Whither Poolings?

As Financial Executive went to press, the FASB prepared to issue its exposure draft on business combinations and intangible assets. Here's a glimpse at the latest thinking behind the FASB's important project - what issues are left to be resolved and how FEI members can influence the discussion.

In mid-August, Financial Executive invited FASB Chairman Ed Jenkins and FASB Project Manager Kim Petrone to talk with John Wulff, vice president, CFO and controller of Union Carbide and immediate past chair of FEI's Committee on Corporate Reporting (CCR), and Peter Bible, chief accounting officer at General Motors and head of CCR's subcommittee on the business combinations project, about the FASB's decision to reconsider its opinions on business combinations and intangible assets. FEI President and CEO Phil Livingston moderated the discussion.

An edited transcript of that conversation follows.

Phil Livingston, FEI: What's the status of the business combinations project? What can we expect next and when?

Ed Jenkins, FASB: The exposure draft should be issued in early September. There will be a 90-day comment period. After receiving the comments, we plan to hold public hearings (probably in the first two weeks of February 2000) and begin re-deliberations. Each issue that requires a decision will be re-deliberated in public, in light of what we learn. We also expect to hold meetings, maybe educational sessions conducted by constituents to discuss the impact of our new standards. So we have a lot of due process ahead. It takes so long because we re-deliberate each issue as we go.

John Wulff, Union Carbide: Assuming you meet the schedule, when would the standard be effective? And broadly speaking, what would be the transition rules?

Kim Petrone, FASB: The standard will be effective for transactions initiated after the final statement is issued, probably at the end of 2000. All prior transactions would be grandfathered.

Jenkins: And we'd use the same definition of initiation we currently have in Opinion 16. So if you initiate but haven't closed a transaction at the time the new standard is issued, you'd still be under the old rule.

Livingston: I did some research and was amazed to learn the history of business combination accounting in the United States. We're coming up on the 30-year anniversary of APB 16. Ed, can you comment on where we've been with this?

Jenkins: Accounting for business combinations goes back to the '30s, when public utility companies were merging rapidly after the Depression. The concern was that the basis for setting rates was historical cost of assets. When an acquisition was made, the cost - in addition to original cost (which is one way of expressing the difference between the fair value of the assets and including goodwill and the historical cost, or book value) - wasn't permitted to be recovered in utility rates. The concept of pooling of interests developed there.

Then, of course, something similar to pooling-of-interest accounting has always been used in related party transactions or intercorporate mergers and such. That, in fact, will continue under the exposure draft.

But Opinion 16 arose because the pooling criteria were perceived as being abused. I can remember, for example, the problem of acquisitions completed after the end of the year but before the financial statements were issued being reflected in the previous year; there were a lot of window-dressing transactions. That was one abuse. Another abuse was grounded in issuing stock at the same time as buying back treasury stock, so at the end of the day it was as if you'd issued cash.

Those kinds of concerns led to Opinion 16, which tried to establish some conditions for pooling transactions. As you know, those conditions are pretty arcane and mechanical. Some of them don't even reflect the substance of the current approach to pooling, because they're designed to control a size test, which ultimately was dropped from the standard.

So we've been living with Opinion 16 for nearly 30 years, and poolings have increased. Certainly the current high market multiples have led to management's desire for more poolings than purchases. Indeed, we see significant evidence, in merger contracts and otherwise, that some companies won't go through with an acquisition unless pooling accounting can be achieved.

At the same time, the SEC has been trying to restrict poolings; it has an adverse view of the method. And [it adds] arcane interpretations to the already arcane conditions for achieving a pooling, so it's difficult today for companies to know whether they actually can achieve pooling-of-interest accounting until they've gone down to the chief accountant's office. And usually that's late in the game.

We put this item on our agenda because of some of these concerns, because of what was going on internationally and because we've always felt at the FASB that, conceptually, an acquisition is an acquisition is an acquisition - and what's basically the same transaction (the acquisition of assets or a group of net assets by a company) shouldn't attract such drastically different accounting.

Livingston: Some people think pooling doesn't hold management accountable for the acquisitions and decisions it makes. Is this a major reason for the proposed rule change?

Jenkins: Suppose you acquire a company with a book value of $30, issue stock that has a value of $100 and account for it as a pooling. So the assets are recorded at $30. Two years later, assume you sell that same company for $90. You'd recognize a gain on the transaction of $60 - the difference between $30 and $90 - when actually, in terms of the value of the consideration you gave for that company, you'd have had a loss of $10.

So we think, just by that simple illustration - and that's only one example - there can be a lack of accountability. Or at least there can be a difficulty for users of financial statements to understand how assets have been utilized for the benefit or detriment of shareholders.

Peter Bible, General Motors: I'm in an industry I think is headed toward consolidation; DaimlerChrysler was first to the trough, if you will. I think Wall Street refers to it as "synergies." Loosely translated, "synergies" means you have to have an increase in net income equal to or greater than the goodwill amortization. That need doesn't exist in pooling accounting. So I think it's probably the biggest issue around this project.

Livingston: Doesn't that ignore the concept of diluted earnings per share, though? What seems to be lost, Ed, in your example, is the notion that you're issuing additional stock, earnings are being diluted. The market is very much driven by earnings per share. Isn't there accountability from that standpoint?

Jenkins: As a CFO, you think about making sure you're going to earn a return on the shares you issue and the accretion of the earnings on the shares. You're accountable for the appreciation in stock and appreciation of the earnings. It's harder when you lay out that much more stock in a pooling transaction. That's where accountability comes in.

Livingston: But you're also getting earnings from the acquired company.

Jenkins: Right. And beyond that, it seems to us, ultimately you finance all your acquisitions, whether they're businesses or buildings or anything else, with stock. So for example, if you issue stock for cash and use the cash to acquire a company or a factory building, you have the same dilution. Or if you issue stock to acquire less than a business - the factory building, say - you have dilution you ought to account for. But no one would question that you ought to account for them at the value of the consideration given - the value of the stock. So we don't believe there's any excess dilution here that wouldn't come about with the acquisition of any assets.

Livingston: Ed, I think it's worse in a pooling, because in your example we build a new plant and our goal is to earn 12.5 percent, our cost to capital. That's on new dollars vs. historical cost dollars that come with the pooling. So it could actually be accretive in a pooling transaction vs. dilutive.

Wulff: What you're doing, then, is drawing an equivalency between cash and stock; there's no difference.

Jenkins: Right. Whether you pay for something in cash or stock or a 50-gallon drum of chemicals, the value of that consideration is all the same.

Petrone: As Ed said, an acquisition is an acquisition is an acquisition; they all should be accounted for in the same manner - based on the value of what was exchanged for the assets acquired.

Jenkins: Over the long run, you have debt/equity ratios you need to maintain, because of industry norms or your own criteria. So it seems to me you'll end up with a similar amount of stock outstanding no matter how you account for a transaction, either by issuing additional stock, by treasury stock transactions or otherwise.

And that's another reason we believe pooling should go by the wayside - the artificial impact it may have on a company's ability to enter into transactions that otherwise would be beneficial for the shareholders, like treasury stock transactions or the disposition of assets near the time of a business combination.

Livingston: So if somebody said, "What's the problem we're trying to solve and what are our major objectives here," how would you respond?

Petrone: Business combinations are all acquisitions and ought to be accounted for the same way. The purchase method provides useful information, not only about the investment being made, but about the subsequent performance of that investment - holding management accountable is important. Two methods of accounting increases the cost to users to compare financial statements and the cost to preparers to meet the criteria.

Livingston: You've said an acquisition is an acquisition is an acquisition. Well, some aren't acquisitions; they're mergers of equals, where it's good for the industry, it's good for the two equals, it's good for our economy. You'd force one or the other firm to use purchase accounting and put a huge intangible asset on the books. What about that case?

Jenkins: If there ever were a merger of equals - and we're not sure we've seen one - the right thing to do conceptually would be to conclude that indeed you do have a new entity and ought to follow what we call new basis accounting, which would put both companies on the books at their fair values. That might or might not lead to goodwill being recognized for both parties. But in today's market, where the stock price is likely to be somewhat higher than the fair values of individual identified assets, including identified intangibles, it could give rise to goodwill on both sides of the transactions - as well as a step-up in basis.

Wulff: Is that the "fresh start" approach?

Jenkins: Fresh start or new basis. This issue's been debated over the years. No one's had the courage, I guess, to move forward with it. And it's a question we asked in the invitation to comment on the G4+1 paper. Few respondents thought it would be the right ticket. So we haven't pursued it, but it comes up in a lot of our projects, such as accounting for joint ventures.

Wulff: Is there concern over whether it's purchase accounting or a fresh start approach or creating these debits that sure don't feel like assets? They're not resources. They can't be liquidated.

Jenkins: Are you getting into the goodwill question, John? As you know, the other half of this project, in macro terms, is goodwill. And Kim can speak to that.

Petrone: The board began by agreeing goodwill clearly met the definition of an asset in our concepts statement. By itself it doesn't directly generate cash flow, but certainly there's some future economic benefit, or you wouldn't have paid so much for the company. Then we tried to think of goodwill as something other than just the amount left over. We talked about the underlying elements, the reasons you're willing to pay a premium for a company. Is it the superior management team? New distribution channels? Synergies? All those types of things. Then we worked on what we call the discernible elements approach, where you try to identify the elements, allocate some portion of goodwill to them and estimate their life.

At that time, the board thought some portion of goodwill might have an indefinite life and some might have a limited life. We tried to see if we could amortize some portion of goodwill. That wasn't an operational approach because of the subjectivity involved and the inability to develop a robust impairment test. So, though the board members all believe some portion of goodwill is a non-wasting asset, the best we could do was to require goodwill to be amortized over some limited period. We thought that would result in the most representationally faithful numbers in the financial statements. Some board members said it's a practical solution to an intractable problem. We beat our heads against the wall, I can't tell you for how many months, trying to develop something.

Livingston: If there were a good answer, a lot of opposition to pooling would go away. It was interesting to look at the history. Everybody was just writing goodwill off, then the SEC stopped that and pooling took off. But it's hard to think conceptually about what goodwill represents in an acquisition and a fair-value trade. You're basically capitalizing the future earnings of the entity you buy. You buy an earnings stream, put it on your books and flow it through against those future earnings. Five years down the road it's obsolete; there's a new view of the future value of the earnings. It's a circular and vicious problem.

Jenkins: What gets recognized, if you do your pricing right, is based on taking a look at the future cash flows and discounting them back at your hurdle rate on asset acquisitions. That's what gets recorded as the total acquisition price, some of which may fall into goodwill after you fair-value everything else.

If you use cash, you're stuck with the numbers, so you give rise to goodwill. (And by the way, 95 percent of business combinations are accounted for as purchases.)

If you analyze the number of combinations on the basis of purchase price, that percentage shifts quite a bit, however. So the only way to deal with concerns about putting goodwill on the books in business combinations presumably would be to write it off immediately. But the problems are at least twofold.

First is accountability. If you write it off immediately, you in effect have a fair-value pooling, where all the other assets get fair values, but you don't recognize any goodwill. So you lose accountability, both with respect to measuring subsequent performance and subsequent disposition of the assets you acquire.

The other problem is more conceptual. You've just concluded this was an asset you paid good consideration for, well, five minutes ago. What's the basis for writing it off in the next five minutes? The board couldn't get over either of those hurdles.

Bible: It's a nonjudgmental approach to a judgmental issue. My concern with the proposed approach is that it doesn't let management exercise its judgment and allocate to general line assets what it felt it acquired. Those assets have to meet rigorous, almost Wall Street Journal-like, daily, quotable-type tests to be recognized. Look at my company, at the names Cadillac and Corvette, for example. At certain times, the name may not be worth as much as others, but you put out a good product and name recognition rebounds.

There's management accountability if users of the financial statements know what judgments you've applied and could monitor those going forward. I recommend taking a cut at this along the lines of wasting and non-wasting assets. That is, assets whose value diminish as a function of time and assets whose value diminish as a function of the market or the products you produce. There's a lot of management accountability to that.

Jenkins: The proposed process is to do your best to identify all the intangibles you can measure, but not let them be subsumed into goodwill. And we have additional exhortations in the exposure draft to encourage that bright hope. What's left, I hope, will be the soft stuff. It may include brand names, because they generally don't have an observable market.

Just as we don't recognize other internally generated intangibles, we shouldn't recognize goodwill that is internally generated after an acquisition. In other words, the goodwill you acquire today has a finite life that may not last long.

If we had an accounting paradigm where we recognized the fair value of intangibles created internally, that would be one thing, but we don't. Therefore, the Cadillac value you acquire today is gone, but you've recreated a new value for Cadillac subsequently, through advertising, quality or whatever.

Bible: My issue with that, though, is that if both get expensed but have an observable value, if someone were to try to acquire Cadillac or any car line, you're expensing maintenance costs, quality costs, advertising costs and what was acquired when you bought Cadillac. It seems to me a conservative model.

Wulff: How do you deal with the economics of the marketplace? If GM were to acquire the BMW brand name, could it lay a value on it? It's got a demonstrable, long life. Would that be separate from goodwill and amortized over more than 20 years?

Petrone: The key to separating goodwill and other intangibles is how reliably measurable the intangible asset is. Certainly the brand name is there and has value; and maybe you can measure it. There's a presumption that its useful life is 20 years. To overcome that 20-year presumption, you have to have clearly identifiable cash flows associated with that asset and it has to either be exchangeable or have some contractual, legal underpinning.

To be not amortized at all, a brand name has to have an observable market, so you have to have similar assets being bought and sold in the marketplace. Those transactions would be used to determine the fair value of that brand.

Jenkins: If all you acquired was the BMW brand, and you paid $1 billion for it, it wouldn't be a business combination; it would be the acquisition of an intangible asset. You have to put it on your books initially at $1 billion. The next question would be, what's its life? If you could show that it's longer than 20 years, you could put a longer life on it. You could put 35, 40, 45, 50. But you'd amortize it.

Now for a third take on that scenario: There's an observable market for the BMW brand. There's only one BMW brand, so it's not going to be an exact match, but say it's the Jaguar brand. Can you interpolate with sufficient accuracy to conclude it's an observable market that gives some assurance you could sell this thing again? Then you wouldn't have to amortize at all, but you would test for impairment annually.

The same would be true if you acquired all of BMW. You could set out the BMW brand as an identifiable intangible, as part of the purchase price, then go through the same considerations as if you had acquired the BMW brand alone.

Bible: To the extent a brand's not there, the purchase price is lower and the cash flows are lower, because what delineates the competition is an elastic price, which is affected by the brand.

Jenkins: To do an acquisition, you put a value on it, which is what you're saying to us, and you should be able to account for that. Ideally, you'd be able to separate everything and wouldn't end up with any goodwill. But we know there's this thing called goodwill, and it may be summarized as synergy or whatever.

Livingston: Ed, are you worried about unintended consequences? Are there too many possibilities to deal with?

Jenkins: I'm not sure the trade-off between acquiring a whole company and a license or brand name would come up as an equal alternative very often. In other words, would it be a good business decision to do one vs. the other just to achieve an accounting result?

Wulff: The impetus for this project, as I think you said, Ed, was to try to simplify the arcane rules around pooling; that's certainly moving in the direction of having more goodwill. I worry that having accomplished that objective, we'll replace it with highly complex rules around the accounting for intangibles which, as Pete said, will probably spur a whole new industry in terms of the way to structure transactions.

Jenkins: It's a concern, and two of our board members take an alternative view in the exposure draft. They think we've done the right thing regarding eliminating the pooling-of-interest method, but on the intangible goodwill question, we haven't moved far. They also think we've arrived at a somewhat arbitrary conclusion - although we think we're grounded in some good rationale and would leave Opinion 17 intact. In other words, for goodwill and intangibles, the 40-year maximum would remain; we just wouldn't address those issues now.

Livingston: What FEI members don t want at this point is to be disadvantaged. They don't want us to make a change and have the rest of the world out of step with us. Can we be confident we won't swing the pendulum too far?

Petrone: Unfortunately, somebody has to go first. The Canadians are working with us pretty much hand-in-hand. Their exposure draft will be similar to ours. We've worked with the G4+1 standard-setters that put together the invitation to comment. They recommended that no one use the pooling method and that each of the individuals go to their standard-setting boards and urge them to change their standards accordingly.

Australia and New Zealand are already there, so that basically leaves the U.K. and the IASC. The U.K. has met and reviewed the comments on their invitation to comment and decided what they have is good. They basically say if you can't identify the acquirer, you can use the pooling method. And the IASC steering committee keeps abreast of our work, but is in a sit-and-wait-and-watch-what-the-U.S.-does mode.

Jenkins: The only place pooling accounting is permitted in either the U.K. or IASC standard is the so-called merger of equals, where you can't identify the acquirer. Canada has that now but, as Kim said, plans to change with us.

Another troublesome issue, though, is - at least in the U.K., for the few accounted for as pooling - they have a strange definition of equal, and that's a 60/40 relationship. I don't think, even if we went to a merger of equals approach, we'd be comfortable with 60/40. We'd have to be closer to 50/50 for our board members to support that.

Also, if you allow pooling-of-interest accounting for any transaction, you still have the same issues of the conditions, in addition to size, that need to be present. Would the treasury stock issue still be there? Would the disposition of subsequent assets still be there? All the conditions that have given us so much trouble still seem to be present, but you'd have this added condition of size, which was eliminated at the last minute when Opinion 16 was issued. We didn't see that it solved the problems; it just drew the line at a different place.

Then we have this concern over the application of 60/40. Canada has permitted what's called "grooming transactions," to get in shape for a size test that's more like 55/45. But they let companies issue stock, buy back stock, sell divisions or acquire other companies to get in shape to meet that 55/45. And those are the same transactions that would prohibit pooling under our conditions. So we felt that wouldn't solve the problems.

Livingston: Are you worried about this at all?

Jenkins: This is a personal view, but I think if the IASC goes in our direction (and they're already gearing up to do this), the U.K. will. If the IASC doesn't, I don't think the U.K. will do it alone. The reason is they just issued a standard to tighten their rules on goodwill accounting; they're reluctant to do it again.

Wulff: It seems, Ed, moving to a purchase accounting world would create pressure to define alternative financial performance measures. There are some industries, like ours, where the analysts probably spend more time looking at EBITDA and EBIT multiples than they do earnings per share. And it seems purchase accounting drives you more in that direction unless you take the P&L hit through comprehensive income. Would you agree?

Jenkins: I don't disagree. The first thing First Call did when we announced our proposal to eliminate pooling-of-interest accounting was to say they were going to start adding back goodwill, coming up with the numbers they call "cash earnings."

Of course, it isn't cash earnings. We all know that, which is another problem. But in our proposal we tried to deal with the display issue in the income statement related to the amortization of goodwill in a way that helps isolate the goodwill amortization and even permits earnings per share numbers, not only for the amortization but for the subtotal before amortization, which is probably the one analysts focus on.

For the longer run, we need to complete our project on other comprehensive income (OCI). As you know, as that standard acknowledged, there's more work to do there.

The board wasn't attracted to the OCI as the place for the amortization of goodwill for a couple of reasons. First, OCI has almost always been presented as part of retained earnings, rather than as a separate statement or a combined statement with net income. We don't particularly like that, and we particularly didn't like it for the amortization of goodwill.

Second, if you put the amortization of goodwill in OCI, would you also, if you had an impairment, record the impairment loss in OCI? That didn't feel too good to us. Then we had the issue that, at some point, most things in OCI get recycled to the income statement; this didn't seem like a recyclable item.

Ultimately, it seems to me, we'll need a project on performance reporting. The G4+1 recently issued a discussion paper on it that may provide some guidance.

We continue to get questions on our cash flow statement, the direct method vs. the indirect method and others. We're also aware of these other measures in lieu of earnings per share. A project to address these issues could be useful. It would be controversial, too, I think. So we're considering new agenda projects before the end of this year. Whether we'll undertake one like that will depend on its relative priority.

For a description of the project summary, visit www.rutgers.edu/Accounting/raw/fasb/project/buscomsumm.html.