First of two parts
On first glance, the New Years Day introduction of an accounting standard that eliminates the need to write down certain assets gained through past mergers and acquisitions every quarter seems like good news for the earnings at many banking companies.
But the change is much more complicated than that, and for some companies, it will likely mean a whole new category of charges down the road.
First, some history. Before June 30 companies had a choice of using purchase accounting or pooling-of-interest accounting for acquisitions. That choice is now gone all companies must use purchase accounting.
Even before June 30 many banking companies, such as Wells Fargo & Co., KeyCorp., Regions Financial Corp., and Zions Bancorp., had opted for purchase accounting because it provided much more flexibility in structuring deals. The trade-off was a lot of goodwill on the books, an intangible asset that had to be amortized every quarter.
The new standard FAS 142, Goodwill and Other Intangible Assets became effective Jan. 1 for companies that follow a calendar year and basically eliminates the need to amortize the goodwill acquired when buying other companies. For those that used purchase accounting in the past, the new standard will translate into an increase of as much as 11% in earnings per share next year.
However, the Financial Accounting Standards Board has not let companies off the goodwill-hook altogether with FAS 142. The standard explicitly states that companies must test the goodwill on their balance sheets for impairment at least every year, and it includes more stringent requirements for assessing that goodwill.
That is a change from the past, when companies would simply make adjustments to the speed at which they amortized the goodwill. If the target was worth less than when they bought it, they would write the goodwill off more quickly.
They will not have to make these regular reductions to net income anymore, but required impairment tests under the new standard mean that companies may still record changes in the value of goodwill as a loss on its income statement just not as regularly.
There could be charges if the current value of the goodwill is not reflective of its true value, said David Stumpf, an analyst at A.G. Edwards & Sons.
A sticking point is how these impairment tests will work, and which companies will need to take them when they start following the new standard.
Most companies have said only that they are reviewing the goodwill on their books for impairment. Further guidance on how to assess the impairment is expected to trickle out as companies report first-quarter earnings, and as their auditors who in turn receive advisement from the FASB formulate a best practice on how to value something that is, by definition, tricky to assess.
In general, we have to acknowledge the fact that this will be a rather nebulous concept with which to deal in the future, said Lee Irving, the chief accountant for the Cleveland-based KeyCorp.
One common way companies assess the value of goodwill is by using a discounted cash flow analysis. This involves comparing the companys original expectations of the incremental cash flows resulting from an acquisition with its estimate of the targets current contributions to cash flow.
If the unit is not making the money originally expected, the company may find it cannot justify the value of goodwill on the balance sheet. As a result, it will take a charge.
But there is an inherent difficulty in testing for the impairment of goodwill, bankers and analysts say. Cash flows from a target company often get combined as the unit is integrated with its parent, and that makes it tricky to determine how much the acquired unit is generating.
Most acquisitions are made, not for the purpose of leaving alone, but in order to integrate them into the company, Mr. Irving said.
But Kim Petrone, project manager for the FASB, said that FAS 142 has addressed the difficulties in testing goodwill from an acquired company by requiring the company to test it at the reporting unit, rather at the corporate level, as it was in the past.
You are no longer testing goodwill specific to acquisition X or acquisition Y. Youre testing all of the goodwill in a specific business line, she said.
Still, assessing for goodwill is not a new concept, and it has resulted in companies taking charges in the past. In fact, in the second quarter KeyCorp recorded a $150 million writedown in goodwill after it downsized its automobile finance unit.
As companies test for impairment, they have an incentive to take charges as soon as possible which means banks may start including them in their first-quarter earnings, and start mentioning them in the upcoming fourth-quarter earnings reports. (In fact, the Securities and Exchange Commission has said that it expects companies to warn investors if it plans to take an impairment charge when they start using the standard.)
FAS 142 allows companies to record that charge for the first year as a special line item that appears below net income, so it will not show up in the all-important earnings per share. After the first year that the company starts reporting earnings under FAS 142, it must lump impairment charges with other expenses which all get swept into net income.
