Goodwill Accounting: The FASB Books New Rules

Two of the accounting rules by which companies play the merger game are about to change. A boost to earnings is expected to be one immediate effect. Longer-term, the rule changes will force manufacturing executives to more closely examine the continuing value of the factories, equipment, and other assets they've acquired. But, in general, experts do not expect the net result of the changes, which are being implemented by the Norwalk, Conn.-based Financial Accounting Standards Board (FASB), to be a marked slowdown in U.S. merger and acquisition (M&A) activity. Much of what is about to take place is spelled out in accounting language that only an obsessive CFO could love. In simplest terms, the new rules -- which are expected to be published next week in a pair of FASB statements -- will change how companies account for so-called goodwill, the premium above "fair value" that they paid when they bought the factories, equipment, and other assets of another firm. The new rules also will eliminate the widely used pooling-of-interests method for M&A bookkeeping as an accounting option. Purchase accounting will be mandated for mergers and acquisitions begun after June 30, 2001. "The impact is going to be fairly inconsequential" on manufacturers' decisions whether or not to do a deal, states William Hurley, national leader of the M&A practice at the Chicago-based Parson Group. Indeed, the rule changes are "not affecting overall acquisition strategies that we see -- or that we are talking with clients about," he relates. "It's our belief that transactions will continue," confirms Brian Heckler, national partner in charge of transaction services in the global financial strategies practice of KPMG in Chicago. No Charge Goodwill accounting is the headline issue. For companies with fiscal years coinciding with the calendar year, next Jan. 1 is a key date. That's when they'll no longer have to take an annual charge against their earnings for the sometimes substantial goodwill M&A price premium. General Electric Co., for example, has been carrying $26 billion in goodwill on its books, General Motors Corp. $7.4 billion, Ford Motor Co. $6.1 billion, Du Pont & Co. $3.9 billion, and Dow Chemical Co. $1.9 billion, figures Michael Mensah, chairperson of the accounting department at the University of Scranton in Pennsylvania. For some companies, the absence of an amortization charge on the books for goodwill, including the goodwill recorded for past mergers and acquisitions, may substantially boost reported earnings. "It won't be uncommon to see 10% increases in earnings-per-share for a lot of companies -- and there will be some cases where there will be much more significant increases in earnings," predicts Justin Pettit, a partner at Stern Stewart & Co., New York. "Companies that made business acquisitions using the purchase method of accounting on -- or prior to -- June 30, 2001 are more likely to see an increase in earnings, due to the discontinuation of amortizing goodwill," suggests Juan Torres, a principal at Mir Fox & Rodriguez, a Houston-based accounting services firm. However, companies won't be able to forget about goodwill. They will have to carry it on their balance sheets, periodically review the performance of the assets they've acquired, and take charges against income for any significant underperformance of those assets. Effective Management By one recent estimate, 70% of mergers and acquisitions do not add to shareholder value -- or actually subtract from it. And paying too much for an acquisition and underestimating the difficulty of integrating assets are merger phenomena that "aren't going away," says Stern Stewart's Pettit. "The new rules will put more focus on how effective management has been in translating the reasons behind doing a deal into results," stresses KPMG's Heckler. "As goodwill will no longer be amortized, management will be challenged to properly identify and value all assets that will be consumed by the company in its earning process, and those that do not, but provide for a competitive advantage," says Torres. "I believe the new [rules] will provide more information to financial statement users, more consistent earnings comparisons between companies, and strong post-merger evaluation of a business combination." The process of evaluating the performance of goodwill is technically known as testing for impairment. In practice, that means checking for a decline in value and then taking a write-off for those operations that Paul Munter, a professor at the University of Miami's School of Business, describes as not doing "as well as you were expecting." Particularly if a company is trying to focus on its core earnings, says Munter encouragingly, a one-time, non-recurring write-off is "a lot easier to explain to analysts" than is an annual amortization charge against earnings spread over 30 or 40 years. Indeed, Munter expects once the goodwill rules take effect a "bunch of companies" will "suddenly" take one-time write-offs for underperforming acquired assets. Although those write-offs will somewhat decrease companies' current earnings, securities analysts and investors could well be favorably impressed since, without the write-offs and amortization of goodwill, future earnings for the companies will be higher, says Munter.