The M&A Game Changes.

The FASB has revised the rules for merger accounting, and the result in the short term may be a lot of confusion.

It has finally happened: Twenty-five years after its first discussion memorandum on accounting for business combinations and intangibles (Aug. 19, 1976), the Financial Accounting Standards Board has issued Statements 141 and 142, doing away with pooling of interests. Apparently, it took an extremely volatile stock market to finally bring resolution to 1970 accounting rules that frequently triggered a structuring of combinations inconsistent with economic reality or sound business practices.

To gain the corporate community's acceptance for the highly controversial rule, the FASB in early spring softened the blow by attaching the elimination of required goodwill amortization. The FASB's justification for eliminating pooling is enhanced comparability and understandability for investors. Will this be achieved? Or has it muddied the waters more? Acquired versus organic growth, complex goodwill impairment tests, intangible asset classification and cash-versus-stock acquisitions are but a few of the issues that may, in fact, make the new acquisition accounting less and not more comparable.

What are the future economic consequences and implications?

By its own rules, the FASB's mission is to ensure neutrality of information resulting from its standards, without influencing behavior in any direction (FASB Rules of Procedure). The board has argued strongly that eliminating pooling will level the playing field and provide more comparable and neutral information. But, once again, accounting standards are not just reporting financial transactions, but are, in fact, driving them. On March 19, the $2.4 billion merger between AmeriSource Health Corp. and Bergen Brunswig Corp. was the first deal structured to align with the new FASB statements. If the FASB hadn't issued its new statements, the deal would not have happened, according to Lehman Brothers. On the other hand, PepsiCo initiated a merger with Quaker Oats in April as a pooling, with a professed concern about the consequences of the new rules.

This is only the beginning. The new rules are poised to change the direction of domestic and international merger activity and to initially increase complexity and confusion in financial reporting, while providing significant new opportunities for "earnings management."

Key Changes

The new FASB statements include several noteworthy changes to current accounting. Statement 141 on Business Combinations: 1) requires the use of purchase accounting for all business combinations initiated after June 30, 2001; and 2) provides new criteria for determining when intangible assets should be recognized separately from goodwill. Statement 142 on Goodwill and Intangible Assets requires that goodwill no longer be amortized, but instead be subject to impairment testing at least annually. Statement 142 goes into effect for companies with fiscal years beginning after Dec. 15, 2001 and applies to all existing goodwill and intangible assets. Early adoption is available for companies with fiscal years beginning after March 15, 2001.

Comparability Concerns

The FASB asserts that the new business combination rules will benefit investors by spurring companies to provide better information on the true cost of both transactions and acquired intangible assets. It argues that investors will be better prepared to ascertain how well the investment has performed over time, and will have better information to compare intra- and inter-company performance. Will this, in fact, be the case?

In the long run, specific information related to a particular business combination likely will be better for investors, once they've gone through the learning curve on evaluating the new rules on acquired intangibles, sifting through new disclosure requirements and changing old evaluation methods. Too, the new rules will eventually enhance year-to-year intra-company comparisons for companies actively involved in acquisitions, as more recent earnings are likely to be tied to the fair value of newly purchased assets. In the short run, however, acquiring companies who relied heavily on pooling will see significant changes in financial ratios as they switch to the purchase method. The early result will be difficult year-to-year comparisons.

Inter-Company Comparisons

Potential effects on inter-company comparisons are much less clear-cut and will depend on the characteristics of the affected industry. Comparability between companies will be enhanced only in industries where companies are fairly homogenous in age and growth style. As such, there will be better comparability when assessing young companies, those with short-lived assets or companies growing primarily by acquisition. It should be easier to compare the results of one purchase transaction against another under the new rules, as all acquisitions will be accounted for similarly. However, comparability will be reduced in industries with heterogeneous companies.

Consider an industry in which many companies grew organically without acquisitions, while others grew primarily through mergers. Some companies will have long-lived assets on their books at old, depreciated values, while those growing through acquisition will have current asset costs on their books. The result: large comparability problems are likely.

Even bigger comparability issues will arise in the technology/dot-com sector, where, by nature, companies have few tangible assets. When these companies grow through purchase acquisition, they will have a host of new intangible assets, including goodwill, while internally grown technology firms will have virtually no assets. For anyone that values fundamental ratios such as return on assets (ROA), earnings per share (EPS) and price/earnings (P/E), these issues may present huge comparability problems. Cash flow, economic value added (EVA) and earnings before interest, taxes, depreciation and amortization (EBITDA) valuation models should continue to gain momentum as key benchmarks under the new rules.

Expenses, Assets and Earnings

Another large threat to comparability across companies arises from allocations to in-process research and development, separately recorded intangible assets (some subject to amortization, and some not) and goodwill. The following chart indicates the five components of purchase price.

A significant issue left unchanged by the new standards is the treatment of acquired R&D (FASB No. 2 still applies). Companies have been strongly criticized by the Securities and Exchange Commission for excessive classification of portions of the purchase price as in-process R&D expense rather than as goodwill, in order to achieve an acquisition year write-off of a large portion of the purchase price. With all acquisitions following purchase accounting rules, this problem may increase exponentially. We expect to see a dramatic increase of in-process R&D expense for technology companies that formerly acquired through pooling. Cisco Systems provides a clear example.

In fiscal 2000, Cisco made 20-plus acquisitions with a fair value of approximately $20 billion. Roughly $15 billion of these deals were accomplished through issuing stock, and were accounted for as poolings; the remaining deals, valued at $5 billion, were accounted for as cash or a combination of cash and stock. The companies acquired under purchase accounting resulted in recording $1.4 billion of in-process R&D expense and $3.6 billion in goodwill. Less than 10 percent of the purchase prices were for identifiable tangible assets.

If Cisco had accounted for all acquisitions as purchases, similar ratios of in-process R&D expense to purchase price probably would have applied to the $15 billion of acquisitions accounted for as pooling. The resulting increase in in-process R&D expense would have been about $4.5 billion -- or more than three times the amount actually reported for fiscal 2000. Under the new rules, companies may attempt to maximize in-process R&D for the one-time acquisition-year hit on earnings, or may maximize the goodwill (with no amortization) to preserve earnings. In either case, this presents a clear opportunity for increased earnings management to meet forecasts, both in the short and long term.

Goodwill Impairment vs. Amortization of Intangibles

Assigning the portion of the purchase price allocated to intangible assets or goodwill is much more complex. Statement 141 calls for recording intangible assets arising from contractual or other legal rights and separable intangible assets separately from goodwill. Under the old purchase rules, many of these intangibles were buried in goodwill. Statement 142 eliminates amortization of goodwill and institutes impairment testing in its place. Intangibles with a definite life, other than goodwill, will still be amortized, while intangibles with indefinite lives will now be tested for impairment annually and on an interim basis when circumstances reduce the fair value below the carrying value.

Although many have heralded the non-amortization of goodwill as the saving grace in the new rules, the benefit is not clear. According to Robert Willens, Lehman Brothers' tax and accounting analyst, "It is not so clear that if you did a purchase transaction that a substantial portion might be allocated to goodwill. A very large amount would be allocated to other intangibles that may still have to be amortized." If items such as customer lists and supplier relationships get heavy allocations, they will still have to be amortized. Companies will be taking a lot more hits to earnings subsequent to the deal than if pooling were allowed.

Since many acquired intangible assets are difficult to measure, and have frequently changing values, this additional classification process is likely to add volatility to the financial reporting process and once again open the door for earnings management through asset-classification selection and the trade-off between intangible amortization and potential goodwill impairment write-offs. Further, when goodwill is recorded, it is unlikely to last forever. The resulting impairment will create still more earnings volatility.

The effects on financial results and ratios will be very significant in years of impairment, and it is hard to see how fair values for goodwill will be objectively determined. The new impairment charges are prime candidates for movable expenses from one period to another to achieve desired earnings targets. Much like depreciation was in the 1920s, impairment may become the key to making earnings estimates -- not to mention the added cost of annual impairment testing.

Further, the new rules apply only to purchased intangible assets and goodwill, not to internally developed intangibles. Thus, the standards still place acquiring companies at a competitive disadvantage to those that build their goodwill and other intangibles internally. Interestingly, the same valuation models could easily apply to internally generated intangibles, but the FASB shows no apparent interest in doing so, despite obvious comparability benefits.

Until the FASB can come up with a model in which all companies are treated similarly, regardless of growth, comparability problems will not diminish. Looking ahead, there are predictable economic consequences inherent in these rules.

Economic Consequences

Cash will be king. Large, cash-rich companies like Microsoft Corp., with $30 billion in cash (recently increasing at the rate of $1 billion a month), will enjoy a distinct advantage in the M&A race. Cash purchases have been avoided in many cases because of asset revaluation and goodwill. Now, the cash-rich will have a stronger market position with the freedom to make cash acquisitions, thereby avoiding the excessive EPS dilution, goodwill amortization and additional issues raised by stock deals.

A Merrill Lynch & Co. study of 1998 mergers and acquisitions indicated that "55 percent of the dollar volume of U.S. mergers employed the pooling method." Thomson Financial Securities Data reported that stock transactions comprised 32 percent of the total in 1999 and 44 percent in 2000. Now, industries such as technology and banking, where pooling-of-interests acquisitions have dominated in recent years, will be ripe for a new wave of acquisitions using cash. This also may lead to more cross-industry acquisitions and a new era of large conglomerate organizations.

Earnings will be more volatile. The bottom line will be lower for most companies previously utilizing pooling. New intangible asset classifications (amortized) and goodwill impairment will ultimately lower ROA and EPS. Resulting P/E ratios will be higher, which could hurt stock prices, depending on market conditions. At the same time, earnings may increase at companies such as Tyco International that have predominantly used the purchase method.

Eliminating goodwill amortization will be a bonus when there is significant goodwill on the books. Dominion Resources Corp. stated earlier this year that earnings could increase by 34 cents per share simply by eliminating the amortization of goodwill resulting from the acquisition of Consolidated Natural Gas Co. The result would be a lower P/E, which may, in turn, drive the stock price up.

Acquisition prices will be lower. A J.P. Morgan Chase & Co. study reported that in pooling transactions, acquirers paid a 35.4 percent premium over the target's stock market value, while acquirers in purchase transactions paid a 28.2 percent premium. While the differences in premiums may reflect real differences in value, it is far more likely that part of the premium reflected perceived advantages in effecting a pooling. Average premiums paid should come down under the new rules, which once again shifts the advantage toward companies with the flexibility to do cash deals.

Losers will he disposed of Eliminating pooling will end the artificial incentive to acquire or retain components of companies that don't fit well economically with the acquirer. A requirement for pooling was that acquirers buy and retain all significant components for tip to two years. Purchase accounting removes both the requirement and incentive. Deals are much more likely to include only attractive components or include explicit plans for disposal of segments that are a poor fit.

International acquisitions will increase. Most European companies already are required to use purchase accounting for acquisitions. Despite this perceived disadvantage, foreign purchases of U.S. companies have been growing rapidly and are at record levels. This may be partially due to more liberal rules in many countries for writing off goodwill, as well as different and often more advantageous tax laws. Nevertheless, elimination of pooling for U.S. companies will level the playing field for foreign companies, making them more competitive in the M&A market. That is likely to accelerate the growth of foreign acquisitions in the U.S.

Management compensation plans will change. To the extent that existing compensation plans are tied to EPS, P/E and other "older" valuation methods, management compensation could be impacted. The key is to revisit pay plans to ensure that the best measures of economic health are used. The old adage that you get what you measure applies here. If incentive plans are focused on specific performance measures acquisition plans will reflect these. If alternative behavior is more desirable, plans should be tied to less volatile measures.

Conclusion

Under FASB 141 and 142, financial reporting should be marginally improved, with deals driven more by underlying economic substance. Unfortunately, the pricing and structure of acquisitions will still be driven in part by accounting rules, Earnings will be increasingly subject to possible enhancement through use of in-process R&D expense, intangible asset classification and timing of goodwill impairment write-offs.

As a result, comparability within and across companies will be challenging, and financial reporting and disclosure will be more complex. We may be stepping from relatively clear waters into muddy ones, but regardless of accounting rules on business combinations, a good deal will still be a good deal.

Joanne W. Rockness is Cameron Professor of Accounting, Howard O. Rockness is Professor of Accounting and Susan H. Ivancevich is Assistant Professor of Accounting, all at the University of North Carolina-Wilmington. Susan Ivancevich would like to thank Dixon & Odom, LLP, for financial support for this project.

COMPONENTS OF PURCHASE PRICE

Purchase Price = Tangible Net Assets at Fair Value

+ In-process R & D Expense

+ Intangible Assets Subject to Amortization

+ Intangible Assets Subject to Amortization

+ Goodwill