Accounting & Tax

Ryan’s Hope

Medtronic CFO Robert Ryan has an alternative cure for the acrimonious debate over pooling accounting. Is it the right one?
Stephen BarrJuly 1, 2000

Robert Ryan’s eyes are transfixed by the images on the small television in his suburban Minneapolis office. It’s a warm April afternoon, and the CFO of Medtronic Inc., the world’s leading medical-device maker, has proudly popped into the VCR a videotape of a woman undergoing delicate brain surgery to treat Parkinson’s disease. With exacting precision, the doctors drill through her skull and insert a new Medtronic product, called Activa, which will stimulate the portion of the brain that causes the intense tremors associated with Parkinson’s. The tape ends with the woman’s ability to walk and care for herself restored.

“This is a company with a strong sense of mission to do things that are truly wonderful for people,” Ryan beams. “I recently spent eight hours in the operating room, standing right at the head of the table for four procedures. I got to see what our products mean to patients, and it was miraculous.”

“This is a company with a strong sense of mission to do things that are truly wonderful for people,” Ryan says, beaming. “I recently spent eight hours in the operating room, standing right at the head of the table for four procedures. I got to see what our products mean to patients, and it was miraculous.”

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Ryan has another mission these days: restoring pooling-of- interests accounting for business combinations, which the Financial Accounting Standards Board wants to abolish in favor of the purchase method. The finance chief is far from the only executive now urging the nation’s accounting gurus to amend their controversial proposal out of concern that it would slow merger activity and hurt the nation’s economy. But he is the only CFO to take those views to Capitol Hill. In March, Ryan testified at the first of two recent congressional hearings on the matter.

Invoking grim metaphors, Ryan told the U.S. Senate Committee on Banking, Housing, and Urban Affairs that the end of pooling accounting (which inflates earnings) would disrupt the “fragile ecosystem” that brings medical innovations to market through the acquisition of new and unproven technologies. With only purchase accounting (which deflates earnings with goodwill), there could be “reduced quality of life or, worse, a shortened life for tens of thousands of patients,” Ryan warned.

A few weeks later, when discussing Medtronic’s six major acquisitions over the previous 18 months, he declares to a visitor to his office, “I can tell you that if we could not have pooled, it would have stopped us from doing some of the recent deals that we’ve done.” (A House Commerce subcommittee heard additional testimony on the issue May 4.)

Skeptics might dismiss Ryan’s emotional appeal on behalf of a company that sells more than half the world’s pacemakers as a bleeding-heart defense of pooling. But the 57-year- old graduate of Harvard Business School is not afraid to assert he has a better answer to this long-standing accounting conundrum than the one FASB has proposed.

In a four-hour interview that included corporate controller and treasurer Gary Ellis and director of external reporting and business development John Mack, Ryan expanded on his testimony and his comment letter to FASB. He outlined why pooling has been important to Medtronic, why it is a better merger-accounting method than purchase, and why FASB’s proposed standard is inadequate and will confuse the market.

That’s not all. He and his colleagues have a remedy that would clarify when purchase and pooling should be used to account for a business combination; simplify the criteria the Securities and Exchange Commission uses to deem whether a deal qualifies for pooling treatment; and improve the disclosures related to pooling transactions.

Call it the Medtronic Tonic.

Passionate Debate

The recent hearings mark a serious turn in FASB’s business- combinations project, the third in the last six years to draw congressional scrutiny. For his part, FASB chairman Edmund L. Jenkins says that pooling hides the true value of a deal from investors, because the merging businesses combine their financial statements at historic cost. In contrast, he argues, purchase accounting is more appropriate, because an acquirer must write up the assets it buys and amortize for a period of not more than 20 years the premium it pays in excess of the target’s book value. To pacify pooling advocates, he would allow companies to put that goodwill amount on a separate line in the financial statements and report earnings-per-share minus the noncash charge.

But Ryan and several others who testified in Washington, including such New Economy notables as venture capitalist John Doerr and former Netscape Communications CEO Jim Barksdale, complain that purchase accounting is fundamentally flawed. For them, deal-values reflect largely intangible items (patents, brands, talent, and so on) that result in a huge write-off. Yet goodwill, they contend, is not necessarily a depreciating asset, because it serves as the basis for new products and services that generate future cash flow. They want FASB to take up the more nettlesome issue of accounting for these intangible assets before it contemplates doing away with pooling.

Such views were echoed by Senate and House members on both sides of the aisle, who pressed Jenkins on delaying the effective date for the new rules, tentatively set for January 2001. But the savvy FASB chairman would only commit to looking at alternative ways to treat goodwill. “There are four or five proposals,” Jenkins stated during the House hearing, “and we will reconsider all of them.” The closest he came to a concession, in fact, was when he noted that the release of the final standard could be pushed back “depending on the progress of the board’s re- deliberations.”

A Bellwether Company

As for Ryan, it’s hardly surprising that he would care so much about the end of pooling. Medtronic, after all, has been on a buying binge since September 1998, completing six deals worth some $9.2 billion. The four largest transactions, which made up all but $330 million of that total, were done on a pooling basis. So committed was Ryan to this accounting treatment that he did a $700 million secondary stock offering in late 1998 to “clear the taint” from Medtronic’s share repurchase program that would have precluded the use of pooling.

With these acquisitions, Medtronic has been transformed from a cardiovascular-focused company to a broad-based medical- devices maker, with sales of $5 billion for fiscal 2000 (ended April 30), up from $3.4 billion two years ago. Pacemakers now account for less than half those revenues, down from two-thirds recently, and some of the fastest growth comes from non-heart-related products.

Lehman Brothers analyst David Gruber calls Medtronic a “bellwether” company that has “used acquisitions more strategically than anyone else in the medical-technology sector” to get into new markets with significant growth opportunities. About 70 percent of what Medtronic now sells was introduced within the past two years.

For each acquisition, Ryan explains, Medtronic looked first at strategy and market opportunities, but eventually evaluated the accounting effect of the pooling and purchase methods. And as it turns out, if the company had accounted for all six on a purchase basis over 20 years, Medtronic estimates it would have earned 18 cents per diluted share in its most recent quarter, instead of 26 cents. Earnings for the comparable quarter before these transactions were 19 cents.

“If Medtronic had said its deals were dilutive [to earnings] because they were done as purchases, and if I had to cut my estimates, the initial market reaction would be different,” confirms Salomon Smith Barney analyst Anne Malone.

Says Ryan, who joined Medtronic in 1993 after stints at McKinsey & Co. and Citicorp, and eight years as CFO of Union Texas Petroleum, in Houston: “Whether it’s right or wrong, our market clearly looks at earnings per share, not cash flow. We can be idealistic and get into whether all these noncash charges really matter. But when we’re promising to show growth in the markets we enter, we don’t want to have to tell people that we’re going to kill their investment for a few years.”

Where’s the Disclosure?

To Ryan, writing off goodwill in a purchase transaction would not only hurt Medtronic’s bottom line, it would also give a distorted view of the company’s financial results. “We don’t buy a company and assume it will lose value,” he says. Moreover, he believes that by restating the results of the merged businesses as if they had always been together, as you do with pooling, you give investors better insight into the comparable performance of the company. (There are no restatements with the purchase method, so companies may show spikes in revenues and earnings the quarter after a deal closes.)

But what about shareholder accountability? With purchase accounting, a company must write up all the assets it acquires–the tangible and the intangible–and show them on the balance sheet. With pooling, its critics insist, there is no such disclosure of how the acquired assets were valued, and investors then have no way to evaluate the future performance of an acquisition.

To which Ryan retorts, “For every share of stock we issue, I feel very accountable. Ed Jenkins says, ‘But you can’t see anywhere on the balance sheet what you paid for that business.’ He’s right. But I’ve put those new shares in my equity section, and my ownership percentage has just changed. That [acquired] company better earn a return on those shares at the same level that the core business does, or we’re going to hurt Medtronic. The market understands that very well.”

For proof that equity is not free, Ryan points to what happened with the $4.2 billion deal for Arterial Vascular Engineering (AVE). Buying the global leader in coronary stents (which are inserted to open blocked arteries and permit blood flow to the heart) caused fiscal palpitations. Soon after the deal closed in January 1999, the AVE business began to go downhill as competitors introduced new products. Market share fell from around 40 percent to about 10 percent, and Medtronic had to preannounce that quarterly revenues would be below analyst expectations.

Medtronic’s woes, controller Gary Ellis concedes, stemmed largely from a lack of precision during the premerger due diligence. In the medical- devices business, physicians are often inclined to try out the latest “toys,” and violent shifts in market share are not uncommon. Medtronic knew the AVE products were on the tail-end of their lifecycle, but also that the acquired company was readying next- generation products of its own for launch in late 1999.

Medtronic’s analysis showed that the acquisition would be accretive for the next fiscal year, but these projections failed to appreciate the short-term impact as competitors’ new offerings hit the market. “We looked at one year, two years, three years,” says Ellis, an 11-year Medtronic veteran and controller since 1994. “But we didn’t understand how significant the decline was going to be for a couple of quarters.”

Wall Street was already concerned that Medtronic had overpaid in the deal. That anxiety deepened when the investors saw the restated results for the merged companies: earnings per share were lower because of the higher share count, and operating cash flow had plummeted by one-third, to $470 million, in part due to transaction costs. “AVE was bought at its peak, and then it lost market share,” says Sandra Hollenhorst, an analyst at Prudential Securities.

Rather than conceal Medtronic’s troubles with the AVE acquisition, Ryan avers, pooling accounting helped expose to investors that the company was not meeting growth targets for the combined businesses. And that assessment was reflected in the stock. Medtronic’s share price fell 20 percent after the preannouncement, and was flat for the rest of 1999. “AVE is a perfect example of not being able to hide a bad acquisition,” Malone of Salomon Smith Barney concurs.

Then in late November, the U.S. Food and Drug Administration approved AVE’s new s670 coronary stent system. By mid- December, some Wall Street analysts polled hospitals and physicians to gauge acceptance of the s670. Once they had evidence that Medtronic was regaining share in the stent market, many put out positive research reports and raised their price targets.

“Everybody knew when AVE wasn’t working, and it didn’t matter that Medtronic used pooling,” says Lehman’s Gruber. “If AVE hadn’t turned around, the stock would still be languishing.” Instead, shares are up since the beginning of the year to around $51 at the end of May.

“You want to talk about being accountable?” Ryan asks rhetorically. “To me, you can’t be more accountable than that. Our stock price really suffered until analysts could see that we were doing what we said we would be doing with that acquisition.”

In Search Of Transparency

FASB’s decision to opt for one merger-accounting method was based on concern that two transactions with the same underlying economics could result in vastly different reported earnings. That may be so, but Ryan counters that what is being done in the name of clarity and a level playing field is destined to foster confusion and end- runs around the new rules.

For one thing, he maintains FASB is wrong to conclude that every business combination should be considered a purchase of individual assets. Although he agrees that a clear acquirer and target can be identified in almost every transaction, he does not want pooling permitted only for a true merger-of-equals, as some have suggested. Rather, he prefers to distinguish between buying a business enterprise–a “living organism,” as he puts it– and a product line, when it comes to choosing the appropriate accounting method.

For Medtronic, Ryan argues, it makes sense to treat differently the acquisition of a company such as AVE, where intangibles such as innovation and know-how are expected to enhance the value of that business over time, and one like Midas Rex, with its line of cranial drills that have a finite life. (At a FASB meeting in February, Jenkins himself entertained the idea of permitting pooling when the value of the intangible assets totaled more than 80 percent of the purchase price.)

Making matters worse, Ryan adds, FASB’s choice of purchase accounting would damage comparability between companies because acquired intangible assets must be recorded on the balance sheet while internally generated intangibles need not. “That concept is just inconsistent,” he says.

Then there’s the FASB plan to permit companies to report an earnings-per- share number that subtracts goodwill amortization charges (though not other amortized noncash intangibles). John Mack, Medtronic’s external reporting director since 1996, says that most analysts already make that adjustment, and that sanctioning what amounts to a fifth reported EPS moves the market further away from a single bottom line. “There’s something wrong with accounting when you say, ‘Here are a bunch of different answers; pick the one you want,’” he asserts.

Also, under FASB’s proposal, companies would want to assign as much of the purchase price as possible to goodwill, because unlike the case with identified intangibles, that write-off amount could be discounted. Exploiting such a loophole, Mack suggests, would yield less information for investors, not more.

But what strikes Ryan and his colleagues as most ironic about the new EPS number is that the accounting board would permit companies to report earnings that would be comparable to what they’d report in a pooling transaction. “Why are we confusing things?” Gary Ellis wonders. “FASB’s saying, ‘We’ll let you come up with an answer that’s similar to pooling and throw it in the financial statements,’ and the analysts are saying, ‘That’s the number I’m going to pick.’”

As the Medtronic finance executives see it, a better answer to FASB’s concerns would be to permit two merger-accounting methods, but refine the rules for using pooling and, most important, improve the disclosures related to pooling transactions. For those that pool, they speculate, wouldn’t transparency be enhanced if a wealth of insight–everything from the valuation techniques used to the pro forma earnings per share on the shares issued–were required as part of a company’s public filings?

“The issue shouldn’t be that there are two methods of accounting for business combinations,” Mack says. “There are different ways to account for inventory that give different results. There are different ways to account for depreciating assets. Even under purchase accounting, the life you amortize [goodwill] over will give you different results. The issue should be how well you disclose what you’ve done so that the reader of your statements understands your assumptions.”

“We would have no issue with more disclosures,” Ryan agrees.

End Game

Could the end game for the pooling soap opera essentially be a compromise on disclosure, as it was with the stock-option melodrama six years ago? Certainly, if Congress intervenes with legislation (most likely to force a delay) it may be necessary to explore fallback options.

Former FASB chairman Dennis Beresford, who pushed for better stock-option disclosures in 1994, when a bill in Congress threatened to undermine the board’s independence, contends the business- combinations project doesn’t lend itself to that kind of solution. He’d prefer to see the accounting group come up with another approach to handling goodwill that would address both the technical and political concerns that have been raised. Others suggest that more disclosures would be burdensome for active acquirers and that the compromise over stock options has proven unsatisfactory. “I hope the board has learned that [disclosure] isn’t a good way to resolve its conflicts,” says Jack Ciesielski of The Analyst’s Accounting Observer newsletter.

Steven Wallman, who took part in negotiating the compromise on stock-option accounting as a then-SEC commissioner six years ago, is not so sure the Medtronic tonic of clearer rules and enhanced disclosures should be so easily dismissed. He calls it “a reasonable alternative that I would advocate, because it would provide more disclosure than the [FASB] proposal on the table, fewer disputes about what goes into goodwill and the amortization schedule, and less confusion than having dual EPS numbers.”

But Wallman believes that the overarching issue still is accounting for intangibles. If that were resolved, he says, “When you do a business combination, all these intangibles would already be accounted for on the books, and pooling-versus-purchase wouldn’t matter as much.”

FASB’s Jenkins, however, has not shown any inclination to delay the merger-accounting project to do more work on accounting for intangibles or to consider ideas like Medtronic’s. Some veteran FASB watchers say the seven-member board is just going through the motions. “We’re looking at a big charade,” says one finance executive who prefers anonymity.

Ryan is less cynical. Right after the Senate hearing broke up in March, Jenkins invited him to discuss his comments and criticisms further. “We’re always interested in hearing from anyone who has something to say on this issue,” Jenkins says, when asked about his willingness to listen to Ryan’s views. The two will participate on June 14, after this story goes to press, in a roundtable discussion on the FASB proposal, run by Senate banking committee chair Phil Gramm.

But Ryan anticipates the two will meet privately soon after that session. If they do, he could tell the FASB chairman that delaying the business- combinations project to study intangibles (and perhaps develop enhanced disclosures) would not be viewed as caving in to political pressure; it would mean being responsive to the ideal of creating the best accounting system possible. And like the woman undergoing the delicate surgery for Parkinson’s disease, he would hope for a miracle.