The great debate on pooling accounting is really about what matters to investors and what financial "terms" are going to have meaning.
The Financial Accounting Standards Board has decided that the best way to red flag a merger event is to create an intangible asset like goodwill on the balance sheet and amortize it through the income statement. This allows investors to find the "evidence" of a merger on all three basic accounting statements - balance sheet, income statement, and cash-flow statement.
Goodwill is a funny thing, though, and it moves and changes across industries and time. It is calculated at the time of the merger by making a comparison between the value of the consideration and the marked-to-market equity account. This one-day snapshot, calculated perhaps at the height of a market frenzy or nadir of a Wall Street bust, may then affect reported income through the next three business cycles.
Very similar mergers conducted in monochromatic industries like banking, but separated in time by as little as 18 months, report radically different results as measured by earnings for no other reason than market fluctuations and the corresponding impact on goodwill calculation.
There are other problems as well.
The mixing of a market-based equity factor with the historical book equity of the buyer creates a mishmash equity number that holds little analytical meaning. This renders a significant number of common analytical ratios, including return on equity and book value per share, useless.
Wall Street analysts trained at institutions like Wharton and Sloan have responded by saying, "Big deal; just adjust for the goodwill," and thereby have invented new ratios like return on invested capital, tangible book per share, and cash earnings per share.
Other sophisticated analysts, like regulators of banks, also are keenly aware of goodwill and its effects. Regulators, as a matter of routine, eliminate goodwill from capital calculations when measuring the health of a bank.
The whole point of the FASB purchase accounting approach, though, is to improve the ability of all investors to assess the effect of a deal. The goodwill approach provides some information, but it does so at a tremendous cost by making key analytical ratios, which are extremely valuable to simple investors, useless.
The interplay of book value per share - how much have I invested - and earnings per share - how much return is being generated - is at the heart of most simple investors' approach to understanding a business.
Book value also is useful as a first-blush approach to assessing bankruptcy risk. Goodwill accounting violates these basic reported figures. It distorts them and in the worst cases renders them meaningless. This is the cost of purchase accounting - the need to reeducate 90% of the investing public or else leave them to be manipulated.
The need for wholesale reeducation also is at odds with a basic tenet of accounting theory, which calls for creation of "see-through" statements. It seems a shame to cause all this harm and eliminate the usefulness of old faithfuls like return on equity for an accounting convention that is not really all that good at serving its purpose in the first place.
Goodwill is inherently unstable. It varies across industries. "Testing" for goodwill is a regulatory nightmare. The goodwill approach creates a one-time, market-based asset and mixes it onto an historical balance sheet. All of this is done when a single goodwill-creating transaction is completed. Imagine analyzing a company that has done seven goodwill-creating deals in the last five years.
If the FASB wants to deliver more deal information to investors, then they should do it.
Add a fourth accounting statement - a merger history statement. Require buyers to disclose the balance sheet and income statement history of target companies, no matter the size of the acquisition. Work with the Securities and Exchange Commission on creating better S-4 disclosure regulations in plain English.
Mandate that yearend statements - audited financials, 10Ks, annual reports - have a merger history section that clearly reports crucial deal information such as completion date, shares issued, cash paid out, debt assumed, etc. for all mergers in the preceding 10 years.
The real bane of valuing a business is lacking access to the right information. Providing this information, not goodwill, in places that are easy to find and track would be the best improvement in merger accounting.
Mr. Holtaway is a principal at Danielson Associates Inc., a bank consulting and financial advisory firm in Rockville, Md.
| Note to Readers |
"Viewpoints" is a regular feature in American Banker, appearing every Friday. It serves as a forum for discussion and debate on a wide range of issues in the financial services industry, including management approaches and strategies, legislative and regulatory matters, and public policy in general. or e-mail your submission to rehm@tfn.com. |
