Yesterday, Mike Trigg detailed the latest at American Express (NYSE: AXP). Amex's expected shortfall was partly due to junk bond -- oops, excuse me, high-yield bond -- write-downs as a result of new Financial Accounting Standards Board (FASB) rules that require investments to be marked down more quickly if they become troubled. Today, we'll look at the latest FASB thinking about -- drum roll please --accounting for mergers and acquisitions (M&A) under the new proposed purchase method. Whoo whoo!
The FASB is at it again. Just when you thought you had a handle on pooling and purchase accounting for M&A, they change the rules, again. What is it with these seven guys in Connecticut? Put down the HP 12-C and slowly back away, please!
Actually, the FASB proposal to rid of pooling-of-interest method accounting in favor of a hybrid purchase method is not new but it is heating up again. (More on the current purchase and pooling methods as well as the proposed method later.) The comment deadline -- the last day the FASB Board accepts comments to be taken under consideration when deciding the matter -- was March 16th, and the general thinking is that the Board will make the change.
Why is the FASB doing this?
In a speech entitled "The New Wealth of Nations," Treasury Secretary Larry Summers noted that we are moving from "an economy based on the production of physical goods to an economy based on the production and application of knowledge." Larr, I've got news for you -- we are already there. According to data from Economy.com, nearly 65% of U.S. workers are employed by private (non-government) service companies. Only 19% work in the manufacturing sector.
Service companies' assets are mostly human capital and other intangibles that are not accounted for easily on the balance sheet. For instance, Microsoft (Nasdaq: MSFT) has net assets -- total assets minus liabilities -- of $46 billion and a market cap of $277 billion. The difference of $231 billion is largely due to the knowledge base of Microsoft's thousands of software engineers. Accounting for these intangibles accurately is vital to the integrity of our accounting system.
Under the current purchase method, assets like human capital only show up on a company's balance sheet as goodwill after an acquisition has taken place and if the acquirer uses the purchase method. Even then, goodwill is written off or amortized slowly over an arbitrarily chosen amount of time regardless of the value of those intangible assets. What if those assets appreciate in value? What is the value of the hundreds of optical engineers JDS Uniphase (Nasdaq: JDSU) has acquired through its numerous acquisitions? What about Johnson & Johnson's (NYSE: JNJ) purchase of Alza (NYSE: AZA)? Is Alza's line of drug delivery products going to depreciate or appreciate under J&J's watch? Pooling is also oblivious to this issue and leaves no trace of the acquisition. The current purchase system ignores the retainable long-term value of the nearly $9.0 billion in "goodwill" that J&J is taking on.
The new proposed purchase method was developed with these issues in mind. Although it does not attempt to address the value of intangibles outside of a merger or acquisition transaction, it is aimed at recognizing that some intangibles do not depreciate.
The old and the new
The Motley Fool first addressed this issue in a December Fool on the Hill article. In it, Rich McCaffery outlined the difference between purchase and pooling accounting, and since I don't write nearly as well as my fellow Rule Maker manager, I will borrow his words.
"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." Goodwill shows up on the balance sheet as an asset and is amortized over its expected useful life, but not longer than 40 years. The amortization hits the income statement lowering earnings. As you'd imagine, acquisitive companies are not lining up around the block to use this method.
They prefer the pooling-of-interest method. Like Rich said, "Under the pooling method, the balance sheets of the two companies are combined, no goodwill is created, and therefore net income isn't reduced by periodic amortization expenses." Not only are the balance sheets combined, but all the financial statements are combined. Income and expenses are restated for prior periods allowing for an apples-to-apples comparison from period to period.
Having two methods creates difficulties per se. Accounting options are not always good for investors because they allow beancounters leeway to massage numbers and create problems with comparability among companies. One CFO may deem the useful life of acquisition to be four years, while another may use 20. On the other hand, options are necessary to allow for extraordinary situations and for accurate accounting.
And there is logic behind the madness of each method. The pooling method results in financial statements that are easily compared from one period to the next and does not penalize a company for using its own bloated stock to purchase another over-valued company. The purchase method forces companies to think twice before paying astronomical prices for other companies as well as leaving a trail of invested capital that investors can follow.
Tomorrow, I'll provide examples of how these changes will affect P/E ratios and why the individual investor should be on the lookout. As many as half the companies with goodwill on their balance sheets may see EPS increases of 10% or more, effectively lowering P/Es. Fundamentally, nothing will change but investors should be ready for adjustments to earnings and P/Es.
On a fun note, if Tiger wins the Masters this week, should it be considered a Grand Slam? Vote on our Golf Tips and Chat discussion board.
Todd Lebor enjoys writing about FASB announcements as much as he enjoys the morning traffic. Todd owns shares of Microsoft and his other holdings can be found online along with the Fool's complete disclosure policy. The Motley Fool is investors writing for investors.