Yesterday, we reviewed pooling-of-interest and purchase method accounting as well as the new proposed purchase method. Today, we look at the impact to earnings per share (EPS) in La La Land and the real world.

You may be surprised to read about EPS at the Fool. We usually concentrate on free cash flow (FCF) rather than EPS and P/E ratios because of the number of ways the GAAP (generally accepted accounting principles) EPS can be manipulated. But I also live in the real world and know that most individual investors think in terms of EPS rather than FCF per share. EPS is plastered all over every financial website (even ours!) while FCF per share is almost non-existent. The simple truth is that calculating FCF requires a little blood, sweet, and tears, which keeps many investors in the dark. EPS has been burned into the collective investor psyche.

In fact, over the weekend my brother mentioned that one of my favorite stocks was trading at a "much higher P/E" than its peers. So, for the umpteenth time, I broke into my but-it-is-spending-hundreds-of-millions-in-non-recurring-advertising speech, and that didn't work. Then after my 15-minute tirade on why EPS is not the best measure of this company's profitability, he emphatically said, "Yeah, but the P/E is still too high." I give up.

So, this one is for those of you who still think in terms of EPS and P/Es. It is intended to prepare you for the possible change in EPS and corresponding P/E ratios coming to a theater near you this summer. But before we go any farther, I must state the obvious: Accounting changes do not change true cash flow or the fundamentals of your investments. Companies will sell the same amount of goods and services regardless of what the Financial Accounting Standards Board (FASB) says.

That said, reported earnings, EPS, and P/Es will be affected by this proposed change in accounting policy. Before we talk specifics, let's look at how the change flows through the financial statements.

La La Land
Amalgamated Thought Co.
(Ticker: HMMMM) uses its stock, which is trading at 80x EPS, to buy Global Telepathic Messaging (Ticker: ESP), which trades at 40x EPS. (Amalgamated has a plan for the next killer app -- telepathic instant messaging -- and it needs Global's technology.) The price is $2.0 billion and Global has $200 million of book assets.

Under the pooling method, Amalgamated simply adds $200 million to its book assets, revises its historical financials, and voil�. There are no financial scars from the transaction and the dollar amount paid is irrelevant because Monopoly money (read: stock) was used as currency. It's like two rain drops meeting on the windshield of your car. Once they merge, you can't tell that they were ever apart, and the merged drop continues to trickle down the windshield as one.

Under the purchase method, Amalgamated would have to book $1.8 billion -- the $2.0 billion purchase price less the $200 million book value -- of goodwill and amortize that amount over the "useful life" of Global. Amalgamated's management team would be reminded each quarter that it paid out the wazoo for Global when it books an amortization charge against earnings and perhaps think twice the next time it considers ponying up $1.8 billion for intangibles -- even if it is worth it.

Under the new proposal, pooling would be eliminated and purchase accounting would be the sole option. The big change is that goodwill would not have to be amortized. Instead, goodwill would be written down or off with a charge to income as necessary. As the proposal states it, "The carrying amount of goodwill would be reduced only if it was found to be impaired or was associated with assets to be sold or otherwise disposed of."

Applying this to our example, Amalgamated would book $1.8 billion in goodwill on its balance sheet but as long as that price holds its value, the goodwill would remain at $1.8 billion. There would be no hit to earnings unless an impairment review event occurs and only then would a onetime charge hit the income statement. Once written down, the goodwill can not be written back up.

The Real World
Bear Stearns (NYSE: BSC) recently looked at 26 companies with market caps over $1 billion and goodwill that represented more than 50% of total assets and found four companies (15%) that experienced a 100% or more increase in EPS as a result of the proposed accounting change. This increase in EPS will in turn lower P/E ratios. Half of the companies are estimated to have increases of 10% or more. So, be prepared for some changes.

On a side note: First Call already reports EPS excluding amortization of goodwill expense -- called "cash EPS" -- for some companies. According to the Bear Stearns report, cash EPS is provided for 251 companies, including Cisco (Nasdaq: CSCO), eBay (Nasdaq: EBAY), Intel (Nasdaq: INTC), JDS Uniphase (Nasdaq: JDSU), and Yahoo! (Nasdaq: YHOO). Therefore, be careful where you get your EPS data. If it's from First Call look for the "(Excl. GW)" next to the company name. If it is from or Market Guide or Hoovers, the EPS number comes right out of the Securities and Exchange (SEC) filings and includes goodwill amortization expense. Know your source.

Adjusting goodwill because assets are impaired is nothing new. GAAP currently requires a periodic review of goodwill assets. Several companies -- such as Lucent (NYSE: LU), Disney (NYSE: DIS), and Excite@Home (Nasdaq: ATHM) -- recently took goodwill write-downs due to the diminished value of purchased assets. But the new proposal expands the impairment criteria and changes the way write-downs are valued.

A few examples of circumstances leading to an impairment review are:

  • Negative cash flows with a history of cash flow losses or projected losses
  • Adverse changes in expectations
  • Pending sale or disposal of a unit

The details are not important (let the CPAs work it out) but the impact on P/E ratios will hit home for the average investor. So don't jump to conclusions if suddenly your favorite stock is trading at a P/E of 15x instead of 30x.

Todd Lebor enjoys writing about FASB announcements as much as he enjoys the morning traffic. Todd owns shares of Cisco, Disney, and Intel. His other holdings can be found online, along with the Fool's complete disclosure policy.