed over the years. To do that, you would have to add back not only unrecorded goodwill, but all goodwill that has been amortized off the balance sheet over the years. And hey, far be it for me to just penalize the Charlotte banks. I think they're great. You'd have to get Chase Manhattan (NYSE: CMB), Citigroup (NYSE: C), the new Wells Fargo (NYSE: WFC), U.S. Bancorp (NYSE: USB), and all the rest of the international and mega-regional acquirers in there. Bank One (NYSE: ONE), get out of the pool!
The analyst's job is to figure out how much capital will need to be deployed to generate future cash flows, prospective returns on investment, what the capital costs, and then internal rates of return inside the operations of the business. Sure, it's stupid to charge your line managers for goodwill, because it's the capital allocators at headquarters that make the acquisition decisions. If I'm the vice president of credit card operations at Bank One, I'm not the guy who makes the decision to acquire First USA, though I might contribute. I have to look at operating assets and the capital allocators have to look at all the capital they've deployed.
I don't know if this sounds lame, but I've really not had the time to convert the entire universe of large banking companies to stand together on a purchase method basis. In the past, I've always deducted goodwill to make everything equal. But that's not the way the market discounts it, I am convinced. In trying to discount cash flows within an EVA (economic value added) framework, under which equity is not free (and this is a basic economic principle), I'm not counting book value acquired when two companies merge. I'm counting the total value of capital traded in return for another entity. That's the market value of the stock issued by the acquirer, not the book value of the acquired company. The market discounts the cost of all the shares issued, which is why EVA or SVA on just book value at BankAmerica, First Union, Chase, or Bank One is so large. If you add back unrecorded goodwill, you get a better picture of what's going on.
All of this is distinct for R&D-intensive companies. They have their own issues, under which amortization of purchased R&D is an economic expense when that acquired R&D is consumed and obsolete within five or ten years or whatever it is. That's another matter at which I've taken a stab at writing about in the past. I called that "Financial Karma's Gonna Get You, Part 1 and Part 2," because I believe the market is not so inefficient as to buy the whole concept of writing off immediately huge chunks of assets representing deployed capital.
For goodwill that is not consumed, you never write it off, because it represents equity and equity is perpetual. For acquired R&D, you're most likely going to have to amortize it, because the acquired R&D usually goes obsolete. That's an entirely different can of worms, since the replacement spending is not capitalized -- it's immediately expensed. I sympathize with Cisco Systems (Nasdaq: CSCO) there. But for pretty much everything outside of R&D-intensive industries, it's time to get out of the pool. The market has always known how to discount you properly. Good to see that the FASB is doing the right thing.
Now, if only the FASB would do the right thing on FAS #125.
Would you work for a bunch of Fools?