Article 4

ACCOUNTING REGULATION

The M&A Game

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

By Joanne W. Rockness,
Howard O. Rockness and
Susan H. Ivancevich

It has finally happened: Twenty-five years after its first discus- sued its new statements, the deal would not have happened, ac-
sion memorandum on accounting for business combinations cording to Lehman Brothers. On the other hand, PepsiCo
and intangibles (Aug. 19, 1976), the Financial Accounting initiated a merger with Quaker Oats in April as a pooling, with
Standards Board has issued Statements 141 and 142, doing a professed concern about the consequences of the new rules.
away with pooling of interests. Apparently, it took an extremely This is only the beginning. The new rules are poised to change
volatile stock market to finally bring resolution to 1970 ac- the direction of domestic and international merger activity and
counting rules that frequently triggered a structuring of combi- to initially increase complexity and confusion in financial
nations inconsistent with economic reality or sound business reporting, while providing significant new opportunities for
practices. “earnings management.”
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. Key Changes
The FASB’s justification for eliminating pooling is enhanced
The new FASB statements include several noteworthy changes
comparability and understandability for investors. Will this be
to current accounting. Statement 141 on Business Combina-
achieved? Or has it muddied the waters more? Acquired versus
tions: 1) requires the use of purchase accounting for all business
organic growth, complex goodwill impairment tests, intangible
combinations initiated after June 30, 2001; and 2) provides new
asset classification and cash-versus-stock acquisitions are but a
criteria for determining when intangible assets should be recog-
few of the issues that may, in fact, make the new acquisition ac-
nized separately from goodwill. Statement 142 on Goodwill and
counting less and not more comparable.
Intangible Assets requires that goodwill no longer be amortized,
What are the future economic consequences and implica-
but instead be subject to impairment testing at least annually.
tions?
Statement 142 goes into effect for companies with fiscal years
By its own rules, the FASB’s mission is to ensure neutrality
beginning after Dec. 15, 2001 and applies to all existing good-
of information resulting from its standards, without influencing
will and intangible assets. Early adoption is available for com-
behavior in any direction (FASB Rules of Procedure). The
panies with fiscal years beginning after March 15, 2001.
board has argued strongly that eliminating pooling will level the
playing field and provide more comparable and neutral infor-
mation. But, once again, accounting standards are not just re-
porting financial transactions, but are, in fact, driving them. On
Comparability Concerns
March 19, the $2.4 billion merger between AmeriSource Health The FASB asserts that the new business combination rules will
Corp. and Bergen Brunswig Corp. was the first deal structured benefit investors by spurring companies to provide better infor-
to align with the new FASB statements. If the FASB hadn’t is- mation on the true cost of both transactions and acquired intan-

1
ANNUAL EDITIONS
gible 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-com-
pany 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 re-
quirements and changing old evaluation methods. Too, the new
rules will eventually enhance year-to-year intra-company com-
parisons for companies actively involved in acquisitions, as more
recent earnings are likely to be tied to the fair value of newly pur-
chased 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 ac-
counted for similarly. However, comparability will be reduced
in industries with heterogeneous companies.
Consider an industry in which many companies grew organ-
ically 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 re-
sult: large comparability problems are likely.
Even bigger comparability issues will arise in the tech-
nology/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, in-
cluding goodwill, while internally grown technology firms will
have virtually no assets. For anyone that values fundamental ra-
tios such as return on assets (ROA), earnings per share (EPS)
and price/earnings (P/E), these issues may present huge compa-
rability problems. Cash flow, economic value added (EVA) and
earnings before interest, taxes, depreciation and amortization
(EBITDA) valuation models should continue to gain mo-
mentum 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, sepa-
rately recorded intangible assets (some subject to amortization,
and some not) and goodwill. The following chart indicates the
five components of purchase price.
2
COMPONENTS OF PURCHASE PRICE
Purchase Price = Tangible Net Assets at Fair Value
+In-process R & D Expense
+Intangible Assets Subject to Amortization
+Intangible Assets not Subject to Amortization
+Goodwill
A significant issue left unchanged by the new standards is the
treatment of acquired R&D (FASB No. 2 still applies). Com-
panies have been strongly criticized by the Securities and Ex-
change 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 fol-
lowing purchase accounting rules, this problem may increase
exponentially. We expect to see a dramatic increase of in-pro-
cess R&D expense for technology companies that formerly ac-
quired 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 bil-
lion, were accounted for as cash or a combination of cash and
stock. The companies acquired under purchase accounting re-
sulted 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, sim-
ilar ratios of in-process R&D expense to purchase price prob-
ably 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 pre-
serve 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 intan-
gible 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 in-
tangibles 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 good-
will 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 good-
will. A very large amount would be allocated to other intan-
gibles 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 classifica-
tion 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 signif-
icant in years of impairment, and it is hard to see how fair values
for goodwill will be objectively determined. The new impair-
ment 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 as-
sets 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 intan-
gibles 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 compa-
rability benefits.
Until the FASB can come up with a model in which all com-
panies are treated similarly, regardless of growth, comparability
problems will not diminish. Looking ahead, there are predict-
able 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 acqui-
sitions, thereby avoiding the excessive EPS dilution, goodwill
amortization and additional issues raised by stock deals.
A Merrill Lynch & Co. study of 1998 mergers and acquisi-
tions indicated that “55 percent of the dollar volume of U.S.
mergers employed the pooling method.” Thomson Financial
3
Article 4. The M&A Game
Securities Data reported that stock transactions comprised 32
percent of the total in 1999 and 44 percent in 2000. Now, indus-
tries such as technology and banking, where pooling-of-inter-
ests 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 con-
glomerate organizations.
Earnings will be more volatile. The bottom line will be lower
for most companies previously utilizing pooling. New intan-
gible 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 compa-
nies 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 good-
will 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 ac-
quirers 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 be disposed of. Eliminating pooling will end the
artificial incentive to acquire or retain components of compa-
nies that don’t fit well economically with the acquirer. A re-
quirement for pooling was that acquirers buy and retain all
significant components for up 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 pur-
chases 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 for-
eign companies, making them more competitive in the M&A
market. That is likely to accelerate the growth of foreign acqui-
sitions 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 fo-
ANNUAL EDITIONS
cused 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 mar-
ginally improved, with deals driven more by underlying eco-
nomic 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 classi-
fication and timing of goodwill impairment write-offs.
Reprinted with permission from Financial Executive, October 2001, pp. 22-25. © 2001 by Financial Executives International, 10 Madison Avenue,
Morristown, NJ 07962.
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 As-
sistant Professor of Accounting, all at the University of North Caroli-
na–Wilmington. Susan Ivancevich would like to thank Dixon & Odom,
LLP, for financial support for this project.