After all the shouting, the pooling-of-interests method of merger accounting is coming to an end with a whimper, not a bang. The predicted rush of firms launching pooling deals before the June 30 deadline didn’t materialize. Generally, in fact, CFOs seem to be taking the loss of pooling in stride, thanks in no small part to new rules for treating acquired goodwill and intangibles in a purchase acquisition.
Consider the battle for control of Wachovia Corp. The new purchase- accounting approach “provides us with a lot more flexibility than pooling” would have, says CFO Robert Kelly of First Union Corp., which agreed in April with Wachovia to merge the two financial concerns, valued at $12.7 billion.
Kelly says that if the deal is completed, “we can immediately undertake much more active balance-sheet management, like stock buybacks and divestitures, if we so desire.” What’s more, First Union has constructed the Wachovia terms to include a hefty breakup fee, in the form of an exchange giving First Union options to buy Wachovia shares. That element certainly makes competing bids—like the one SunTrust Banks Inc. initiated for Wachovia—more difficult. (SunTrust has challenged First Union in court, and a SunTrust spokesman argues that “breakup fees are not designed to be poison pills.”)
The Wachovia—First Union situation is just one case suggesting to M&A experts that the new accounting standards set by the Financial Accounting Standards Board are finding acceptance. Coming in for special praise: FASB’s revision to the purchase-accounting rules, allowing firms to forgo the amortization of acquired goodwill. (Goodwill from previous transactions stops being amortized at the start of an acquirer’s fiscal year.)
“I think nonamortizing goodwill has gone a long way toward alleviating the concern of many who wanted to keep the pooling model,” says Norman Strauss, director of accounting standards at Ernst & Young LLP. “Under the old rules, companies would not do the deal unless they got pooling accounting,” he says. Companies, especially financial firms and those in the high-technology and pharmaceutical industries, often chose pooling as their way of avoiding the long-term earnings dilution from such amortization of goodwill—the excess of the cost of an acquired entity over the net of the amounts calculated for assets acquired and liabilities assumed. FASB’s banning of pooling, of course, reflected concerns that it tends to hide the financial impact of a transaction from investors.
Instead of the old approach of amortizing goodwill for up to 40 years, companies now must subject the acquired goodwill to a complex annual “impairment test” aimed at determining whether there has been a decline in the value of that goodwill. Write-offs would be required only if the value has been impaired.
That new approach is fine with First Union’s Kelly. He sees the biggest challenge in the acquisition of Wachovia —after winning out over SunTrust, presumably—to be “focusing on business as usual, providing and improving top customer service, and revenue momentum.” He says that, “conceptually,” he foresees no difficulty dealing with the impairment test.
Another advantage of the pooling approach was that it made it easy for the merging entities to fend off hostile rival bids. But even before the rival SunTrust bid was submitted, Kelly noted that First Union had taken the threat of hostile takeovers “into account in our structuring of the merger” through the inclusion of a $780 million breakup fee, with its option-exchange feature. “In a pooling world,” Kelly now says, “the breakup fee would prevent pooling” from being available to a rival, and thus discourage competing bids. “In the new world,” he says, “we get significant economic value in the breakup fee.”
Not every finance chief is ecstatic about the options offered under the new M&A accounting standards. “These new regulations are more favorable for where we use purchase accounting, but unfavorable compared with pooling,” says Johnson & Johnson CFO Robert Darretta. In an interview with CFO.com, he said, “the impact will be initially positive because of the goodwill aspect” no longer requiring automatic amortization. In May, after Darretta made the general comments about the new purchase- accounting rule, Johnson & Johnson announced a deal to acquire Inverness Medical Technology’s diabetes-care products business using the purchase method.
And FASB’s new approach is certainly more complicated than amortization. Under the new FASB goodwill and intangible-asset measurement standards, companies generally must perform an impairment test yearly for each reporting unit. It’s a two-step test that first determines whether the book value of acquired assets of the reporting unit exceeds the unit’s so-called fair value—typically measured through discounted cash-flow estimates. If fair value is lower than book value, the company then must determine whether the fair value of the unit’s goodwill is less than the goodwill’s book value, which would necessitate an impairment loss being recognized. (Companies have six months after adopting the new rules to perform the first step.)
Since companies don’t know in what year goodwill may become impaired, Ernst & Young’s Strauss warns that CFOs may be challenged to predict earnings internally to a greater degree. Further, he sees “tension” over FASB’s new criteria for determining whether some acquired intangible assets, like patents, should be recognized separately from goodwill, and perhaps amortized over the assets’ perceived life span. “Intangible assets, with some exceptions, would still have to be amortized,” explains Strauss. Also, “once companies learn more about the difficulties of doing the impairment test, that might put a little damper on some of the enthusiasm” for the new standards.
Drug distributors AmeriSource Health Corp. and Bergen Brunswig Corp. have certainly embraced the standards warmly, though, making their pending merger contingent on FASB’s rules being adopted. “We’ve had our respective accounting advisers, Deloitte & Touche and Ernst & Young, review all the exposure drafts,” says Bergen CFO Neil Dimick.
“When we were in negotiations, the different accounting treatments, purchase and pooling, were discussed,” he says. And “the prospect of the new accounting rule being implemented before our deal closed gave us the opportunity to utilize the best aspects of both accounting treatments” for the $7 billion deal. In other words, Dimick says, “we could get the flexibility of purchase accounting coupled with the income-enhancing aspects of pooling.”
Polycom Inc. CFO Michael Kourey doesn’t see the impairment test “being any more challenging than anything else we have to comply with,” as the conferencing-equipment maker moves ahead with its $362 million proposed acquisition of PictureTel Corp. Kourey’s accounting staff is reviewing the proposal with PricewaterhouseCoopers LLP. “Impairment has to be adequately recorded,” he says, “but that’s a process we have to go through for our own internal analysis.”
Kourey strongly believes that any accounting issue must be a secondary element compared with the strategic fit of an acquisition. The use of purchase accounting “was beneficial to us” in several ways, he claims. “From the standpoint of various employee agreements, to the extent you would want to modify stock options or vesting, you get that flexibility with a purchase deal.”
Still, such basics should be all in a day’s work for a CFO, says Kourey. “It’s the job of the finance group to determine the accounting treatment,” he says, “but not let that get in the way of closing a favorable transaction.”
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