An old Far Side cartoon showed a mathematician at a chalkboard trying to explain away a gap in a complicated proof. "Then," he says, "a miracle happens." The picture isn't much different in Corporate America--as CEOs try to justify the sky-high sums they pay for acquisitions. Only they don't call it a miracle: They call it accounting.
Depending on the accounting method, similar deals can have wildly different effects on reported earnings. And these days, more and more acquisitions are being done in ways that protect earnings but that also provide minimal disclosure to investors, who management hopes will let greed be their guide.
Why does this matter? Because the merger boom of the 1990s has helped push price-earnings ratios to new highs. If the accounting has papered over misvaluations and if mergers don't pay off, the market could be in for a huge correction.
To reverse this trend toward blurry bottom lines, the first thing that needs repair is goodwill--which is to accounting what "dark matter" is to cosmologists: massive and invisible. Goodwill (table) is a residue--the difference between the fair value of a company's net assets and the price of acquiring the company. Think of it as the value of unmeasurable things such as customer loyalty.
KNOTTY. Buyers hate goodwill because they must amortize it over 40 years at most. And even though it's a noncash charge that doesn't affect cash flow, it does cut reported earnings per share. "We focus on reported earnings per share because that's what the investment community focuses on," says William P. Boardman, senior executive vice-president at Banc One Corp. in Columbus, Ohio.
That's why Banc One is combining with First Chicago NBD Corp. in a $30 billion deal that won't place a penny of goodwill on the books. Instead, it will be a pooling of interests: an immaculate conception in which no goodwill is created--because neither company is treated as acquirer. The balance sheets of the two equals are simply merged.
But while pooling helps avoid goodwill charges, it's not usually in the interest of investors. First, pooling spoils the comparison of earnings between companies formed by pooling and other merger-formed companies. Second, merger-minded companies often twist themselves into knots to qualify for pooling as ostensible equals. For instance, they will abstain from stock buybacks before and immediately after acquisitions, because such transactions would preclude poolings. Finally, pooling also perpetuates fictions--such as recording assets at unrealistic historical costs--that would be set right in conventional purchase accounting.
The Financial Accounting Standards Board (FASB) is considering a limit on eligibility for poolings, which, says Securities Data Co., have accounted for half of the billion-dollar-plus deals announced this year. Poolings might be restricted to mergers in which it is truly impossible to identify an acquirer--say, because each company's shareholders will own half of the merged company. Banc One would fail such a pooling test: Its shareholders will own 60% of the combined company.
The FASB would push companies to use old-fashioned purchase accounting, in which they must calculate the fair value of each of the target's assets. That wouldn't stop the merger boom, but it might at least discourage companies from overpaying. Even here, however, there are problems. It's still too easy for acquirers to use the goodwill line on the balance sheet as a dumping ground for various intangible things--patents, trademarks, customer lists--that should be regarded as assets.
If the FASB takes away some of the ability to pool, it should also make purchase accounting less onerous by allowing companies to declare some goodwill to be of permanent value and therefore not to be amortized unless circumstances change. Whatever FASB decides--and its proposal won't be issued until next year--the goal should be more disclosure for investors and less opportunity for miracle-seeking, merger-happy CEOs.