Special report: the battle over pooling of interests.

In an effort to improve financial reporting and increase harmony between U.S. GAAP and international accounting standards, FASB introduced a controversial proposal that would require companies to reveal more of the costs associated with their mergers and acquisitions (M&A). However, some in the investment banking and academic communities argue that it may disrupt the M&A world and seriously weaken FASB's status as the primary accounting standards setter.

On September 7, FASB issued a two-part exposure draft, Business Combinations and Intangible Assets, which proposed eliminating the pooling-of-interests method of accounting for business combinations. The first part, which addresses the method of accounting for business combinations, is an amendment of APB Opinion no. 16, Business Combinations. The second, which supersedes APB Opinion no. 17, Intangible Assets, addresses accounting for intangible assets (including goodwill), whether acquired singly, in a group or as part of a business combination.

In place of pooling, the FASB recommended mandatory use of the purchase method, which, unlike pooling, requires companies to account for goodwill when they report on acquisitions.

Agreeing to disagree

In a press release announcing the issuance of the ED, FASB Chairman Edmund L. Jenkins said, "We believe that the purchase method of accounting gives investors better information about the initial costs of the transaction and the acquisition's performance over time than does the pooling-of-interests method."

After a comment period, which ends December 7, the FASB will take into account all comment letters and testimony as it discusses each issue during public hearings to be held early in 2000. "We estimate that our process will be complete and a final statement issued by the end of 2000," Jenkins said. If adopted as final, the statement would be effective for business combinations initiated after its publication.

But some observers think that relying on the purchase method will needlessly and significantly hinder the U.S. economy's current robust growth. The strength of that expansion, they say, is made possible largely by strategically sound business combinations for which the pooling method is an essential tactic.

A study of the pooling-vs.-purchase controversy, Valuing the New Economy: How New Accounting Standards Will Inhibit Economically Sound Mergers and Hinder the Efficiency and Innovation of U.S. Business, published by Merrill Lynch last June, said "the [purchase] accounting method itself would prove an obstacle to a merger that both parties are eager to consummate. As a result, the wave of consolidations that has enhanced productivity, encouraged innovation, and stimulated dynamism in the U.S. economy may notably decline."

Former FASB Chairman Dennis R. Beresford, now executive professor of accounting at the University of Georgia's Terry College of Business, told the JofA that, while he understands the reasoning behind such arguments, he cannot accept them. "The FASB believes that it should be neutral in its standard setting" he said. Beresford added that FASB doesn't consider "economic consequences" arguments during its deliberations, which do not focus on the achievement of economic goals.

Disclosure vs. earnings

Those critical of the FASB proposal point out that mandatory use of the purchase method can saddle a business with goodwill charges for intangible assets, such as intellectual property. In deals involving significant amounts of such assets, goodwill charges can erode earnings significantly, making a prudent deal look like a strategic error.

In completed deals that opponents of the proposed plan use to illustrate their point, goodwill charges would have given investors a negative view of the transactions' consequences. Ultimately, however, the deals proved economically and strategically sound, those critics say, because the assets they combined were properly valued, despite any premium over book value (i.e., goodwill) that was paid for them--in other words, the end justified the means.

Lest anyone think FASB is making a fuss about something purely theoretical, evidence abounds of the need for guidance from carefully considered accounting models. In the heady world of high-tech M&A, for example, CEOs and CFOs may lose their focus on the importance of full disclosure, becoming more intent on developing and maintaining investors' and analysts' support for a deal. In view of the exponential growth the right merger can provide their nascent enterprises, the executives' enthusiasm is understandable.

During a September 15 press conference to announce Microsoft's purchase of Visio Corp. in a stock swap valued at $1.3 billion, Visio's cofounder and president, Jeremy A. Jaech, said, "This transaction takes us further than we'd ever have achieved on our own. It's really a `1+1=3' equation for us." But FASB wants companies in Microsoft's position to spell out exactly how goodwill figures into such a deal.

Jerry Masters, Microsoft's senior director of financial reporting and planning, said in an interview that he doesn't have a problem with that. The Visio deal would have been made whether or not the pooling method was available, he said, showing little concern over the effect of goodwill charges on Microsoft's earnings. "We don't want accounting to drive this stuff any more than it has to," he added. "Analysts and readers of financial statements will understand these premium amortizations are not necessarily a part of ongoing operations."

By "premium," Masters meant the amount over market value that Microsoft will pay for each share of Visio stock. If the stock-swap deal, for example, had been completed at press time, valuations of Microsoft and Visio stock would have resulted in Microsoft's paying approximately 3% more than market value for each share of Visio stock. So far, however, the companies have not announced when they will complete the deal, which is subject to regulatory approval. But since the Visio deal is likely to close before the FASB proposal can be put into effect, Microsoft can use the pooling method when it accounts for the transaction.

But Microsoft isn't the only big company involved in a merger with substantial intangible assets. For even a giant like America Online, goodwill charges' impact on earnings can be damaging. Merrill Lynch's study points out that in AOL's acquisition of Netscape, goodwill constituted almost 70% ($6.88 billion) of the deal's value. Following that transaction, which was accounted for using the pooling method, AOL reported a net loss of $71 million. If the purchase method were mandated, AOL instead would have reported a net loss of $759 million.

In both scenarios, the economics are identical. But the difference between them is that many companies, unable to inspire the level of investor confidence a Microsoft possesses, could see their market value decline significantly when stating earnings under the purchase method.

Recent history shows how common pooling deals are. The Merrill Lynch study noted: "In 1998, 55% of the dollar volume of U.S. mergers employed the pooling method. Many of these mergers--and the efficiencies they produced--would not have occurred had companies been forced to comply with the new [mandatory purchase] accounting standard now being contemplated."

Thus far, a full-blooded bull market has given investors few reasons, if any, to regret buying into the majority of the entrepreneurial visions that spark these combinations.

So, for FASB, the question is where to draw the line between creative, yet acceptable, deal making and accounting practices that, intentionally or not, prove to be deceptive.

Calling on Congress

Merrill Lynch's study of the pooling controversy said that, "according to the U.S. Department of Commerce, three knowledge-intensive industries--financial services, information technology and pharmaceuticals--accounted for nearly 30% of America's GDP (gross domestic product) in 1998." The study also noted that, in 1998, U.S. mergers were far greater in number and total value than those in Europe and Asia combined.

With those kinds of numbers supposedly at risk, it's not surprising that opponents of the FASB plan are waging war against it on several fronts. Beresford confirmed this development: "People aren't getting the answers they would like and are saying to their congressmen, `You'd better look into this terrible FASB process.'"

If Congress decides to convene hearings, it will carefully examine not only the allegations that FASB's plan will harm the economy, but also whether the proposal will meet its stated goals. One of those goals is the harmonization of international standards, which, according to FASB, mandate the purchase method.

According to the Merrill Lynch study, however, "the changes that FASB proposes would still fall short of creating a uniform global standard." It said international standards tolerate several exceptions to the purchase method. In Germany, for example, companies merging in a stock-based deal can immediately write off against equity the cost of goodwill, while the FASB proposal would require companies to amortize their goodwill within a 20-year period. The study went on to say that, in the United Kingdom, when companies of similar size merge, they can use the pooling method. Merrill Lynch concluded that FASB's push for harmonization comes at an inopportune time--when there is no international consensus on accounting principles involving all aspects of business combinations.

Recently, two U.S. senators--Charles E. Schumer (D-N.Y.) and Richard C. Shelby (R-Al.)--asked the Senate Banking Committee's Securities Subcommittee to hold hearings. In anticipation of the hearings, the AICPA announced on August 19 that it continues to oppose congressional intervention in the private sector standard-setting process.

In the meantime, FASB is doing what it can, in good conscience, to meet the needs of business. First, FASB backed away from its original intention of shortening the goodwill amortization period from the current 40 years to no more than 10 years--the ED calls for a maximum amortization period of 20 years.

Second, FASB will attempt to soften the impact on corporate earnings that dramatically swifter amortization would produce. The FASB's Kim Petrone, project manager for business combinations, explained. "The proposal requires that goodwill be a separate line item and that a subtotal precede it," she said. "Therefore, that subtotal and the amortization line itself could both be given an earnings-per-share amount on the face of the income statements--this is permitted, not required." Thus, investors would see how much the company earned whether or not pooling was banned.

Win the battle, lose the war?

But a large question remains: What will happen if FASB doesn't prevail? Some believe that besides preserving pooling for the time being, a FASB defeat could ultimately result in even greater regulatory oversight of accounting for business combinations.

"Be careful what you wish for; you may get it," warned Robert C. Lipe, KPMG Professor of Accounting at the University of Oklahoma. "It's certainly possible," Lipe said, "that, if the FASB pooling plan is defeated, Congress may question whether FASB should continue to be the primary standard-setting body."

Lipe, a former academic fellow at the SEC, said that during the 1998 debate over how derivatives would be handled under FASB Statement no. 133, Congressman Richard H. Baker (R-La.) of the House Banking and Financial Services Committee introduced legislation that would have required the SEC to vote on all FASB rules. The bill didn't pass, but under it, Lipe said, Congress could have overturned anything the SEC commissioners voted on--a situation that proponents of laissez-faire mergers and acquisitions policy would find even more restrictive than the proposed ban on pooling.

In response to earlier congressional scrutiny of another FASB project--on derivatives and hedging--the AICPA board of directors approved a resolution in September 1997 supporting FASB as the primary ac-counting standard setter. The resolution stated, "We believe it is the private, independent FASB, with the oversight of the SEC, that is best positioned to set accounting standards that reflect economic realities in financial statements and result in the highest degree of investor and creditor protection in the public interest."

The voice of experience

Beresford, a veteran of campaigns like this one, thinks observers will warm to the FASB plan after they've had more time to think about it. "If the economics are there, ultimately the transaction will get done," he said. "It will just require some people to rethink the guidelines they've had."

Beresford said that some institutional investors' actions are limited by their own investment strategies, which may prohibit putting money into companies that don't have positive net income. Since, under the purchase method, goodwill charges could produce a net loss where the pooling method would not, investors' initial reaction could be negative. "But," he continued, "they may also say, `Wait a minute, now. The economics haven't changed here. Just because the accounting has changed doesn't mean we shouldn't invest in this thing.'"

"I think there will be a period of adjustment," Beresford concluded. "There almost always is when there are changes in financial reporting. We typically get `the sky is falling' arguments--that this will be the end of Western civilization or certainly the finish of capital markets and so forth. Obviously that never happens, and after six months or a year or so, we'll pretty much be back to normal, but, I hope, with better financial information."

The text of FASB's exposure draft is available for viewing and downloading at its Web site (www. fasb.org). The deadline for comments is December 7, 1999. FASB will hold public hearings to discuss comments on the ED on February 3 and 4, 2000, in San Francisco; on February 10 and 11 in New York City; and, if necessary, on February 8 in Norwalk, Connecticut.