You’ve heard these arguments before. On one hand, finance executives and equity analysts worry that investors fail to ignore the impact of goodwill amortization on earnings. On the other hand, standard setters and accounting experts contend that goodwill is an asset that belongs firmly on the balance sheet.
Now, a proposal from the Financial Accounting Standards Board would enable companies to report, on the income statement, a fully diluted earnings-per-share figure without goodwill, even when goodwill appears on the balance sheet. At first glance, the proposal might seem relevant only for companies bedeviled by earnings hits following the demise of pooling. But analysts say the proposal will have a much broader impact.
The reason, says Robert Willens, a tax and accounting adviser at Lehman Brothers Inc., in New York, is that it represents “a big step” on FASB’s part toward establishing a generally accepted accounting principle for reporting cash flow on the income statement. At present, lacking a standard for showing cash flow, analysts have come up with definitions of their own. These vary widely, depending primarily on the industry covered. Adding to the confusion, some companies have developed their own cash-flow definitions, which may differ from those of analysts. “They’ll try to convince analysts to use their preferred version, and cut out of conference calls those who don’t go along,” notes Martin Fridson, a high-yield bond strategist at Merrill Lynch & Co. The range of definitions can lead to apples-to-oranges comparisons of corporate performance, and mislead investors.
“You can define cash flow lots and lots of different ways,” says Rick Escherich, a managing director in J.P. Morgan & Co.’s mergers and acquisitions group, in New York, “so this will help a great deal.”
Is Cash King?
Demand for a more formal standard is growing, at least in the industries that use cash-flow analysis most widely. A recent survey by J.P. Morgan found that 55 large companies reported some type of cash-earnings number in the first seven months of 1998, 60 percent more than during a similar period the year before.
The survey also found that 72 percent of 178 analyst reports from such brokerage firms as Merrill Lynch and Salomon Smith Barney published a cash-earnings multiple of some kind. In some industries, namely media and publishing companies, real estate investment trusts, and energy companies other than integrated oil concerns, that figure jumps to 94 percent. Indeed, some analysts at such brokerage houses as Keefe, Bruyette & Woods; J.P. Morgan; Goldman, Sachs; and Credit Suisse First Boston have gone so far as to jettison earnings in favor of cash flow when valuing stocks.
Whether investors should ignore goodwill is another matter (and one far too complicated to address here). But one thing is clear: The proposal would enable companies that are aggressively pursuing acquisitions–and paying big premiums over a target’s book value into the bargain–to report much larger cash earnings compared with the traditional kind on their income statements.