Accounting & Tax

Coming into Focus

New merger-accounting rules may sharpen investor views of intangibles, but CFOs should also consider the impact of write-offs.
Jennifer Caplan and Roy HarrisJanuary 1, 2002

Around midyear, investors will be getting a better look at corporate balance sheets, thanks to new accounting rules covering goodwill and how to reflect its impairment. The big question is, will they like what they see?

Financial Accounting Standards Board Statements Nos. 141 and 142, of course, require companies to disclose a great deal of information–about acquisitions, fluctuations in the value of merger-related goodwill, and what their other intangible assets are worth, as well. Now, for example, acquiring companies will have to describe, in notes to their financial statements, why they paid a premium over the market price, if they did. They also must prepare condensed balance sheets disclosing goodwill amounts assigned to each major asset.

But for investors, perhaps the most important requirement is that companies discuss the circumstances leading to any impaired goodwill, and provide information about the reporting units for which impairment losses are recognized. (Calendar-year companies must adopt the standards starting January 1, and prepare any necessary initial impairment assessment reports by June 30.)

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To date, most discussion about the rules has focused on the confused reaction of many CFOs to the revised reporting requirements. And Wall Street seems to be considering the reporting changes something of a non-event. In some cases so far, companies have added earnings back on their books after adjustments for goodwill that no longer needs to be amortized under the new rules. Hardly a worry for shareholders.

Any CFO caught up in the M&A mania of past years, though, should start focusing attention on investor reactions right away. As companies begin to test for impaired goodwill, major write-downs will result. Last week, management at AOL Time Warner announced that the media giant will be writing down as much as $60 billion because of FAS 142.

Expect more where that came from. Crocker Coulson, a partner in the Sherman Oaks, California, investor relations firm of Coffin Communications Group, for one, expects a series of “headline- making, potentially record-setting losses” as companies implement the rules. “Under the old rules, goodwill was being amortized, so you knew that companies were eating into it,” notes Tom Burnett, president of New York-based Merger Insight, a research affiliate of Wall Street Access. “Now it’s going to be hanging around, so it can have much more of an impact in a single stroke when it is written off.”

Write-offs will depend on the results of an impairment exam, a two- step process that first tests to see if existing goodwill is impaired and then determines the size of any impairment. One instant indicator of potential impairment: goodwill that exceeds market capitalization.

Timing Is Everything

Burnett believes shareholders will indeed pay more attention. “A high goodwill ratio to assets and equity will be a turnoff to investors,” he says. “If goodwill is more than 10 percent of equity or more than 5 percent of total assets, I think that will be a warning signal.”

Other experts expect the timing of goodwill write-downs to carry as much weight as their size. Companies must take the first step of their impairment test within the first six months after adoption of the approach, disclosing the results in a quarterly 10Q report. If necessary, companies have one year from adoption to complete the second stage: a disclosure, in the period that a charge is taken, of the business unit recognizing the goodwill-impairment loss, how much that loss is, its causes, and the amount of any remaining goodwill. All charges taken within the first year after a company adopts the new approach may be written off as the result of an accounting change. After that, goodwill-impairment charges must be disclosed as an operating expense, and reflected as a hit to earnings.

Investor-relations consultants encourage companies to disclose impairment-test results, and any write-downs they produce in the very first quarterly report after adoption, rather than wait until later in the year. Why? For one thing, companies recognizing charges after the first postadoption quarter must restate financial results for preceding quarters. “Restatements may send out a signal that perhaps there is not as much financial control as there should be. It could undermine credibility,” says Coulson. And in general, he adds, “investors are more likely to take notice of impairment charges” if they come after that first quarter.

Along with their enhanced knowledge of impaired assets, investors will also have increased access to information about business combinations, and about the value of intangibles in general. The rules require companies to disclose goodwill values at the reporting-unit level. This knowledge could make Wall Street less patient with companies taking impairment charges late in the game, especially if the report comes more than a year after adoption.

Some experts say Wall Street already has demonstrated unhappiness with impairment-related surprises. As the market soured last year, some companies took huge impairment charges for declining goodwill using the old accounting guidelines. San Jose, California-based JDS Uniphase Corp. announced $50.1 billion in reductions in carrying charges for goodwill in the last two quarters of its June 30 fiscal year. And Nortel Networks Corp. wrote down $12.3 billion of goodwill in June. Both moves reflected changes necessary in the wake of the long bull market, when stock was used to purchase high-tech companies at what turned out to be inflated prices.

Analysts at investment banking firm Houlihan Lokey Howard & Zukin followed those 2 companies and 17 others writing off goodwill through July 2001, including Ariba, Aetna, and VeriSign. Companies taking an impairment charge smaller than their market capitalization saw share prices decrease an average of 1 percent. If charges exceeded market cap, shares fell an average of 5 percent. JDS’s hefty charge–more than four times market cap–was followed by a stock-price decline of almost 10 percent the next day.

Direct causality can’t be established. In the view of JDS’s executive vice president and CFO, Anthony Muller, the accounting charges “were largely ignored by the investment community.” Muller attributes the share- price fall to “changes in guidance showing that sales were projected by the company to decline.” The press, he adds, “covered the write- downs extensively, and in most cases accurately.”

But Houlihan Lokey senior vice president Karen Miles suggests her firm’s findings make it reasonable to assume there is some correlation, and that the stock reaction will continue for “companies across sectors that have had significant price drops, and made lots of acquisitions when prices were high.”

A World of Confusion

Another important issue for investors may be the puzzlement they see emanating from finance departments. Some uncertainty–and attendant stock-market volatility–may reflect the differing timetables under which companies adopt the rules. But the confusion in finance runs far deeper.

“The new standards add complexity both to structuring the deal and to the valuation of intangible assets going forward,” says Brian Heckler, partner in the transaction services practice for KPMG LLP in Chicago. The requirements for reporting from business segments affected by a transaction could cause special problems, particularly if those segments in the past “managed their businesses by P&L, without a balance sheet.”

A recent KPMG survey of 121 finance executives from a range of industries found that nearly two-thirds felt their business-development staffs lack a thorough understanding of the implications of the new rules, for example. More than 60 percent said their companies hadn’t estimated the impact of the rule changes on such standard company metrics as earnings and return on assets. And only 4 percent indicated that they have made “significant progress” in implementing the standards.

Perhaps CFOs see adjusting to the new rules to be business as usual. JDS’s Muller expects his finance department to have a handle on the standards by the time the company must report under FAS 141 and 142, at the beginning of its fiscal year in July. He doesn’t see a rush, though. “We’ll work on it, and implement them rigorously,” but other issues are more compelling now, and staffers “don’t have to work on it yet,” he says.

In theory, of course, accounting changes for goodwill and intangibles shouldn’t have any effect on share prices, since there’s no impact on cash flow. But Houlihan Lokey’s Miles suggests that the higher earnings created over time by the new rules, as companies cease to amortize merger goodwill, could affect valuation by changing price-earnings perceptions. That’s because “many investors look at pricing only in terms of P/E ratios for many industries and companies.” P/E multiples will adjust significantly for many companies, Miles adds, assuming their market caps remain unchanged.

Jennifer Caplan is a staff writer at CFO .com. Roy Harris is a senior editor at CFO.

What, Me Worry?

A KPMG survey suggests CFOs are relatively unconcerned, and somewhat conflicted, about the impact of FAS 141 and 142.

My company has estimated the rules’ effects on metrics like EPS, ROA, EBITDA, and tax rates.

  • Yes: 39%
  • No: 61%

Business-development people at my company have a thorough understanding of the new rules’ impact on reporting and forecasting.

  • Yes: 36%
  • No: 64%

The more-extensive disclosures of M&A activity will help our financial-statement readers.

  • Yes: 62%
  • No: 38%

More robust identification of intangibles in financial statements will increase the perceived value of our company.

  • Yes: 25%
  • No: 75%

Source: KPMG LLP, Based on 121 Surveys