Shawn Tully
Consider how pooling has paid off for one of the hungriest acquirers in the Fortune 500, BankAmerica CEO Hugh McColl. As the head of NationsBank, McColl concluded two megadeals last year, first purchasing Barnett Banks for $13.7 billion, then devouring BankAmerica for $42 billion and adopting its marquee name. Accounting consultant Jack Ciesielski notes that McColl paid a total of $55 billion in stock for the two acquisitions, $30 billion over the estimated fair market value of the assets purchased.
Thanks to pooling, BankAmerica's earnings per share can now grow unimpeded by the amortization of $30 billion in goodwill. Ciesielski estimates that had BA used traditional purchase accounting, amortization would have cut its projected 1999 earnings per share by 11%, from $4.65 to $4.16. Purchase accounting would also require BA to add that $30 billion to the balance sheet. The combination of higher equity and lower earnings would drop BA's return on equity in 1999 from a respectable 17% to 9.1%. Says Ciesielski: "BankAmerica is burying over half of the deals' equity cost."
Appealing as pooling may be, not every would-be dealmaker can use it. The method is forbidden, for example, if an acquirer is buying only part of another company, or if either party has been heavily purchasing its own shares. As a result, in Silicon Valley, where companies frequently swap businesses and buy back shares to mitigate options dilution, dealmakers often have no choice but to use purchase accounting.
Not to worry, though. For technology acquirers, the write-off for in-process R&D is almost as good as pooling in its magical effect on post-merger earnings and balance sheets. This peculiar provision requires buyers of companies with heavy research and development costs--basically any infotech or medical-technology company--to write off immediately the estimated value of products still in development. Why? Because it's impossible to predict whether the "in-process" R&D will lead to revenue-generating merchandise like software or a heart drug. So the prudent path, according to accounting standards, is to consider these projects nonassets and delete them from the balance sheet.
Nonsense, says Lev. "The acquirer is paying a real arm's-length price for the R&D," he points out. "It's expecting a stream of earnings from it. So not to consider the acquired R&D project an asset is unrealistic."
Unrealistic or not, R&D write-offs have been a boon to Cisco Systems, No. 192 in the Fortune 500. In the past 30 months, Cisco has bought 15 companies under purchase accounting for a total of $1.9 billion, while managing to write off no less than $1.5 billion of the purchases, or 80% of the cost. That's a lot of goodwill Cisco doesn't have to amortize against earnings. Cisco replies that it buys so many companies and takes so many R&D write-offs that its reported earnings would actually be higher without them. "The write-downs are the conservative, proper way to account for R&D," says Dennis Powell, Cisco's controller. "The outcome of any R&D investment is uncertain."
But where is the risk, really? Wall Street tends to ignore the earnings hits caused by R&D write-offs, as it does most one-time charges. But if the acquired research works out, Cisco gets full credit for the profits without having to amortize the cost of developing the product. "Cisco gets the earnings stream without the baggage of the assets," explains James Abate, a portfolio manager with Credit Suisse Asset Management.
What irks the authorities most about R&D abuse is its sheer brazenness. "Companies are being far too aggressive," says Edmund Jenkins, FASB's chairman. An acquirer can assign exaggerated values to in-process R&D projects and then write off the entire cost of an acquisition. It's a bizarre paradox, since the whole idea is that the outcome of R&D is so uncertain that it doesn't even rate as an asset. To stop the abuse, FASB has announced a preliminary plan to end in-process write-offs next year. The new rule would force companies to put in-process R&D on the books and expense it as the revenues from the research bear fruit.
In June, FASB will also present its official position on pooling. The board is almost certain to recommend that all acquisitions be accounted for under the traditional purchase method. Though FASB must still weigh the fierce complaints from banking and tech, the final decision is strictly up to its seven-member board. The odds favor reform, if only because one of FASB's main missions is harmonizing U.S. accounting with practices in other countries.
To be sure, limiting dealmakers to purchase accounting doesn't solve accounting's failure to keep up with the knowledge economy. Under the proposed FASB reforms, for example, reported earnings would go from cosmetically enhanced to understated. Still, getting rid of pooling and in-process R&D write-downs would have two major advantages. First, the entire acquisition price would sit on the buyer's books. If the merger fails, management has nowhere to hide. "Purchase leaves a trail that shows if the deal succeeds or flops," says Ciesielski. Managers would have to show that they're generating robust returns on the entire purchase price, not just the paltry assets they put on the books.
Second, companies would have to provide far richer details on their earning power. FASB wants companies to itemize and value all the intangibles and amortize them over the periods in which they actually earn money, instead of lumping them into goodwill. That alone would make reported earnings far more useful. And goodwill would become a specific number--the premium the acquirer paid over the target's stock price before the offer. But there's one drawback: If the merger is thriving, there's no reason to expense goodwill. With synergies lifting earnings, the goodwill should either stay the same or grow.
The ideal solution would be to leave goodwill on the books and write it down only if the merger fails, something FASB doesn't trust companies to do. But investors can crunch the numbers themselves. All you have to do is add back the amortization on assets that hold their value, including goodwill, in a successful deal. With once invisible assets like patents and brands clearly valued, mining the right figures would be far easier than it is today.
One thing is sure. Companies wouldn't want analysts to focus on the suddenly shrunken earnings per share they would have to report under FASB's proposed rule changes. They would start to steer analysts to cash-based earnings figures that do a better job reflecting performance in a knowledge economy. That would certainly be an ironic consequence of accounting reform: The great distorters of financial statements might end up showing Wall Street the way.
