The Goodwill Games

Pooling of interests in mergers and acquisitions may be problematic, but so is the alternative.

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There isn’t much peace in M&A-land these days, but there may soon be plenty of goodwill. Or at least much more than finance executives are creating today if, as expected, the pooling method of accounting for mergers gets the boot from the Financial Accounting Standards Board (FASB). That’s because the alternative, purchase accounting, calls for long-term goodwill amortization and regular impairment tests, which pooling avoids.

But if one looks at current practice, the rules for purchase accounting are badly in need of repair. Companies facing a fresh pile of goodwill are likely to explain it away, share it with partners, write it down over a shorter period, or avoid it altogether through accounting magic.

In consequence, their results are becoming harder and harder to compare, judging from the growing number of companies already playing goodwill games.

IT’S THE CASH THAT COUNTS

Part of the problem lies in measuring goodwill. Loosely defined, it is any premium that a company pays for another company’s assets. Even so, finance executives across the corporate spectrum insist that goodwill charges are irrelevant and, by extension, that earnings per share is losing credence as a measure of value creation. After all, cash earnings are what really matter, and investors ignore big noncash write-offs like goodwill impairments anyway, right?

Right, says Rodney Jacobs, CFO and vice chairman of Wells Fargo. “Goodwill doesn’t change the cash flows or the economics of a deal. None of [the questions about amortization] should matter, because it’s just accounting,” he says.

Then why is Wells Fargo going to great lengths to explain its treatment of an $11.3 billion stock purchase last March of First Interstate Bancorp., which more than doubled the assets of the San Francisco­based bank to $108 billion? Answer: It added $7.2 billion of goodwill to Wells’s balance sheet. To quell investor anxiety over the effect of the $290 million in annual amortization on earnings per share, management regularly reminds investors that purchase accounting allowed the bank to retain the ability to buy back stock quickly with the regulatory capital created by the goodwill amortization, to better manage its capital ratios, and to return capital to investors through stock buybacks. The bank also reports “cash earnings” to shareholders on a quarterly basis, and suggests they value the bank using that preamortization number instead of EPS. To drive home the point, Wells explained the differences between poolings and purchase accounting, and the irrelevance of goodwill, in a special brochure it sent to shareholders a few months after the merger.

Yet Jacobs says the efforts are not really necessary. “[Explaining goodwill and cash earnings] to investors really turned out to be a nonissue for us. Share values in the market are driven by the smart money,” he says, “and the smart money understands the economics of cash flow.”

In fact, investors at the moment seem more concerned about the merger’s ability to produce cash, as Wells has had a hard time integrating systems and retaining customers.

Yet Wells is far from alone in trying to draw shareholders’ eyes up a few entries from the bottom line. NationsBank, the southeastern banking empire based in Charlotte, North Carolina, emphasizes “cash basis” earnings in its reports to shareholders, now that it has booked $6.4 billion of goodwill from the $9.7 billion purchase of Boatmen’s Bancshares, of St. Louis.

There is also The Walt Disney Co., which is whittling away at the $18.3 billion of goodwill from its $18.9 billion purchase of ABC Inc. in 1995 to the tune of about $450 million in amortization each year. Yet Disney CFO Richard Nanula–who declined to comment for this article–wrote in the company’s 1996 annual report: “Disney believes that the most meaningful measure for valuation purposes is pro forma earnings per share adjusted to exclude the amortization of goodwill associated with the acquisition [of ABC].” That amounted to 66 cents a share last year, reducing Disney’s pro forma EPS from $2.89 to $2.33, a 19 percent drop that would have been avoided with the magic of pooling treatment for the transaction. Consider actual reported earnings of $1.96 a share, since the ABC transaction was not completed until February 9, and goodwill reduces EPS by a third.

Disney analysts take Nanula’s suggestion to heart, noting that the goodwill charges are predictable, transparent, and noncash. “Amortization is a complete nonissue. My focus is on free cash flow and EBITDA [earnings before interest, taxes, depreciation, and amortization],” says Christopher Dixon, a managing director at PaineWebber. “Do I care how you report earnings? No. I think EPS is pretty worthless. Any sophisticated CFO can hit his earnings numbers any quarter.”

GENESIS LIMITS GOODWILL

Other companies are structuring deals in ways that enable them to take on as little goodwill as possible. Geriatric-health-care provider Genesis Health Ventures, with $671 million in 1996 revenues, recently dove into a $1.4 billion joint venture with two venture capital firms to gain control of Multicare Inc., with $532 million in revenues, nearly doubling the number of nursing home beds and pharmacy facilities under the Genesis name. But Genesis took only a 42 percent stake in the transaction for its $300 million of borrowed capital, leaving 58 percent for Texas Pacific Group and Cypress Group to split. Each anted up $210 million for its share. The goodwill on the deal? More than $600 million.

Nevertheless, Genesis shareholders shouldn’t be concerned, says CFO George Hager. “Investors value a company like ours–a capital-intensive, highly leveraged, consolidating growth company–around cash-flow multiples,” he says.

Hager professes not to care about goodwill, and discounts the value of pooling because it enables small increases in income to have a disproportionately large impact on the bottom line. “We’re fundamentally opposed to pooling- type transactions, because it allows for what appears to be incremental accretion, with no step up in asset values or reflection of economic cost.” The additional problem with pooling, he says, is the dilution one gets after 18 to 24 months. “Unless the operating earnings grow faster than reported earnings, you eventually get dilution.”

But a closer look shows that Genesis has taken pains to keep most of the goodwill off its balance sheet. Despite its minority stake, the company will control Multicare’s assets, so it is consolidating the company’s results. Yet it will amortize only 42 percent of the goodwill for the next several years. How is that possible? Hager says Genesis will consolidate only “related” goodwill.

Eventually, Genesis will likely own all of the joint venture and all of the remaining goodwill, once a put/call arrangement is triggered four years out. Even then, however, Hager contends he will remain unconcerned. “This was a good economic transaction for us.”

THE BAXTER APPROACH

Another company jumping through hoops to avoid the ongoing drag of goodwill is Baxter Corp. When it spun off hospital-supply subsidiary Allegiance Corp. to shareholders last fall, it pushed down $1.1 billion of goodwill onto the newly public company, nicely cleaning up its own balance sheet. A month later, the new shareholders were told that the company would take a $550 million charge to goodwill due to “a change in accounting policy,” according to the company’s Form 8K. The change will permanently boost net earnings by 33 cents a share, or $19 million a year.

But just what kind of change in accounting justifies such a write-down, especially on the heels of a public spin-off during which such an impairment should have been detected and taken by the parent company? Allegiance changed its impairment testing methodology from undiscounted cash flow, the standard recommended for long-term assets by FASB, to a fair-value method involving a quarterly comparison of the stock’s price/earnings multiple with that of an industry peer group. Allegiance CFO Peter McKee declines to explain the basis for the change, although the company’s auditor, Price Waterhouse, approved the switch.

In any case, the company’s stock jumped 6 percent the day after the announcement. Allegiance went on to report a 50 percent increase in fourth-quarter net income in 1996, from $11.6 million to $17.3 million, despite no sales growth, most of which was due to the writedown. Both trends continued in the first half of 1997.

“There’s nothing clear in GAAP that determines how a company is supposed to write down goodwill,” says Jack Ciesielski, editor of the Analyst’s Accounting Observer, a Baltimore- based newsletter. “As a result, you see examples like Allegiance, where companies are taking contorted steps to get rid of goodwill and boost reported earnings.”

Some companies are more conservative. Take the $2.4 billion write-down of goodwill by Eli Lilly and Co. related to its $4.1 billion purchase of PCS Inc., a pharmaceuticals benefits manager, which closed just over two years ago. The company stuck close to the FASB standard on the impairment of long-lived assets, using several estimates of projected undiscounted cash flow to determine impairment.

“The numbers just didn’t add up to the goodwill we were carrying,” says Charles Golden, CFO of the pharmaceuticals giant. “The long-term growth trend in managed care we expected when we bought PCS, and the ability of PCS to deliver incremental increases in sales of Lilly products, have both been significantly slower than we expected.”

Other companies aggressively write off potential goodwill before it ever even hits the balance sheet. Such high-tech companies as 3Com, Novell, and IBM have taken advantage of the rules on writing off the value of “in- process” research and development in the wake of acquisitions. Under this approach, they can expense that piece of the acquisition price instead of capitalizing it as goodwill. But they are hardly alone. All told, nearly 400 companies have used the rule in the 1990s, according to a study by Baruch Lev, a professor of accounting at New York University, and Zhen Deng, an NYU graduate student. And, on average, acquirers wrote off 72 percent of the purchase price as in-process R&D.

Lev is appalled. “Companies are inflating their earnings by avoiding what would otherwise be accounted for as goodwill and written off over time,” he says. “This inflates their share values in the short term, and gives them market valuations that are three, four, even five times book value. Their balance sheets are clearly out of whack with reality. It’s ridiculous.”

THE FASB UPDATE

This hasn’t been lost on FASB, which is working on a new approach to combination accounting. “There are a lot of troubling issues with this proj-ect,” says FASB member Gaylen Larsen, who chairs the task force overseeing the project. “To answer the questions over pooling versus purchase accounting, we really need to decide how to treat goodwill and intangibles–to decide whether they are assets and to deal with the arbitrary nature of their amortization periods. So we’re going to address that issue first.”

While there’s no telling what the rules will look like when FASB is done with them, there’s no shortage of opinion being offered in the meantime. Most of the current ideas were recently summarized in a FASB special report prepared by the research staff with the input of the dozen members of the Business Combinations Project task force.

By far the most popular notion is to make goodwill an infinitely lived asset that would not be amortized but rather held on the balance sheet and tested regularly for impairment. “If the Board adopted this kind of treatment, most companies would forget pooling ever existed, because it avoids the negatives associated now with goodwill,” says Robert Willens, managing director for accounting and tax analysis with Lehman Brothers Inc.

This is essentially the dominant practice that existed in this country before the current standard was established in 1970. But it came about to address other abuses, such as overstating assets. As Michael H. Sutton, the Securities and Exchange Commission’s chief accountant, has commented, “We had [indefinite treatment] before and it didn’t work, so we shouldn’t go back to it now.”

CONTRA-EQUITY

What about treating goodwill as contra-equity instead of as an asset, charging it off immediately against equity, completely avoiding the income statement? That’s how it’s done in the United Kingdom, notes Errol M. Cook, a managing director at venture capital firm E.M. Warburg, Pincus Co. and a member of the project task force. “I like that idea because it gets rid of the goodwill quickly, outside the income statement, which creates more comparability of earnings,” he says.

But other problems abound. For one, large purchases would play havoc with one’s equity ratios, which has become evident in the U.K. during the three years since the practice was adopted there. And it betrays the conviction of some that goodwill is indeed an asset. “You paid money for something, with the expectation of a return, and you can value it. It seems clear it is an asset and should be somehow amortized through the income statement over time, like other assets,” says NYU’s Lev.

The unresolved issues raised by purchase accounting don’t end there (see “A Can of Terms,” page 98). And no matter how goodwill gets sliced, a ban on poolings would still leave differences between pooler and nonpooler balance sheets for decades. This leads observers like Cook to call for a clean-slate transition plan in which companies would be allowed to write off all the goodwill on their balance sheets–at least all that would have been disposed of during the previous five years–at once, when the new plan started, creating instant comparability of earnings.

Still, none of these issues has even been discussed by the Board, let alone proposed as a standard. And with the first discussions on the matter slated for October, FASB’s Larsen observes, “I think it is fairly optimistic to think that we’ll even have an exposure draft on this project ready in the next two years. There is a lot to be done and done carefully, and we’ve just barely begun.”

A CAN OF TERMS

FASB determination that goodwill is an asset will not resolve everything; in fact it will only lead to more questions. There is, for one thing, the issue of goodwill’s life. Currently, companies have leeway in determining the expected lifetime of the goodwill they purchase, with a maximum of 40 years allowed. Some firms take that maximum life as a given, while others, particularly new technology companies, try to write off goodwill over two to five years, because the pace of change and technical obsolescence is so short in their industries.

Although more rapid amortization is similar to that for tangible assets, some experts, like Errol M. Cook, a managing director at E.M. Warburg, Pincus Co., would like to see a five- year life span used globally. “We need to have one solution around the world to create real comparability between companies no matter where they are,” says Cook. “So if we’re going to have goodwill, we should get rid of it as quickly as possible in the same period of time, because the lives are arbitrary as they are.” Such a rule would mesh nicely with the International Accounting Standard Committee’s, which allows goodwill to be written off in 5 to 20 years, with an emphasis on the shorter term, and would help FASB meet its objective of international harmonization of standards.

Another alternative would be to keep goodwill as an asset, but shift the amortization charge to comprehensive income, below EPS. FASB will probably consider this option, says senior project manager L. Todd Johnson, but he notes that it also poses significant problems. “Once you include something like goodwill amortization in comprehensive EPS, why not other items, like other intangible charges, depreciation, and so on? It would be difficult to know where to draw the line.”

And yet another concept would create a new line item for cash EPS or cash earnings as part of GAAP, that would be required for all companies–creating a set method of determining the cash-generation power of companies at a glance.

“Anything that gets financial reporting to better reflect the underlying economics would be good,” says Wells Fargo CFO Rodney Jacobs.

Adds Charles Golden, CFO of Eli Lilly and Co.: “I’d prefer not to burden our income statement with goodwill amortization, but a cash EPS number isn’t a bad idea. It would help with earnings comparability around the world, no matter what the amortization rules might be.”

Others are even more adamant. Their thinking is that investors and analysts will continue to focus on EPS and P/E ratios, so long as measures of EBITDA or cash earnings vary. “Unless cash EPS or cash flow per share becomes a GAAP-required and -standardized disclosure, I don’t think the separate reporting of cash earnings, like Wells Fargo does, will work in the long term [to support share valuations],” says Robert Willens, managing director for accounting and tax analysis with Lehman Brothers Inc.

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