Whither Pooling? - Part II.

The comment period on the FASB proposal to eliminate pooling of interests in favor of purchase accounting for all business combinations just closed. Based on my sampling of the letters, this is going to be a tough debate; there are strong positions on both sides. CEOs and CFOs routinely cite mergers and acquisitions as top strategic priorities. Further, the record level of merger activity reflects its importance to corporate efficiency and competitiveness. The FASB is working toward issuing a final standard by year-end 2000, and will hold public hearings to discuss comments on the proposal on Feb. 3 and 4, 2000, in San Francisco, and Feb. 10 and 11 in New York.

Unfortunately, the FASB began the project with a faulty key premise -- that all business combinations are acquisitions. It claims, "an acquisition is an acquisition is an acquisition," and that it's difficult to make clear rules that identify the rare cases of a true merger. But I believe the elimination of pooling will prevent many true mergers that would be beneficial for the companies and their shareholders, as well as their global economic competitiveness. Imposing purchase accounting on such transactions will result in many distorted and largely ignored income statements overwhelmed by purchase accounting charges for goodwill amortization.

Another false assumption of those who favor the abolition of pooling is that it doesn't reflect the merger cost to shareholders and their management teams. This view naively ignores what all good management teams know about the high cost of issuing stock: Management teams are increasingly focused on cash flow per share and earnings per share toward driving their shareholders' per-share value. Issuing stock dilutes the existing enterprise's per-share results. The earnings potential of the acquired company must be significant to cover that dilution. Buyers know when stock is issued, a large part of their own future and growth prospects goes to the seller. This important point is illustrated by the dramatically lower use of stock for acquisitions in the 1980s when equities were significantly undervalued. The cost of issuing stock is real, large and actively considered in dealmaking.

We should retain both methods of accounting, but restrict pooling to those few mergers of equals (DaimlerChrysler and Citigroup, for example). A true merger -- where ownership interests are continued, no change in control of the company's assets or liabilities transpires, no culmination of an earnings process occurs, and risks and rewards of net assets obtained are similar to those given up -- warrants pooling-of-interests accounting. Carrying over the historical cost statements of the companies involved is the best method for representing and tracking subsequent management performance.

The second part of this difficult debate centers on the goodwill amortization method and rate under purchase accounting. FASB members openly acknowledge that their proposed 20year maximum amortization period is arbitrary. Further, it's based on an assumption that goodwill is a depreciating asset. This simply isn't economic reality. The growing disparity between book and market values in large part reflects goodwill actually appreciating. A leading finance authority, NYU's Prof. Baruch Lev, repeatedly points out the growing -- in fact, compounding -- nature of the knowledge capital that is the bulk of goodwill. He favors no amortization of goodwill unless it's impaired. When the FASB began its deliberations, it recognized that a regular and fixed amortization rate for goodwill was not theoretically correct. It field-tested methodology that would adjust goodwill only upon impairment of the asset. It concluded that such an approach may be too difficult for practical implementation, and abandoned it for the arbi trary 20-year life.

Goodwill should be recorded as outlined in the exposure draft, but not amortized on a straight-line, periodic basis as proposed. Goodwill should remain on the balance sheet and be adjusted only if the firm's overall enterprise value (whether from the stock market or from common valuation approaches) is clearly less than its book value capitalization. I believe management judgment and auditor review enable us to accurately and reliably report the proper carrying value of goodwill.

Stay tuned; this important debate will be lively. Please participate. Send a letter to the editor with your view.