Biz News--The Post:>>>A Tech Push to Keep 'Pooling' on Books
washingtonpost.com
By Albert B. Crenshaw
Washington Post Staff Writer
Sunday , June 25, 2000 ; H01
Executives and lobbyists from high-tech companies around the nation are working the halls of Capitol Hill and wearing "paths in the carpet," as one official put it, at the Securities and Exchange Commission.
The object of this intense effort is not a new tax break from Congress or a regulatory complaint at the SEC. Instead, it is aimed, obliquely, at a tiny private-sector group in Connecticut that writes the accounting rules by which public corporations and their auditors must live.
That's because the private group, the Financial Accounting Standards Board (FASB), has proposed a rule change, effective Jan. 1, that would do away with a frequently used method of accounting for mergers, known as "pooling of interests." And the FASB, at least so far, has turned aside the industry's arguments.
Pooling lets companies take over rivals without having to amortize, or write off, as "goodwill" the value of various intangible assets--often a large part of the worth of today's knowledge-based companies. Instead, the FASB wants corporations to use "purchase accounting" and take a charge on their reported earnings each year as the value of the goodwill declines.
The dispute provides a window on how a seemingly arcane accounting issue might affect transactions at the core of the "new economy" and how a significant part of corporate America is bringing political clout to bear on public and private regulators to protect its advantage. And as more Americans tie their financial future to the stock market, the outcome of these struggles has impact well beyond Wall Street and the professional investing world.
The affected companies say the new rule would have calamitous results. Many of the major mergers of the past few years have been "pooling of interests" deals.
America Online Inc.'s $10 billion takeover of Netscape Communications Corp. last year simply would not have taken place had the FASB's new rule been in place, James Barksdale, the browser company's former chief executive, has said on several occasions.
A recent analysis by Merrill Lynch & Co. shows why. Taking numbers from earlier years and comparing them using the old rule and the new one, it found that the merged company would have been saddled with $688 million in goodwill to write off annually. This would have depressed earnings for years. For example, in one year the combined company would have seen a $35 million profit become a $653 million loss.
The financial newspaper Barron's recently estimated that Cisco Systems Inc., a leading lobbyist in the effort to save pooling, probably would have had its $2 billion in earnings last year wiped out if it hadn't been able to use the accounting provision as it scooped up smaller companies.
"Elimination of pooling will derail the engine that is driving the strong economy of this country," Cisco's controller, Dennis D. Powell, said in a recent interview.
To some extent, the debate comes down to perception. The actual cash flows in a transaction are identical regardless of which accounting method is used. The question is what the market's reaction would be to a long period of reduced reported earnings.
FASB Chairman Edmund L. Jenkins counters the corporate critics by saying that investors are entitled to clear and accurate portrayals of what the company has done, and that the change is necessary to provide that. "The market has to get its information someplace," he said. "That's the basic concern I have. Pooling doesn't make management accountable for the investments it has made."
"We think that the transparency provided by purchase accounting is far superior to pooling of interests," he said in an interview.
SEC Chairman Arthur Levitt Jr. agrees. He praised the AOL-Time Warner Inc. merger early this year for not using pooling to account for the proposed deal.
Pooling is allowed only for transactions that meet 12 specific criteria, including deals in which parts of the new company aren't sold off. Most of the conditions are either easily met or irrelevant for high-tech mergers. The key one--that the merger be an all-stock deal--is the norm in that industry.
Some investor and consumer groups support the accounting standards board's side of the argument. They say the current widespread use of pooling of interests gives larger companies such as Cisco an unfair advantage in the marketplace by letting them use their stock to ingest small rivals.
High-tech companies have been slow to enter Washington's lobbying and fundraising world but are moving rapidly to catch up to more experienced corporate giants. During the 1999-2000 election cycle, for instance, high-tech companies have donated roughly $13 million to the two major political parties--almost twice what they gave four years ago, according to the Center for Responsive Politics, which tracks political giving.
Cisco CEO John Chambers, for example, gave $210,000 to Republican Party committees in March, just before Virginia GOP Reps. Thomas J. Bliley Jr. and Thomas M. Davis III wrote a letter to the FASB criticizing the proposed change. A Cisco spokesman said the timing was a coincidence.
The House Commerce Committee, of which Bliley and Davis are members, and the Senate Banking Committee held hearings in the spring in response to the general clamor. Just 10 days ago, Sen. Phil Gramm (R-Tex.), chairman of the Banking Committee, organized a rare "roundtable" discussion to go over the fine points of the issue again.
One reason the corporate executives are converging on Washington to seek help on the pooling issue is that such an approach has worked before. Although it is legally independent and receives no government funds, the FASB has found it prudent before to pull back in the face of vociferous corporate and political opposition.
Twice in the 1990s, it proposed tightening the way stock options are accounted for on corporations' books, and twice it ended up easing or dropping its proposals amid industry-generated pressure from Congress.
The options debate "became so intense and divisive that it threatened to harm the FASB's future relationships with its constituents and, indeed, to harm the future of private-sector standard setting," the FASB now says.
Jenkins recently said he doesn't think the current debate has reached that point, and several senators at the roundtable said they think legislation would be inappropriate and they would fight any congressional attempt to interfere with the FASB.
The standards board has held hearings on its pooling proposal in California and New York and received voluminous comments. Jenkins, 64, a longtime accountant, replies judiciously to questions about political influence and damage to the economy. "We certainly don't have any interest in causing harm to any industry," he said, "but our primary focus is on investors."
He cites studies that conclude investors will understand the effect of the change. "When you put all that together, this is not going to have detrimental impact on the merger business," he said.
At its core, the controversy is about how to account for the amount an acquiring company pays above and beyond the value of the other company's physical and clearly identifiable assets.
When purchase accounting is employed for an acquisition, accountants assign fair market values to such things as land, plant, vehicles and equipment. They add those figures up and subtract that sum from the purchase price. The amount left over--the amount that cannot be assigned to any specific asset--is listed as goodwill.
Goodwill, which is traditionally viewed as encompassing things like market presence and name recognition, is put on the books as an asset. But it is one that must be amortized over a period of years and subtracted from earnings every year.
In a high-tech deal, the acquired company often has little in the way of identifiable assets. Instead, most of its value will be wrapped up in its skilled employees and brain power. In such a case, most of the purchase price can end up assigned to goodwill--and the resulting amortization will act as a drag on the earnings of the acquiring company for years.
When accountants use pooling of interests for a merger, they take the "book value" of the target firm's assets, usually the original purchase price minus depreciation, and add it to the acquiring company's books. In a sense, the acquiring corporation "steps into the shoes" of the acquired company, taking over its assets at the same value that they had been carried on the target company's books.
With pooling there is no recording of goodwill, no write-off and no resulting drag on earnings.
Critics say that is an unacceptable omission.
"The pooling method of accounting is per se misleading," Calvin Johnson, a University of Texas law professor, said at last week's roundtable.
In addition to requiring purchase accounting, the FASB proposal would reduce the amortization for goodwill to 20 years from the current 40, thus increasing the annual drag on earnings during the write-off period. But it would also let companies show their earnings before as well as after accounting for goodwill, thus allowing investors to see the impact and presumably to disregard it if they wish.
Corporations reply that many investors continue to look at the bottom line and the impact there would be very damaging.
For example, Medtronic Inc., a Minneapolis-based maker of medical devices such as replacement heart valves, would have seen about a third of its first-quarter earnings this year disappear under purchase accounting, Chief Financial Officer Robert Ryan told the Senate Banking Committee roundtable.
Medtronic has been involved in $9.2 billion worth of mergers and acquisitions in the past 18 months, of which $8.8 billion were pooling-of-interests transactions, Ryan said. The company currently has 1.2 billion shares outstanding, about 20 percent of them issued as a result of merger activity, he added.
Under current accounting rules, the company reported a profit of 23 cents a share for the first quarter of the year, but under the FASB proposal that figure would have been 14 cents a share, Ryan said.
"We all realize that the economics of the transactions are unaffected by the FASB's proposal," Ryan testified. "At Medtronic, we value transactions using projected cash flows, not earnings. However, we are all participants in the U.S. public capital markets--and earnings per share matters! When we acquire a company at Medtronic, we have no intention to have the value of that enterprise diminish over time, and therefore disagree with the concept of expensing the value of our acquisitions over an arbitrary 10 or 20 years."
Some tech companies say they would accept either a very long amortization, which would mean a slight drag on earnings, or an immediate write-off, so that the hit would take place all at once. That is sometimes referred to as "big bath" accounting--making it easier for the market to look beyond it.
Others say the FASB ought to step back and review the entire concept of goodwill and intangible assets because they have a far different meaning and role in today's economy than in the smokestack past.
"The issue has to do with intangible assets. Without addressing the problem of how to value intangible assets, they are putting the cart before the horse" on pooling of interests, said Paul Brownell, of the National Venture Capital Association, whose members include investors in high-tech companies.
Gramm said he saw amortization of goodwill as the key: As "a financial snapshot at the point of an acquisition, I would argue that purchase accounting is superior to pooling of interest." He asked whether the FASB couldn't "develop some approximation that would allow you to assess periodically the value of goodwill and determine whether or not it's being preserved, whether or not it's declining, whether or not it's actually rising in value?"
Jenkins said the FASB is addressing that question. Some sort of "impairment test" might be acceptable in lieu of, or in addition to, amortization, he said. He noted that Britain allows companies that sort of choice. The FASB plans to hear more on the subject next week.
In the meantime, the market is already sorting through the differences, several experts said. Craig Chason, a McLean lawyer who has been involved in many merger transactions, said some analysts are already citing earnings per share with and without the effect of writing off goodwill.
He said whether a deal is "poolable" is still "one of the first questions" asked when a merger is contemplated. But "for large companies that have a lot of coverage, the analysts are going to look through effect of purchase accounting."
A Deep Pool
"Pooling of interests" accounting has been used in some of the largest mergers in U.S. history. Among them:
Value Deal
Target Acquirer (in billions) announced
Warner-Lambert Pfizer $89.2 Nov. 1999
Mobil Exxon $78.9 Dec. 1998
Ameritech SBC Communications $62.6 May 1998
BankAmerica NationsBank $61.6 April 1998
GTE Corp. Bell Atlantic $53.4 July 1998
SOURCE: Thomson Financial Securites Data
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