A Goodwill Gesture From Fasb
The economy may be faltering, but corporate earnings are about to get a cosmetic pick-me-up. In the biggest change in accounting rules in years, the Financial Accounting Standards Board (FASB) has announced that as of July 1 companies will no longer have to amortize goodwill. Gone will be those yearly reductions to earnings to reflect premiums companies paid for assets over fair value. Corporate bottom lines will look better without any change in sales, cash flow, or management.
Wall Street is excited, and for good reason. Investors will see higher stock prices, in part, because more companies will be encouraged to launch takeovers. Now companies hesitate to make deals heavy with goodwill because of the hit to earnings. With that penalty removed, they'll have less fear that deals will hurt their stocks. Also, investment bankers expect an easier time persuading corporations to buy one another. "This will drive strong M&A volume," predicts Gary Posternack, managing director at Lehman Brothers Inc.
How much better will earnings look? The impact will vary widely. For companies loaded with goodwill and short on profits, earnings per share could rocket. For Coca-Cola Enterprises Inc., the bottler, earnings should look 122% better this year, according to investment bank UBS Warburg. For Pepsi Bottling Group Inc., the improvement will be only 30%; for PepsiCo Inc., 4%.
FESS UP. The big gainers skew the picture for the whole market. If the change had happened last year for companies in the Standard & Poor's 500-stock index, the average gain in earnings would have been 17%. But the median gain would have been only 4%, estimates Trevor J. Harris, managing director at Morgan Stanley Dean Witter and a Columbia Business School accounting professor who was instrumental in persuading FASB to make the change. Exact numbers are impossible to get. Many companies have yet to disclose just how much they've been amortizing. UBS Warburg chief global strategist Edward M. Kerschner estimates the S&P will get a 5% to 6% boost.
FASB's new stance is in response to widespread dissatisfaction with accounting for mergers and acquisitions. Most tech companies and analysts who follow them already disregard charges for goodwill amortization. They say current rules wrongly assume goodwill always represents an overpayment that should penalize earnings. Amortizing it obscures real cash profits. The new rule will require companies to show goodwill on their balance sheets. Having it there will help investors hold officers responsible for how much they pay to do deals. If something happens to reduce the value of an acquisition, companies will have to admit it and mark down goodwill with one-time charges. Champion investor Warren Buffett recommended the approach last year. FASB will issue guidelines for when goodwill must be revaluated.
But don't expect stock prices to go up as much as earnings, even in industry sectors that are not already ignoring the amortization. "The companies are the same as before," says Chuck Hill, research director at First Call Corp. "Theoretically, price-earnings multiples should come down instead, but I don't think the market is that sophisticated." While many institutional investors already add back estimates of goodwill amortization, others find that too tedious. Hill predicts a blend of slightly higher stock prices and slightly lower p-e ratios.
Still, some corporate executives remain convinced that their stocks will go up because of the change. Dominion Resources Inc., for instance, has stated that it will increase annual earnings by 8%, or 34 cents. At a price-to-earnings ratio of 13, that could mean an additional $4.45 a share, the company notes on its Internet site. "We are valued on net income and we think we will see a change in valuation," explains Dominion's controller, Steven A. Rogers.
SHOPPING SPREES? Despite all the celebratory tone surrounding the new FASB stance, there's clearly a downside. Since acquiring companies won't have to worry about seeing their earnings per share decline because of goodwill amortization, they will be more likely to make bad deals. And another big risk is that deal-happy executives will try to increase earnings through a flurry of dubious acquisitions, as happened in the 1960s, says David F. Hawkins, a Harvard Business School professor and Merrill Lynch & Co. accounting analyst. "There'll be companies that go on an acquisition binge," says Hawkins. FASB tries to thwart that result in details of the rule. Its success will depend on auditors holding executives to the standard, never a sure bet.
Even so, the new FASB rule will be like a shot in the arm to most companies. And that, in turn, is sure to give a welcome boost to investors.