Bad news doesn't get much worse than this. On June 15, Nortel Networks Corp. (NT ) announced that its sales for the second quarter would fall 38%, to $4.5 billion, excluding discounted operations. To make matters worse, the communications-equipment maker said it expects to lose $19.2 billion in the quarter, one of the largest losses in corporate history. Nortel Chief Executive John Roth blamed the reversal of fortune on the rapid slide in the U.S. economy and the resulting financial problems at many telecom companies.
True enough. But there is a broader, little-understood problem lurking behind the Nortel announcement--and it is one that is likely to lead to a wave of huge earnings charges throughout Corporate America. The biggest chunk of Nortel's loss was a $12.3 billion write-down for acquisitions that are now nearly worthless. Many other companies are in the same boat, having made acquisitions over the past couple of years that have declined in value along with the stock market. Worse yet, new accounting rules are going into effect Jan. 1 that will force companies to be more rigorous about writing down the value of these assets. Many companies are facing the abyss, contemplating huge charges in the next six months. "It's going to be a bloodbath," says Bob Willens, an accounting and tax analyst at Lehman Brothers Inc.
Who's next? So far, no one has done a comprehensive study of the extent of problem. Now BusinessWeek, aided by sister company Standard & Poor's Corp., has sifted through the financial statements of more than 1,000 of the largest public companies to find out. The data suggest that dozens of companies could have to take multimillion-dollar charges in the next few months. Not all of them are beleaguered telecom and technology sectors. Along with Net hotshot VeriSign, the list includes large insurer Aetna and video giant Blockbuster.
Here's a primer to help understand the issues and who will be affected.
Why do companies have to take these big write-downs?
Typically, when a company makes an acquisition, the price that it pays is recorded on its balance sheet as an asset. If the value of that business declines, then the acquirer has to write down the asset on its balance sheet to reflect its current value. This is true whether the acquisition is made in cash or with stock. For example, Nortel paid $8 billion for an Internet switching company called Alteon Websystems in October, 2000. As part of its announced loss, it's writing down the value of the business to zero.
Why is this happening now?
The Financial Accounting Standards Board (FASB) is implementing rules that force companies to be more rigorous about writing down goodwill, which is the amount a company pays in an acquisition beyond the value of an acquiree's existing assets. Specifically, companies will now have to justify the value at which they're carrying acquisitions on their balance sheets once a year. "In the past, there was no explicit requirement to test each year," says Kim Petrone, the project manager at the FASB who is handling the issue. FASB plans to give final approval to the rules at the end of June, and most companies will have to adopt them by Jan. 1.
When will companies have to take these write-downs?
The timing is tricky. Certainly, companies and their auditors will be fighting tooth and nail over when exactly to take the hit. Nortel was going to have a terrible second quarter in any case so the company's execs may have decided to toss the big write-down into the avalanche of bad news. (Nortel wouldn't comment for this story.) Other companies will take them when they determine the fair value of the assets they acquired is no longer as high as what they paid for them.
How do you determine fair value?
There are several different ways to do it. The simplest way to calculate fair value is to look at the market value of comparable companies that have publicly traded stock. This valuation will create all sorts of headaches because stock prices have plunged over the last year, particularly for technology and telecom companies. Another way to calculate fair value is to look at the cash flow that the acquired businesses are generating. But this approach also is problematic because so many of the tech and telecom companies that have been acquired have little or no profit. "There's no way in the world these businesses will ever generate the cash needed to justify the purchase price," says David F. Hawkins, a Harvard Business School professor who specializes in accounting issues.
How can you tell which companies will take these charges in the future?
One rule of thumb that FASB is suggesting is to look at shareholders' equity on the balance sheet compared with the current market cap. If the equity shown on the books is greater than the company's market value, then its assets may very well be overstated. "The market is telling you something you can't ignore," says Willens. VeriSign (VRSN ), Aetna (APPAX ), Lucent (LU ), and components maker JDS Uniphase (JDSU ) have shareholders' equity that is at least $5 billion greater than their current market caps. That could lead to multibillion write-downs at each company.
What about Cisco?
Everybody asks about Cisco Systems Inc. (CSCO ) The networking giant has made loads of acquisitions, and it has built up goodwill of $4 billion. That's nowhere near its $120 billion market cap, but it still may have to take a write-down for some of those deals. The FASB rules affect acquisitions that were made using purchase accounting, but they don't affect pooling of interest acquisitions. With a handful of exceptions, Cisco made pooling of interest acquisitions.
What's the difference between pooling and purchase?
With pooling, the company making the acquisition and the acquiree simply combine their balance sheets, so there is no goodwill created. It's sort of like pretending that the two companies have always been together. Purchase accounting is different: The acquiring company puts its target's net assets on its own balance sheet, and anything it paid in addition to those net assets is called goodwill. For example, VeriSign bought Network Solutions Inc., which doles out Internet domain names, for $19.6 billion and added Network Solution's $1.3 billion in net assets and $18.3 billion in goodwill to its own balance sheet.
The reason FASB is changing its rules now is to get rid of pooling and have all companies use purchase accounting. As part of the change, companies no longer have to amortize goodwill. VeriSign will be able to stop taking a charge for goodwill amortization, which has been running more than $1 billion per quarter.
Do the companies admit they have a problem?
Some have. Optical components maker JDS Uniphase Corp. has asked regulators for help in figuring out how to write down $40 billion in assets. Spokesmen for Lucent, NTL (NLI ), and WebMD (HLTH ) say they will comply with FASB rules after they're finalized. Dana Evan, the chief financial officer for VeriSign, says the company analyzed its assets at the end of last quarter and concluded they're at fair value. "Next quarter, we'll do it again," she says. Most companies point out that these write-downs don't cost any cash.
Wait a minute, it doesn't cost them anything? Why have I been wasting my time reading this story?
Temper, temper. Yes, companies don't have to pay out any cash when they take these write-downs. But they're still costing shareholders plenty. If a company made an acquisition in cash and later writes down the value of the deal, the company is admitting that the cash was wasted. Even if the acquisition was made for stock, shareholders may have suffered dilution. And Roth isn't alone in costing his shareholders money. It's just going to take a few months for other CEOs to fess up.
By Peter Elstrom, with David Henry, in New York