Viewpoint: Why Such a Fuss Over Goodwill?

By Ole-Kristian Hope, CPA

The Financial Accounting Standard Board's proposed elimination of the pooling-of-interests method, which would leave the purchase method the only accounting choice in business combinations, has been met by vehement opposition from investment advisers and CEOs, as has the proposal to shorten the maximum amortization period for purchased goodwill from 40 years to 20. Opponents argue that changing current accounting methods for business combinations will have dire consequences for the economy. Following intense lobbying, the board decided in May to reconsider the proposed rules. Why has there been such heated debate over the choice of two accounting methods and a non-cash goodwill amortization expense?

A History of Controversy

Accounting for business combinations has long been one of the most controversial financial reporting issues, both in the United States and internationally. It has generated 41 AICPA interpretations, 3 FASB interpretations, 50 Emerging Issues Task Force Issues, 4 SEC Accounting Series Releases and 8 SEC Staff Accounting Bulletins. The primary distinction between purchase and pooling accounting is the treatment on the consolidated financial statements of the difference between the purchase consideration for the shares of the acquired company and the book value of its net assets. While pooling ignores this difference, the purchase method explicitly revalues the acquired assets and liabilities to their fair values. The difference between the purchase price and the fair market value of the net assets acquired, if any, is allocated to goodwill. FASB and its supporters argue that the purchase method best portrays the underlying economics of the transaction, that a single method would be desirable in business combinations to ease comparisons and that doing away with pooling would be a step towards harmonizing accounting standards internationally. In addition, under purchase accounting it is easier for investors to tell what price was actually paid for the companies to merge and to track the acquisition's subsequent performance. Finally, purchase accounting eliminates some obvious earnings management vehicles.

FASB has received over 400 comment letters from a broad range of companies, investors and other groups on its exposure draft. The majority were opposed. Merrill Lynch, for example, has argued that many recent mergers, and the efficiencies they produce, would not have occurred had companies not been allowed to use pooling-of-interests accounting. They assert that the new accounting rules might create a "static environment more reminiscent of the slow-growing 1970s than the rapidly moving 1990s." Wall Street seems especially concerned about the effects on knowledge-intensive industries, whose values are often derived largely from intangible assets. Investment bankers and accountants are frequently quoted saying that companies walk away from deals if they cannot pool.

What Is the Problem?

The proposed elimination of pooling and shortening of the amortization period for purchased goodwill would not have any cash flow effects for firms. As all companies would have to use the purchase method, purchase method companies should not be at a "competitive disadvantage" compared with pooling firms (especially since pooling is also going out of fashion in other countries). Nevertheless, there is strong opposition from a number of groups. It is likely that much of the concern is over the effect on reported earnings. Even some well-known financial analysts appear to believe that reporting lower earnings, even with no concurrent cash flow effect, would have a negative effect on share prices. This could be the case if investors and financial analysts focus on (unadjusted) earnings per share and price-to-earnings rather than discounted cash flow models in valuing companies. However, academic studies have shown that investors, at least on average, are able to see through the effects of using various accounting methods. In particular, there are studies that suggest that the concern about the negative valuation implications of purchase accounting are not justified. It may of course be that managers and their advisers are not aware of such research evidence or choose not to believe it. But even if the financial markets are efficient and managers believe that investors are rational, managers (and their advisers) may still have incentives to lobby against accounting standards that could adversely affect their personal wealth. If, for example, a manager's bonus is based in part on attaining a certain ROA, the purchase method would both depress the earnings number in the numerator through amortization charges and increase total assets through the revaluation of acquired assets. Both effects would decrease the reported ROA, which could have an adverse effect on the bonus unless the compensation committee adjusts for effects of using the purchase method. Other contracts that are based on accounting numbers, such as debt covenants, may also be affected by the choice of accounting method. Other than such contract-based explanations, it is somewhat difficult to understand why so many people get so upset about the proposed elimination of the pooling-of-interests method and the shortened amortization period for goodwill.

At this writing, it is unclear what the eventual outcome will be. If FASB's exposure draft is adopted, I believe that analysts, executives and other users of financial statements will realize that mergers can still occur when accounted for under the purchase method. A continuing challenge for analysts will be how to treat the goodwill amortization expense in valuing companies. Under the proposed rules, these charges will be more transparent and not hidden among other operating expenses.

In the United Kingdom, companies have recently been required to put purchased goodwill on the balance sheet (rather than writing it off against equity), and it is interesting to observe that many companies voluntarily amortize goodwill, although they have the option of leaving it on the balance sheet unamortized. A potential explanation is that companies are allowed to separately disclose the amortization charge on the face of the income statement, and they are also allowed to present goodwill-adjusted earnings per share figures. The FASB ED resembles these U.K. disclosure rules. Based on the U.K. experience, it is not unrealistic to expect that companies will actually allocate more rather than less to goodwill in future acquisitions if they can highlight the non-cash nature of the subsequent amortization charges. In the meantime, it will be interesting to follow the comments FASB receives and also see whether corporations will accelerate deals to qualify for pooling before it is too late.    

Ole-Kristian Hope, CPA, is a PhD candidate and lecturer in the Department of Accounting Information and Management, Kellogg Graduate School of Management, Northwestern University. He acknowledges helpful comments from Tom Fields of Harvard Business School and financial support from the Arthur Andersen LLP Foundation. Interested readers can obtain an unabridged version of this article by contacting the author at okhope@nwu.edu.