VideoYou'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.
Consider AT&T's results. Had the company been able to exclude $184 million in goodwill from its acquisitions of Tele-Communications Inc. and IBM Global Network last year, AT&T's fully diluted earnings per share for the quarter ended last June 30 would have been 53 cents, not 49 cents. And the increase over the year- earlier quarter would have been 26 percent, not 17 percent. For the first six months of the year, AT&T's earnings would have been 95 cents instead of only 88 cents, and the higher number would have represented a 7 percent increase compared with the first six months of 1998, instead of a 1 percent decline.
What's more, the effect would have been twice as great after taking into account another proposal that is also part of FASB's business- combinations project. This would halve the amortization period for goodwill from 40 years to 20. As it stands, AT&T faces still more goodwill amortization, since the company has yet to account for its $62 billion acquisition of MediaOne earlier this year. Based on the premium that price represented over MediaOne's book value at the time, as much as $34 billion more goodwill could soon appear on AT&T's balance sheet.
But under FASB's proposals for amortizing and reporting goodwill, AT&T would be able to add back as much as $1.7 billion or so a year in earnings for that deal alone. This would amount to about 52 additional cents a share when considered on a cash basis.
Dan Somers, AT&T's CFO, declined a request for an interview to discuss the potential impact of the FASB rule on investor perceptions of the company. But analysts say the cash- earnings number is likely to draw more attention away from the traditional earnings number reported by AT&T. Willens goes so far as to predict that cash earnings will soon become "the primary performance number" used in stock valuation.
To be sure, AT&T is something of an anomaly, since so many other blockbuster deals in recent years were accounted for as poolings, which allowed the acquirers to combine their targets' assets at their current market value rather than at historic cost. AT&T didn't use enough stock in financing these deals to qualify for pooling-of-interest treatment.
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