Goodwill Accounting: The FASB Books New Rules

Dec. 21, 2004
Earnings boost is one likely result of merger and acquisition changes.

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.

About the Author

John McClenahen | Former Senior Editor, IndustryWeek

 John S. McClenahen, is an occasional essayist on the Web site of IndustryWeek, the executive management publication from which he retired in 2006. He began his journalism career as a broadcast journalist at Westinghouse Broadcasting’s KYW in Cleveland, Ohio. In May 1967, he joined Penton Media Inc. in Cleveland and in September 1967 was transferred to Washington, DC, the base from which for nearly 40 years he wrote primarily about national and international economics and politics, and corporate social responsibility.
      
      McClenahen, a native of Ohio now residing in Maryland, is an award-winning writer and photographer. He is the author of three books of poetry, most recently An Unexpected Poet (2013), and several books of photographs, including Black, White, and Shades of Grey (2014). He also is the author of a children’s book, Henry at His Beach (2014).
      
      His photograph “Provincetown: Fog Rising 2004” was selected for the Smithsonian Institution’s 2011 juried exhibition Artists at Work and displayed in the S. Dillon Ripley Center at the Smithsonian Institution in Washington, D.C., from June until October 2011. Five of his photographs are in the collection of St. Lawrence University and displayed on campus in Canton, New York.
      
      John McClenahen’s essay “Incorporating America: Whitman in Context” was designated one of the five best works published in The Journal of Graduate Liberal Studies during the twelve-year editorship of R. Barry Leavis of Rollins College. John McClenahen’s several journalism prizes include the coveted Jesse H. Neal Award. He also is the author of the commemorative poem “Upon 50 Years,” celebrating the fiftieth anniversary of the founding of Wolfson College Cambridge, and appearing in “The Wolfson Review.”
      
      John McClenahen received a B.A. (English with a minor in government) from St. Lawrence University, an M.A., (English) from Western Reserve University, and a Master of Arts in Liberal Studies from Georgetown University, where he also pursued doctoral studies. At St. Lawrence University, he was elected to academic honor societies in English and government and to Omicron Delta Kappa, the University’s highest undergraduate honor. John McClenahen was a participant in the 32nd Annual Wharton Seminars for Journalists at the Wharton School at the University of Pennsylvania in Philadelphia. During the Easter Term of the 1986 academic year, John McClenahen was the first American to hold a prestigious Press Fellowship at Wolfson College, Cambridge, in the United Kingdom.
      
      John McClenahen has served on the Editorial Board of Confluence: The Journal of Graduate Liberal Studies and was co-founder and first editor of Liberal Studies at Georgetown. He has been a volunteer researcher on the William Steinway Diary Project at the Smithsonian Institution, Washington, D.C., and has been an assistant professorial lecturer at The George Washington University in Washington, D.C.
      

 

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