Manager’s Journal:

FASB Plan Would Provide False Accounts

By Harvey Golub

Wall Street Journal  January 31, 2000

An important debate is under way about what accounting method should be used in mergers and acquisitions. Today, a company will use one of two, well-established accounting methods: “pooling of interests ,” in which the two companies’ balance sheets and income statements are combined as if they had always been a merged company, or “purchase accounting ,” in which the difference between the price paid and the book value of the acquired company’s net assets is written off over time as an annual expense.

If companies merge using pooling, transaction accounting has no effect on future years’ reported income. But if they use purchase accounting , reported income decreases, mostly due to the annual write-off of a new, intangible asset called “goodwill,” and then magically increases when the write-off period ends.

The Financial Accounting Standards Board has proposed eliminating the use of pooling. It offers several arguments, all of which are wrong or irrelevant:

  • Purchase accounting provides investors with more Perhaps, but the information is less relevant. Under purchase accounting, the balance sheet of the acquired company is “marked to market” at a single point in time, and then has historical cost accounting applied thereafter. The resulting hybrid financials are more distorted than are historical costs carried over with pooling. In any case, investors are increasingly turning to cash-flow valuations and economic-value analyses, neither of which rely on “accounting” earnings.

 

  • Pooling ignores the value of the merger or acquisition itself. So what? When companies merge, the value of the transaction is recognized not by the combined entity, but by the shareholders. The stock of Company A and the stock of Company B become the stock of the combined company. One company isn’t really “investing” in the other, even though the legal transaction may take that form.

 

  • Under pooling, investors cannot tell how much was invested in the transaction, nor can they track its subsequent performance . In fact, the value is immediately determined in the one place that matters – the market.  What is relevant to shareholders is the market value of the overall company after the merger. Likewise, when big companies merge or smaller businesses are acquired, there’s no way even under purchase accounting to track the specific performance of a business combination, unless the acquired company remains a separate operating segment.

 

  • Having two accounting methods makes it hard for investors to compare different companies. Businesses, even within the same industry, consistently use different methods of accounting for such things as inventory, depreciation and costs. If the FASB wants only one accounting method, that’s fine. Use pooling. It’s better.

 

  • Because future cash flows are the same under either method, pooling artificially boosts reported earnings. Just the opposite: Purchase accounting artificially reduces earnings. The FASB claims that pooling “masks the presence” of assets and liabilities that were not previously recorded. But the reason they aren’t recorded is because the company is complying with the FASB’s generally accepted accounting principles.

Companies increase the value of their brands by advertising, and the value of their service capabilities by training employees. Current accounting practices capture none of these assets, which could only be valued subjectively. But these assets would somehow appear overnight, with a value attached, if a company were acquired. Markets today are fully capable of recognizing these “hidden” assets and reflecting them in valuations. That’s why stock-market prices differ from book equity.

 

  • Acquisitions should be accounted for based on the value of what is given in exchange. This argument assumes that a merger with stock is the same as a purchase for cash. It isn’t. Different business combinations require different accounting treatment. One company buying another for cash is decidedly different than an exchange of stock, which consolidates the ownership of the two entities.

Several recent studies, including ones by Goldman Sachs and Salomon Smith Barney, show that the market does not give higher valuations to companies that combine via pooling rather than purchase accounting. The market doesn’t seem to care which accounting method merging companies use. Why should the FASB?

 

Mr. Golub is chairman and CEO of American Express. He is a member of the board of directors of Dow Jones & Co., which publishes this newspaper.

(See related letter: “Letters to the Editor: FASB’s New Proposal” -­ WSJ Feb. 8, 2000)

(See related letter: “Letters to the Editor: Major Transparency For Major Acquisitions” — WSJ Feb. 15, 2000)

(See related letter: “Letters to the Editor: Pooling Worth Billions In Goodwill Creation” — WSJ Feb. 17, 2000)