FASB Changes: A Dealmaker’s Guide

By: Steven P. Chin

Recently, the Financial Accounting Standards Board (FASB) issued new rules that change the way buyers account for acquisitions. Specifically, FASB eliminated the “pooling of interest” method, and significantly changed the rules on goodwill and the amortization of goodwill. Acquisitions completed after July 1, 2001 must use the new rules. Starting on January 1, 2002 most companies, public and private, will have to adopt the new rules.

The new rules will eliminate most of the goodwill amortization incurred in an acquisition. This simple change will have a significant, positive earnings-enhancing effect on the buyer’s financial statements. In many industries, including information technology, service, consulting, and light manufacturing, there are very few “fixed assets” carried on the balance sheet, so acquisitions generate substantial goodwill for the buyer.

Goodwill is the amount a buyer pays in an acquisition beyond the value of the target’s existing assets.

Old Rule: If Yahoo! acquires startup.com for $100 million, and startup.com only has $20 million of asset value, Yahoo! would book the value of the acquired assets (possibly restated) on Yahoo!’s balance sheet, as well as $80 million of goodwill. This goodwill will be written off – a charge against earnings -- over 40 years at the rate of $2 million per year.

Although most transactions are priced according to earnings-multiple/metrics, at the end of the day most public companies considering an acquisition evaluate the terms from the perspective: “is this deal going to enhance my current earnings-per-share? Or is this deal going to dilute my current earnings-per-share?” Theoretically, since amortization is a non-cash charge to earnings, buyers really shouldn’t care. However, most (particularly public companies) are sensitive about acquiring intangible goodwill, even private buyers, which often acquire with an eye towards an eventual public offering. Accountants and advisors can and should focus on the deal’s potential impact on future earnings (and earnings per share) when advising clients.

As amended, FASB rules will prohibit “pooling of interest” – the combination of two business entities by simply “adding the balance sheets together” and booking the difference between asset value and purchase price as goodwill. Instead, all transactions completed after July 1, 2001 must use the purchase method of accounting.

In purchase accounting, the acquired assets are valued on the day of the acquisition. There may be a “step-up” in the value of some of the assets if the seller has already heavily depreciated them. According to the new FASB rules, the buyer must then place a value on any intangible assets the target business may have. The difference between the purchase price and the fixed asset plus intangible asset values is booked as “goodwill.”

Intangible assets include agreements and contracts, patents, copyrights, trademarks, rights (such as broadcasting licenses, franchise agreements, supply agreements, mineral or mining rights), airport gates, databases, customer lists, sales routes or territories, files and records, technical drawings, secret formulas, processes and recipes. A key test to differentiate goodwill from intangible assets is whether you can sell the asset to another business or entity. If you can, you can book it as an intangible asset. Otherwise, it’s goodwill.

Once valued, any new intangible assets must be evaluated to determine if they have an indefinite life or a finite life (think the recipe for Coke compared to the subscription list for Bride magazine). Any intangible assets with an indefinite life, and the related goodwill from the transaction, are carried on the balance sheet at the lower of cost or market for the rest of their economic lives. New Rule: any intangible assets with a finite life will be amortized over their respective economic lives.

Impairment Test

Companies carrying goodwill on their books will generally have to test the goodwill for impairment every year. The business unit with the goodwill will have to obtain or determine fair market value for the business unit, and then compare this value to the value of the business unit’s total assets (including goodwill). If the fair market value is less than the carried asset value, goodwill will be written-down so the recorded value of the business unit will return to fair market value.

FASB has actually proposed a multi-step test for impairment and has carefully (favorably) defined the term “business reporting unit.” Management and accountants can divide a company into business reporting units and allocate the goodwill among the different units. “Business reporting units” may exist only for accounting and tax purposes; then need not parallel the actual organization of the reporting company. The key test is the ability to sell or sever the business unit from the parent. If you can sell a customer list, trademark or business unit, you can treat it as a separate asset and a separate business unit, with its own allocation of goodwill.

The New US Advantage

Internationally, most deal flow is between the United States and the European Economic Union (“EEU”). The EEU has adopted uniform accounting standards, which include the amortization of goodwill generally over 20 years. Two identical companies – one German, one American -- can bid for a French company. Look at the example again on the page 2. With the same deal and the same price paid, the American company will be able to report higher earnings than the German company.

One German manager, after being briefed on the impact of the new accounting rules, commented “this is American companies declaring war on Europe!”

Public company write-offs to come

The impact will also be felt closer to home, as publicly traded companies take massive goodwill write-offs through their income statement during the next six months. Take WebMD as an example. The company has made loads of acquisitions, building up goodwill and intangible assets in excess of $6 billion. This far exceeds WebMD’s $2.4 billion market capitalization. When this goodwill is eventually written off, WebMD’s reported earnings-per-share could be reduced about $10.00 per share.

Write-offs of this magnitude will affect many companies, including JDS Uniphase, Lucent Technologies, R.J. Reynolds Tobacco, Aetna and Raytheon. Screen any public company database for companies whose goodwill is in excess of their current market capitalization and you can see magnitude of the problem.

Note that goodwill write-offs are non-cash events, generally reported below the operating profit figure. That fact will certainly be emphasized during the coming months as public companies with an abundance of goodwill take write-offs to bring their asset values in line with their market capitalization.

Capitalizing on the New Rules

We believe this is an ideal time for American buyers to acquire in Europe. The dollar is still very strong against the Euro and the British pound, and the new accounting rules give American companies significant advantages against European competition for deals.

The time is also ripe for European companies to expand their US operations. In our international practice, we have seen a number of European companies “biting the bullet” and buying in the US. Once they establish significant operations, they can use American (FASB) accounting rules for their entire company and possibly seek a re-listing on an American exchange.

From a dealmaker’s perspective, we believe the new rules will have two major impacts on our practice. First, we are sure to see an increased demand for valuation work. Companies will be required to place a fair market value on any business reporting units on at least an annual basis.

Second, we must change the way we model deals today. Goodwill must be examined carefully to see if any intangible assets with a finite economic life can be separated out. We have posted the latest list of intangible assets on our office walls and are modifying our models by taking out the goodwill amortization routines. Virtually every transaction we have evaluated under the new rules has been dramatically changed in terms of future reported earnings.

We applaud the changes made by FASB. Not because they are good for American companies interested in doing deals and not because the new rules are sure to increase the volume of our valuation consulting services and M&A advisory business, but because the new rules make good economic sense. Historical data strongly suggests that the amortization of goodwill is wrong, and has little or no bearing on the actual asset or enterprise value of the business.

We believe – and FASB appears to concur-- that companies are more than just the sum of their parts. Companies are an assemblage of cold hard assets and warm bodies, but what makes them work and economically viable is the intellectual capital and intelligence of the workers and the systems of the organization. Goodwill recognizes this intellectual capital as an asset. I like to think that we get smarter over time, and our intelligence and value to the world does not depreciate. The new rules take us closer to the reality of life.