Jumping Through Hoops: Goodwill Offers Investors Clarity and CFOs Complexity.

While the economic slowdown has been a challenge to the bottom line for many businesses, finance and operations officers will face new hurdles in the new year in the form of mergers and acquisitions and the Financial Accounting Standards Board's new purchase accounting rules. In a move that aligns the United States more closely with international accounting standards, FASB Statement 141, Business Combinations has abolished the pooling of interests method. While FASB Statement 142, Goodwill Amortization and Other Intangibles, requires that goodwill no longer be amortized to earnings, but tested for impairment. The rulings, released in July, aim to improve the quality of financial reporting for acquisitions and give investors a clearer picture of a company's value.

"The new model is fairly revolutionary," said Norman Strauss, Ernst & Young executive professor in residence at Baruch College in New York City, during the UC Berkeley Haas School of Business' 12th Annual Conference on Financial Reporting. "FASB determined that the pooling method was not useful, it was abusive and it was flawed. And goodwill amortization was arbitrary and didn't provide useful information to investors."

Timothy Lucas, FASB director of research and technical activities, agrees. "Pooling created an incentive to twist transactions to reflect favorable accounting of a merger, and the criteria for pooling was complex.

"At the same time, goodwill amortization was not meaningful. In that aspect, the release of statements 141 and 142 is a success story. It's been the longest-running project we've accomplished, even though we haven't reached closure on some of the issues."

Indeed, the five-year FASB project went through many revisions before its final release this year. And FASB hopes the benefits of the statements will outweigh their complexity. "While I accept that the impairment judgment is complex in its own right," says Lucas, "it came about out of the necessity of making the economics of M&A transactions more clear."

A NEW KIND OF COMPLEXITY

It has been a trade-off. One set of complex standards--the pooling of interests--will be replaced by another set of complex rules--the goodwill impairment test. "Getting rid of pooling makes life simpler, but testing for when goodwill is impaired will be more robust and rigorous," says Doug Barton, a partner in merger and acquisition services with Deloitte & Touche in San Francisco.

Under FAS 141, companies must use the purchase accounting method for new M&A transactions, since the pooling of interests method has been eliminated. And the purchase accounting method has changed under FAS 142.

When FAS 142 becomes effective, Jan. 1, 2002 for most companies, companies can no longer amortize goodwill to earnings, but instead review it for impairment. If the value of the acquired asset declines, it must be written down as goodwill impairment under operating expenses.

To determine the amount of goodwill impairment, a company will compare the book value of the acquired reporting unit to the current implied fair value of that unit, and the book value of goodwill to its implied fair value, as part of a two-step test.

GOODWILL'S SILVER LINING 

But the trade-off will make a difference to investors, Lucas says, and he hopes companies will benefit, too.

"Managers will also benefit from the better information," Lucas says. "It's good for companies to take an organized look at the value of the business periodically."

If management knows how well or badly a reporting unit is operating, they can inform investors to avoid surprises. "While investors can be tolerant of losses, they tend to be unforgiving of surprises," writes Tony Aaron on Ernst & Young's Web site. Aaron, a partner in Ernst & Young's corporate finance valuation group in Los Angeles, adds "since impairment depends on market values, it will be much less predictable than straight-line amortization based on acquisition price. Firms will want to monitor value on an ongoing basis."

Rather than amortizing goodwill for up to 40 years, the new rules will reflect what's happening to the company in real time. "The new accounting is closer to economic reality than what we used to have," says Barton. "But it will be more costly and subjective."

THE COST OF VALUATION

The goodwill impairment test is inherently subjective and puts more emphasis on valuation evidence, Barton says. This is likely to open the doors to second- guessing and scrutiny from the SEC.

Barton advises companies to step carefully when applying the new standards. And some experts, like Jeffrey Jones, a partner in merger and acquisition services at Deloitte & Touche's San Francisco office, say "having the documentation that an expert performed the valuation will hold up better under subsequent scrutiny."

Depending on the complexity and size of a reporting unit, a valuation or appraisal may cost between $15,000 and $20,000, said Alfred King, chairman of Valuation Research, in the June 29 CFO.com article, "Intangibles Revealed." Add to this, the cost of outside auditors who must sign-off on the assessments and any potential legal costs. "And this is only for step one," says Strauss. "Step two could be much more expensive."

Though the costs for valuations may vary widely, some firms may not have the extra funds to spend in an already tight market.

"In the private sector, it burdens an already burdened finance or operations officer to become a market sage or make them spend money on valuation experts in a tight-cash flow market," says Jay Siegel, principal of financial accounting at RBZ, LLP in Los Angeles. "If we were talking a hot market, then there would be cash to spend."

GOOD IDEA, BAD TIMING

The slow market also could affect how companies value their assets, Siegel adds. "The valuation of intangibles in a slow economy may not be the inherent value of the intangibles. Clients have to look at the underlying values of the intangibles over the longterm as opposed to a knee-jerk valuation for what may be short-term market fluctuations, like the tragic events of Sept. 11."

But even short-term fluctuations won't eliminate the impact of an economic slump on acquisitions purchased during the boom, especially in industries with high value intangibles, such as technology, biotechnology and many consumer goods and services. "Several record-breaking years of consolidation activity, followed by a decline in valuations, have left many companies with acquisitions worth less than the purchase price," writes Aaron.

In fact, there "may be more than a few companies reporting impairment losses during the first quarter," says Lucas, because most companies operate under a calendar fiscal year. But it also may be because of the slow economy and some companies may have impairments that have built up over the past 20 years.

Taking a hit in the first quarter may be the best way for companies to get the new accounting rules under their belt. "Some companies will prefer that they have impairment write-downs at the transition, so they can label it as an accounting change," says Lucas.

Aaron suggests companies carefully consider how to integrate their acquisitions, since "the composition of reporting units will have a big impact on whether impairment occurs." It may be better to organize reporting units into only a few units as opposed to several smaller reporting units, Aaron adds. But "reporting units will need a sound rationale to withstand SEC scrutiny."

THE FIRST STEP IS ALWAYS THE HARDEST

As accountants head into uncharted territory with the new accounting rules, FASB hopes the complexities and potential losses will pay off in the long run for both investors and managers.

Sharon Ross is an associate editor of California CPA.

RELATED ARTICLE: TIPS ON MINIMIZING GOODWILL IMPAIRMENT

* Carefully Consider How to Integrate Acquisitions:

Goodwill impairment is calculated at the reporting unit level, and cannot be netted against gains from another reporting unit. So the composition of "reporting units" will have a big impact on whether impairment occurs. In general, companies probably will be better off with a smaller number of larger reporting units although, of course, reporting units will need a sound rationale, particularly to avoid SEC scrutiny.

* Avoid Surprises: Valuations should be performed and reviewed using a conservative approach, thoroughly documenting the methodology employed.

Certain acquired intangible assets continue to be recognized separately from goodwill and amortized over their estimated useful life, It is essential to quantify the value of these intangibles--such as intellectual property, high-profile brands and a strong customer base--prior to a deal to predict the resulting earnings dilution.

* Educate Personnel: Fair value, allocation of goodwill to reporting units versus intangibles, and the way reporting units are defined, are all open to interpretation. Those serving on audit review committees must be educated on making these subjective calls to the satisfaction of shareholders and the SEC. Also, deal makers must be trained to factor the goodwill rules into their projections. Finally, investor relations professionals will have to be able to explain why write-downs have occurred and the expected impact on the firm's current and future earnings.

* Communicate With the Market: Educate shareholders on the implications of the new standards and the ways that it will impact earnings going forward. Since impairment depends on market values, it will be much less predictable than straight-line amortization based on acquisition price. Firms will wont to monitor value on an ongoing basis, to catch impairment indicators in the early stages to allow time to take corrective action. The key thing to remember is, while investors can be tolerant of losses, they tend to be unforgiving of surprises.

Jill Voigt

Tony Aaron

Jill Voigt is a partner in Ernst & Young's Global Corporate Finance group. She can be reached at [phone] or at [e-mail].

Tony Aaron is a partner in Ernst & Young's Corporate Finance Valuation group. He can be reached in Los Angeles at [phone] or at [e-mail].