The tax implications of FAS 141 & 142.

Pooling--dead. Goodwill amortization--gone. Goodwill impairment tests--mandatory.

It's been more than a year since FASB released its unprecedented Financial Accounting statements 141 and 142 on business combinations that sent the merger and acquisition sector reeling from the implications.

While the statements left the tax treatment of business combinations and goodwill untouched, they are having a ripple effect on M&A deals, bringing up some significant tax issues. In some cases, the issues affect only a small number of business combinations. But because of the complexity of tax accounting combined with the new financial accounting standards, it's important to use caution when charting the course for a company's tax statements, says Dan Giannini, a mergers and acquisitions tax partner at PricewaterhouseCoopers in San Jose.

"Failure to pay close attention to the tax effects of adoption and implementation of the new pronouncements can quickly result in a misstatement of an acquiring company's financial statements," writes Giannini in PricewaterhouseCoopers' newsletter Nextwave.

THE RIPPLE EFFECT

The combination of new accounting rules and the existing tax law have the potential to yield some short-term benefits and long-term risks for acquiring companies. Adoption of FASB's new statements has the potential to boost earnings per share by increasing the bottom-line book income, now that acquired goodwill and indefinite-lived intangible assets (in a tax-free deal) are back on the books without amortization. And since the tax law (IRC Sec. 197) remains the same, goodwill is still amortized for 15 years for tax purposes, which decreases the effective tax rate for asset acquisitions.

But this benefit comes with consequences. While amortizing goodwill for tax purposes does create an even and certain tax deduction during the length of amortization, it creates a deferred tax liability once those 15 years are up. Goodwill also has the potential to hurt earnings if it ever becomes impaired, since FAS 142, which eliminated amortization of goodwill and intangible assets, also requires annual and periodic impairment tests.

Once considered a hindrance to a company's financial statements, goodwill absent impairment now becomes an asset, remaining on a company's books indefinitely and fattening earnings per share. This is in addition to the potential benefit of getting a tax deduction, specifically for asset acquisitions or stock purchases treated as asset acquisitions.

"For the first time, it is possible, in an asset acquisition for example, that goodwill is deductible for tax purposes but not amortizable for financial accounting purposes," writes Giannini. "Upon adoption of FAS 142, a company should expect its effective tax rate to decline." So, the effective rate won't rise for a new acquisition.

While goodwill may be an asset in the short term by lowering the tax expense, it may not necessarily lower the tax burden, because it transforms into a tax liability in the future, says Tom Snell, associate professor of accounting at MacMurray College in Jacksonville, Ill., and a California CPA Education Foundation instructor.

ENTER FAS 109

The new accounting standards do not change the rules set forth in FAS 109 about deferred tax liabilities. In fact, FAS 142 refers to paragraph 30 of FAS 109: "Deferred income taxes are not recognized for any portion of goodwill for which amortization is not deductible for income tax purposes," and "the recognition of deferred income taxes is required when amortization of goodwill is deductible for tax purposes."

When acquired goodwill and intangibles are tax deductible, the difference in income for accounting purposes and tax purposes, or the book/tax difference, is recognized as a tax liability or asset. This difference is treated as temporary. The deferred taxes are reversed if and when the goodwill is disposed of or if it becomes impaired, says Giannini. When goodwill is not tax deductible, the book/tax difference is considered a permanent difference and no deferred taxes are recognized. When a company makes an acquisition, it may be required to reclassify its acquired intangible assets as goodwill if the intangibles are not tax deductible, and any deferred tax liability associated with those intangibles will be reversed as a reduction to goodwill, according to Giannini.

The combination of FAS 109 and FAS 142 when applied to a taxable deal that involves non-amortized goodwill on the financial statements, but amortized goodwill on the tax return, will result in the recording of a deferred tax liability, writes Jim Bean, a tax manager with California Federal Bank in San Francisco, in a letter drafted by the Financial Institutions Accounting Committee to the Federal Reserve recommending the reconsideration of the treatment of the goodwill capital deduction.

"This deferred tax liability represents the tax effect of the difference between the book basis of the goodwill (reflecting no amortization) and the tax basis of the goodwill (adjusted for the amortization taken on the tax return)," writes Bean.

Bean offers the following example: "Assume $100 of goodwill. The goodwill is amortized over 10 years for tax purposes and there is no book amortization under FAS 142. Assume the applicable tax rate is 40 percent. The tax amortization of the goodwill after year one will result in a tax basis of $90 while the book basis remains at $100. The applicable accounting entries would result in a deferred tax liability of $4 (40 percent of the $10 difference between the book and tax basis)."

In the case of a tax-free deal, generally stock-for-stock exchanges, stock-for-asset exchanges and statutory mergers, the book/tax difference of goodwill does not generate a deferred tax liability, but it does generate a deferred tax liability for other intangibles. This liability is recognized as an asset or additional goodwill. And since this "book-up" or additional goodwill no longer needs to amortized, it causes an increase in earnings per share.

These examples speak only to a portion of the tax implications of FAS 141/142, but they point out the many complexities of tax accounting for business combinations and how the tax implications may significantly influence the way a company approaches a combination.

THE NUMBERS LOOK GOOD FROM HERE

"For publicly held companies that are more interested in earnings per share, carrying the tax liability is not a big deal," says Snell.

Phil Holthouse, a partner with Holthouse Carlin & Van Trigt LLP in Los Angeles, agrees: "A privately held company cares more about the tax side, while a publicly traded company is more worried about FASB. So having a tax write-off each year for 15 years is a huge benefit in the generally accepted accounting practices world."

Companies are seeing the rosy side of FAS 142 as they watch their EPS numbers increase upon adoption. In a survey of early adopters in December 2001, Ernst & Young reported an average annual increase in EPS of 8 cents to 24 cents per share as a result of not amortizing goodwill and certain other intangible assets. In May, Business Week reported in its Flash Profit survey of 122 companies that profits actually rose 6 percent in part to the "winding down of the practice of goodwill amortization."

So, will companies want to maximize their goodwill? Not necessarily, says Holthouse. "Companies that want to maximize earnings might be inclined to lump more into goodwill. For instance, if a company's stock is beat up, they may write down goodwill hoping to improve earnings." However he adds, "It's quite possible a company would go the other way and allocate less to goodwill (and more to other assets) to give themselves more steady and certain expenses and deductions for several years."

"There may be an incentive, if it's a gray area, for people to report that goodwill is more than what it really is," says Bean. "So what accountants have to do is make sure management is being accurate when assigning value to assets."

ENTER THE VALUATION EXPERT

This is the tricky part. By eliminating pooling (FAS 141), instituting specific allocation requirements and mandating impairment tests (FAS 142), the statements add to the already subjective process of valuing a company's assets, increasing the possibility of bringing in an outside valuation consultant.

"If a company wants to maximize its goodwill, it would first lower the amount it allocates to identifiable assets according to fair market values, and leave the residual for goodwill," says Jeff Kinrich, a principal with Analysis Group/Economics in Los Angeles.

But enhancement of goodwill is not the intention of FAS 142. Instead, the focus is to allocate as much of the purchase price to intangibles as possible, limiting the amount in goodwill. This is designed to help investors see the true value of a company and what's actually behind all those numbers.

"FAS 142 is specific about identifying intangibles, yet the list of intangible assets that FASB delineates in FAS 142 includes only 29 items, and some are as esoteric as opera scores. The list is very broad and no company can fall under all 29," says Alfred King, vice chairman of Valuation Research. It's a fine line that valuation experts and accountants walk.

"In the end," says Kinrich, "the allocations must stand up under an auditor's examination and the SEC's inquiry, specifically for publicly traded companies. While there is a reasonable range of value, the new standards should show the underlying worth of a company and bring the value of its assets closer to reality."

THE DARK SIDE OF GOODWILL

For Wendy Perez, a tax consulting partner with Ernst & Young in San Jose, it's about risk. Posting goodwill on the balance sheet also carries the potential for impairment, which could lead to big future write-downs on the profit and loss statements, and increase the effective tax rate for previously acquired goodwill for the period in which the write-down is recorded.

"Eventually investors and shareholders will turn their attention to a company's cash flow," says Perez. "You could see a short-term benefit by attributing more to goodwill, and EPS might be higher. On the other hand, there may be a significant, one-time write-off if goodwill is impaired. That's what we're seeing in the Silicon Valley right now, a lot of write-offs like the AOL Time Warner merger and JDS Uniphase."

In March, AOL Time Warner announced it would take a $54 billion charge--perhaps the largest in corporate history--due to impaired goodwill of AOL's purchase of Time Warner last year. JDS Uniphase comes a close second with a goodwill impairment write-off of nearly $50 billion posted last summer. Now the high-tech company faces a class action lawsuit that was filed in April alleging that it issued false and misleading statements concerning the company's business and financial conditions.

THE EFFICIENT MARKET

"The market has a way of seeing through accounting changes," says Snell, and the whole concern with EPS may be shortsighted. "The market is very good, in most cases, at separating reality from accounting numbers."

King calls it the efficient market hypothesis--the stock market is efficient and since goodwill doesn't affect cash flows, investors will have a tendency to ignore accounting changes and zero in on cash flow and operations.

Wall Street observers barely blinked when AOL Time Warner posted its impairment loss because it didn't affect the media giant's cash flows. It was simply a loss on paper and, some say, an aftershock from the Internet bust. It also helped that AOL Time Warner gave its investors a few months to soak up the news.

Still, the numbers mean something to FASB, which drafted the accounting changes to bring some transparency to financial reports. Now that investors are seeing what companies are really worth, impairment and all, the statements are doing what they set out to do. And, many investors are taking a closer look at what's behind those earnings.

RELATED ARTICLE: good will write-downs

AOL Time Warner $54 billion

JDS Uniphase $51 billion

Nortel Networks $12.4 billion

VeriSign $9.9 billion

Corning $4.8 billion

Excite@Home $4.6 billion

Qwest Communications $3.5 billion

AT&T $1.6 billion

Caldera $74 million

FAS 109

Financial accounting statement

No. 109, Accounting for Income Taxes Issued February 1992, effective Dec. 15, 1992

* Requires an asset and liability approach for financial accounting and reporting for income taxes. Its objectives are to recognize:

a) the amount of taxes payable or refundable for the current year. Taxes payable for the current year are classified as a current liability on the balance sheet; and

b) deferred tax liabilities and assets for future tax consequences of events that have been recognized in an enterprise's financial statements or tax returns.

* Tax consequences of temporary differences: When the carrying or book amount of an asset or liability is different than the tax basis amount of that asset or liability, a temporary difference is recorded because this difference results in taxable or deductible amounts in. future years.

Taxable amounts increase taxable income in the future while deductible amounts will decrease taxable income in the future.

* Deferred tax liability: Recognized when a temporary difference between the book and tax amount of revenue, assets and related accounts receivable will result in taxable amounts in the future.

* Deferred tax assets: Recognized when temporary differences will result in tax deductible amounts in future years and for carryforwards. A temporary difference is created when a liability will result in tax deductions in future years.

Sharon Ross is a freelance writer and editor.