They came to see The Man Who Wants to Kill the New Economy –the man who, they fear, could wreak more havoc than a mere millennium bug. About 85 technology executives and venture capitalists assembled at a hotel along Massachusetts’s fabled Route 128 to take a swat at Edmund L. Jenkins, the chairman of the Financial Accounting Standards Board. Here was their chance to voice objections to two proposed accounting-rule changes: one, to end pooling-of-interests accounting for business combinations in favor of the purchase method; the other, to slap tough restrictions on the repricing of stock options.
For the past year, conventional wisdom has held that these pet practices would eventually be history. No more pooling, which has fueled the New Economy’s acquisition frenzy, allowing companies to expand rapidly without diluting earnings. No more free chances to reprice options, which has helped emerging businesses retain valuable employees when their volatile stock has been hammered.
But conventional wisdom meant nothing to the high-strung crowd that gathered outside Boston in late September. As far as they were concerned, FASB’s new rules would ground the high-flying high-tech sector. Surely Jenkins could be made to see that.
There was the CFO who wondered if investors were really all that perplexed by the quirks of pooling accounting. And the venture capitalist who advanced the notion that purchase accounting, in stock deals, creates a double hit on earnings through dilution and amortization charges. And another finance executive who pleaded the case that companies must reprice underwater options to keep employees from being poached by competitors. And the fervent CEO who insisted that pooling was a necessary tool for “creating winners” in the New Economy.
But in the end, none could wring concessions from the accounting guru before them. “There was nothing I hadn’t heard before,” an unruffled Jenkins remarked afterwards.
Or won’t hear again.
Avoiding a Blowup
In the months ahead, Jenkins’s resolve will be put to the ultimate test, as FASB goes in for the kill. The accounting board is expected to finalize its new dictates on stock compensation early next year. At the same time, it will sift through comment letters, due this month, on its plans to eliminate pooling by January 2001. In a rare move that augurs the level of opposition to the business- combinations project, FASB has already called for public hearings in February, in New York and San Francisco.
“The board is cognizant that it has to win support [for its proposals], as opposed to pushing something down on us,” says Ken Goldman, CFO of Excite@Home, an Internet media company based in Redwood City, California. “Holding hearings symbolizes that they understand they have to listen to their constituents.” In recent months, Goldman has been doing a lot of talking, spearheading efforts in Silicon Valley to challenge FASB’s plans by arranging private meetings with Jenkins and other board members. “They are still very much interested in getting input,” he says optimistically.
But to what effect? So far, FASB has shown no sign of wavering on plans, as spelled out in an exposure draft issued on September 8, to chuck pooling (which inflates earnings) and keep purchase accounting (which deflates earnings with goodwill). Similarly, the board has stuck with the most crippling component of its March 31 exposure draft on stock options: companies that reprice options must record a charge against earnings.
At the Route 128 confab, Jenkins invited “constructive comments” in order to “make sure we haven’t missed anything in this process.” Translation: If you want to accuse FASB of sabotaging the New Economy, don’t bother.
“Jenkins is a real sharp cookie who has a great deal of confidence that he’s covered all the angles,” says Robert Willens, an accounting expert at Lehman Brothers Inc. “He’s made strategic compromises, and he’s been reasonable in the sense that he gives and he takes.” The effect, Willens adds, has been “to take the starch out of the opposition.”
Or as Phil Ameen, comptroller of General Electric Co. and a longtime FASB watcher, puts it: “Ed has managed difficult issues to avoid a blowup.”
Yet, a blowup is what many still hope to provoke. Throughout the fall, technology trade groups and loosely formed coalitions of executives, including many CFOs, have been weighing plans of attack. Some believe they can still save pooling–at least when the merging companies are nearly equal in size. Others, however, see that as a lost cause, and will go after FASB’s proposed rules on purchase accounting. By picking at conceptual details around goodwill and other intangible assets, they hope to force a more favorable compromise.
And as in the nasty stock-option war of 1994, when the board caved (and in the more polite debate on derivatives, when it stood tall), FASB’s critics once again are threatening to get Congress involved. A Senate banking subcommittee has considered holding hearings on FASB’s recent accounting moves, but had not scheduled any as of mid-November.
“The people I represent are not in favor of going to Congress, but somebody has to look at the real-world economic impact of these changes” in accounting rules, gripes Washington, D.C., attorney Mark Gitenstein. Gitenstein is chief lobbyist for The Technology Network, an influential Silicon Valley organization backed by a veritable who’s who of the high-tech elite, such as Cisco Systems Inc. CEO John Chambers and former Netscape Communications Inc. CEO Jim Barksdale. “We’re not seeking a legislated solution, but we want an accommodation,” warns Gitenstein.
But how accommodating will Jenkins be?
No one disputes that the end of pooling would hit hardest the merger-happy technology companies that are fashioning the Internet and the nation’s telecommunications infrastructure. According to Robertson Stephens, of 207 technology mergers in 1998 worth more than $50 million, nearly 27 percent used pooling accounting. Of all mergers worth more than $50 million, only 14 percent were poolings. (Financial-services players have also been among the pooling fans.)
“What’s broken and needs to be fixed?” wondered Dennis Powell, controller of Cisco Systems, in a recent interview with CFO. “We’re talking about a financial model that’s creating the highest level of confidence in capital markets in the world. This accounting model has served us.” Indeed, Cisco has used pooling accounting in 16 acquisitions since 1995, helping it become the worldwide leader in networking for the Internet.
Others so fancy the accounting technique that they write in their merger agreements that a deal is off if, upon review by the SEC, it doesn’t meet the 12 criteria necessary to qualify as a pooling transaction.
The reason for this preference is simple: Pooling makes the books look better. The value of these tech companies lies mainly in their intangible assets, including the goodwill premium that buyers pay over a target’s book value. Under purchase accounting, that amount must be amortized against future earnings as a noncash charge. But in a pooling transaction, the two businesses combine their financial statements at historic cost, as if they had always been one company, and the earnings charge for the acquired intangibles and goodwill is avoided.
Technology companies looking to speed expansion tend to buy companies with few reported assets on their books. These deals might still get done, but they would certainly be much more expensive from an accounting standpoint. For instance, had Lucent Technologies Inc.’s $24 billion acquisition of Ascend Communications last June been a straight purchase, it would have generated about $10 billion in goodwill.
Pooling partisans are also incensed that FASB seems to be acting more out of expedience than principle–trying to relieve the Securities and Exchange Commission of the burden of determining whether a deal meets the Byzantine rules for pooling, and looking to “harmonize” with international accounting standards, which largely do not permit pooling transactions.
“I don’t know why we have to care about being consistent with other countries,” grouses Excite@Home’s Goldman. “They’re not creating the New Economy — we are.” He wonders why FASB can’t make the rules for pooling simpler, and leave it at that.
And then there is the argument of tech executives, venture capitalists, and many investment bankers that FASB is endangering a vibrant economy by creating a disincentive to do deals. Without pooling, acquisition prices would fall for private, venture capitalbacked companies, as buyers seek to minimize the premium they pay and the goodwill charges they might incur. These start-up firms would, in turn, find it harder to attract venture investments.
“People are just waking up to the fact that this will have an impact on their valuations,” says Jim Daniell, CEO of OrderTrust, a privately held order-processing network for E- commerce, based in Lowell, Massachusetts.
Such alarms have been sounded before, and so far have impressed neither FASB nor its supporters. Indeed, to some investors, concerns about the earnings impact of purchase accounting are unfounded, and even tend to encourage companies to make deals that don’t always make economic sense.
“More shareholder value has been destroyed by management doing stupid deals because they can [use pooling] than by putting goodwill on the books in a purchase transaction,” charges Jeffrey Bronchick, chief investment officer of Reed, Conner & Birdwell Inc., a Los Angeles based money management firm. “Purchase accounting at least gives me a paper trail — what was paid in an acquisition and what the returns are.”
As a compromise, at least one Fortune 500 CFO believes it might still be possible to convince FASB to allow an exception where a merger of truly equal-sized firms is accounted for as a pooling. But absent a ground swell of protest from the rest of Corporate America or Congress, many executives are willing to concede that a fight to preserve pooling simply cannot be won.
“I think poolings are dead,” says Jerry Masters, senior director of planning and reporting at software giant Microsoft Corp. At the same time, however, he believes FASB is going to have to make more changes to purchase accounting than already proposed if it wants to quiet pooling advocates and win broad support.
A common theme in comment letters will be that the board has failed to fully address what goodwill truly represents. Many argue that the board should have found a new approach to enhancing the visibility of the purchase price without clouding the income statement with noncash charges.
“This should be a bigger project,” asserts GE comptroller Ameen, who was a member of the task force that advised FASB as it outlined the proposals in its exposure draft. “They should have trashed business combinations and goodwill and started with a clean sheet of paper.”
At least two board members, both considered accounting purists, have expressed similar sentiments. In published comments, James Leisenring and Neel Foster have taken their brethren to task for their “piecemeal” approach to the project and their failure to “address all issues associated with the purchase method and accounting for intangible assets comprehensively.” (Both support an end to pooling.)
Jenkins has acknowledged that purchase accounting has flaws, and has promised that after pooling is eliminated, there will be a second phase to the business-combinations project to address those flaws. “We wanted to deal with the big issues first,” he says.
But many FASB foes hope that challenging the board’s approach could weaken its credibility and possibly even keep pooling alive a bit longer. “Jenkins has said he would take up these other issues down the road, but to eliminate one accounting method and get to the other later is a pretty ludicrous way to set good accounting policy,” says Mark Heesen, president of the National Venture Capital Association, an Arlington, Virginia-based trade group. “FASB should leave things as they are as it comes up with a better system.”
Ideas that surely will be floated in comment letters include immediately writing off the goodwill amount; not writing it off at all unless at some point it is proven to be impaired; and running goodwill and other acquired intangibles through comprehensive income. But it’s unlikely, veteran FASB watchers concede, that anyone will come up with an idea that the board hasn’t heard of and considered, at least in a cursory way.
Jenkins dismisses the notion of an immediate write-off when a company has just paid a lot of money for an acquisition. And though many FASB members agree that the entire goodwill amount is not a wasting asset, the board found practical problems with testing to determine what part wasn’t wasting. Practical problems also scuttled the comprehensive-income concept, which Jenkins himself expressed support for: to pursue that option would require the board to revisit the whole area of comprehensive income.
Ultimately, how bruising the battle over business combinations gets will depend not on the novelty of alternatives, but on how far FASB is willing to bend before finalizing its new rules. “The optimist in me says FASB will have to go back to these alternatives and come up with a good compromise to get people to buy into purchase accounting,” says Microsoft’s Masters.
The board members “have an opportunity to demonstrate they can think outside the box,” says Mark Nebergall, president of the newly formed Software Finance and Tax Executives Council, in Washington, D.C. “But the process they have embarked on doesn’t leave a lot of room for that; they seem to have this preordained result.” And if that’s the case, he adds in a thinly veiled threat, “it may be time to rethink how accounting standards are set.”
The Politics of Principle
At the very least, FASB’s critics approach the next stage of the pooling-versus-purchase debate anticipating that the board will be responsive to their entreaties and ready to compromise–without congressional intervention.
The board has recently shown a willingness to respond to some corporate concerns. In late July, after several months of aggressive corporate lobbying, the board opted not to abolish the immediate write-off of purchased R&D. This one-time charge, which helps companies minimize the goodwill charge in a purchase transaction, was in the SEC’s cross- hairs, and FASB had proposed capitalizing this so-called in-process R&D.
“The more rocks we overturned, the more worms we found,” says accounting expert Jack Ciesielski, a member of the American Institute of Certified Public Accountants’s task force that advised FASB on the in-process R&D issue. “We concluded the whole area of R&D needed to be revisited.”
Political maneuver or sound accounting policy, the reversal on in-process R&D was just one of several recent instances in which the board has been willing to rethink its positions. Also last summer, FASB delayed by a year the effective date of its new standard on derivatives after companies said they couldn’t modify their computer systems in time. And the proposal to display goodwill amortization on a separate line in financial statements was unabashedly designed to gain support for the overall business-combinations project.
Jenkins’s crew also dampened some of the fury over its stock-option project in August, when it deemed that grants to outside directors would not incur a compensation expense. Even though the charge would probably add up to less than a penny a share, executives argued that the accounting change would make it harder to attract directors, especially at emerging, cash-poor companies. Comment letters to the board spelled out various theories to justify considering these directors as employees.
(Board member Tony Cope acknowledges that politics played a part in FASB’s change of heart. The decision to exempt directors “defused a significant amount of opposition,” he says.)
What remains to be seen is whether these concessions are a sign of FASB’s vulnerability, or its strength. “Some people view standard-setting as ‘Let’s make a deal,'” notes Greg Jonas, a partner at Arthur Andersen LLP. “Ed doesn’t approach negotiations from the standpoint of seeing what he can get. When the compromising starts, he wants some concept to latch on to for the compromise.”
By listening, as he did in Massachusetts last September and will do in numerous other venues before the public hearings in February, Jenkins gives critics a chance to vent on the business-combinations project. But that doesn’t mean the board will move one inch from its position. Indeed, the lesson FASB learned from the 1994 stock-option debacle may have been that it shouldn’t let itself be put on the defensive–not that it was wrong on the accounting concepts.
“FASB has never been beaten on the rightness of its position, but it has been outpoliticked,” says Patrick McGurn, director of corporate programs at Institutional Shareholder Services, a proxy advisory firm in Rockville, Maryland. “It doesn’t want that to happen again. It wants to win the war.”
But no matter how hard Ed Jenkins listens, he may not be able to defuse the anger that continues to brew among the avatars of America’s New Economy. They say they support FASB’s independence–and in the next breath they say they will drag Congress in if FASB won’t respect their wishes. If that happens, Jenkins may find the war much harder to win. — Stephen Barr is senior contributing editor of CFO.
———————————————– ——————————— Goodwill Games: Ill Will Over Goodwill
Critics say FASB’s proposed treatment of goodwill will confuse investors.
Many observers predict the fiercest battles of the business-combinations project will be fought over the treatment of goodwill, not the preservation of pooling.
In its preliminary deliberations, FASB weighed several alternatives to the current 40-year maximum write-off period for goodwill, eventually opting for a period of not more than 20 years. To help companies minimize the amount of the purchase price that gets allocated to goodwill, the board compiled a lengthy list of intangible assets that could be amortized over their particular “useful life.”
And in what many executives see as a bone to pacify pooling advocates, FASB offered to permit companies to put the goodwill amount on a separate line in the financial statements and report a second EPS number minus that charge. “We wanted to find a way to make the elimination of pooling as palatable as possible,” FASB chairman Edmund L. Jenkins told CFO.
But instead of minimizing investor confusion and reducing SEC staff involvement in reviewing acquisition accounting, FASB’s new rules would have the exact opposite effect, argue critics.
They say the board’s approach to dealing with intangibles is far from satisfactory. These are assets that previously were not on the books, and critics point out that in field tests on several completed purchase transactions, FASB discovered significant variances in the approach to valuing these assets.
The allocation process for intangibles “is going to be as arbitrary as it can be, with enormous amounts of second-guessing,” asserts GE comptroller Phil Ameen. “You won’t have valuable information when you get through with it.”
Display of the goodwill charge is also drawing fire. Many investors already subtract out the amortization totals, and doing the arithmetic for them may cause more confusion than clarity. After all, the amount on the separate goodwill line will not include other amortized noncash intangibles–Jenkins himself cringes when anyone refers to the new EPS number as “cash earnings”–and FASB may end up sanctioning a new earnings number at a time when pro forma earnings are proliferating in financial reports.
“You’re getting away from hard-and-fast rules for creating EPS,” complains Ken Goldman, CFO of Excite@Home. Adds Jack Ciesielski, of The Analyst’s Accounting Observer newsletter: “They are adding one more way to defile the concept of earnings.”
The concern of some tech executives goes even further. If this concession by FASB takes effect, companies would be inclined to allocate as much as possible of a purchase price to goodwill, because that write-off amount would be displayed and discounted. That, in turn, could heighten SEC scrutiny.
“The next battleground would be the SEC coming in and saying your goodwill is too high,” predicts Jerry Masters, senior director of planning and reporting at Microsoft Corp.
———————————————– ——————————— About Face?
The Jenkins Report saw no need to eliminate pooling accounting.
In 1997, when Edmund L. Jenkins was coaxed out of retirement to run FASB, he was deemed “the right guy at the right time” to lead what was then a beleaguered organization, according to a former colleague. The board had taken a beating over its 1994 stock-option proposal, and derivatives accounting was in the offing.
A career accountant at Arthur Andersen LLP, the 65-year-old Jenkins had been a founding member of the Emerging Issues Task Force, a FASB advisory board, where he gained a reputation as a consensus-builder and a cooler head that would prevail. He was also widely respected as an innovative thinker on the topic of financial reporting. The 1994 Jenkins Report was the product of a committee he chaired that systematically surveyed the needs of investors and creditors, and recommended dozens of reporting improvements.
“This is a guy who is committed to the belief that financial reporting is a big damn deal,” says Greg Jonas, a Jenkins protégé at Arthur Andersen. As for his mentor’s mild-mannered demeanor, “Ed’s style is to keep the communication going, and not let things degenerate into us-versus-them.”
Now in the third year of a five-year term, Jenkins has earned high marks for listening well to others, but ironically finds himself at the center of a storm that had been presaged in his 1994 report, which stated: “A project to do away with either [the pooling or purchase] method would be very controversial.”
What’s fascinating about this premonition is that the Jenkins Report saw no need for any change in acquisition accounting. The study effort determined that “the existence of the two [accounting] methods is not a significant impediment” to investor analysis and that a project to end either pooling or purchase “in the end is not likely to improve significantly the usefulness of financial statements.”
In an interview, Jenkins says those conclusions mirrored the committee’s consensus, not his own personal beliefs. “The chairman doesn’t win them all,” he quips. “I have personally had a long-standing view that we should have one method [of accounting for business combinations].”
Back in 1994, Jenkins explains, analysts and investors were dissatisfied with both accounting methods–purchase, because it enabled companies to set up reserves that could be tapped later to smooth earnings; pooling, because it allowed companies to shroud the total price paid for an acquisition and inflate earnings. The report called for better disclosures for both accounting methods.
But over the past five years, Jenkins avers, the rationale for ending pooling has been strengthened by its increased use: “We’re letting accounting drive the transaction, rather than reflect the economics of the transaction.” He argues that the difference between the market value of acquired companies and the underlying book value of the acquired assets has widened considerably, and the effect has been investor confusion.
“In a pooling, investors can’t tell what price was actually paid for the companies to merge,” Jenkins says, “nor can they track the acquisition’s subsequent performance.”
So perhaps the cooler head does prevail, eventually.