When the US Financial Accounting Standards Board (FASB) on June 30 eliminated the “pooling” method of accounting for business combinations, the usually staid world of accounting rules saw the curtain fall on one of its most vociferous and political dramas in recent memory. In taking aim at pooling, which had been one of two accepted ways to account for combining businesses, FASB sought to bring greater clarity and consistency to accounting rules. But its effort drew the ire of corporate executives and venture capitalists, some of whom went so far as to invoke the national interest to preserve an accounting method they considered a dynamo of M&A activity and economic prosperity. Even members of the US Congress jumped into the fray over the otherwise arcane accounting topic.
True, the new rules, which dispatch pooling in favor of the alternative “purchase” method of accounting, represent a compromise. But we believe it is a step forward, particularly for those companies that prepare themselves for the post-pooling world.
Pooling’s supporters liked the method because using it for M&A transactions could result in higher reported earnings and, they argued, greater value creation than would be possible using purchase accounting. The debate centered on “goodwill,” or the amount paid for an acquired company above the fair value of its book assets. In pooling accounting, the book value of the acquired company is carried over as is, with no goodwill. In contrast, under the new version of purchase accounting, goodwill is to be recorded as an asset that must be periodically tested for a loss in value—or impairment. If it is judged to have fallen in value, the difference must be written down and charged against earnings. Both methods result in identical cash flows, since any write-down of goodwill would result in a noncash charge.
The new rules accommodate those who objected to the change by eliminating the earlier purchase accounting requirement to systematically amortize goodwill via annual charges to the income statement. Instead, FASB agreed that companies be required to test the goodwill balance for impairment only periodically, and to take a charge against earnings only when such impairment is found to have occurred.
Our view is that purchase accounting does not destroy value, as its critics charged, regardless of whether or not it requires systematic goodwill amortization. Substantial evidence suggests that analysts, investors, and ultimately capital markets see through accounting treatment—and that the form of accounting for combining businesses has no impact on shareholder value. For example, it has been shown that price-to-earnings ratios of companies that have entered into purchase transactions tend to rise to offset goodwill amortization (exhibit).1 It has also been demonstrated that market-to-book ratios of acquirers remain constant once accounting treatment is taken into account.2
Evidence suggests that investors and analysts see through accounting treatment.
Indeed, there are many examples of deals that have been well received by the market despite the fact that purchase accounting drove significant earnings dilution. For example, the market celebrated Viacom’s proposed $37 billion purchase of CBS by increasing its stock price 12 percent,3 despite a projection that the way the combination was accounted for would dilute earnings per share (EPS) by $0.33, or 43 percent.4
Finally, although McKinsey research has found little statistical difference in how purchase and pooling deals perform, we have seen many cases where pooling accounting actually destroyed value. Companies expend significant hard costs to qualify for pooling treatment and subject themselves to a range of hidden costs, for example, forgoing restructuring options for up to two years following a transaction in order to comply with pooling regulations that limit significant divestitures.
Getting the most out of purchase accounting
The compromise thus represents a significant step forward in bringing clarity and consistency to accounting and avoiding the risk of significant value destruction. However, the change requires corporations to prepare for purchase accounting to help ensure continued value creation from strategically rational business combinations. Executives looking to make the most of the new regime will need to reevaluate internal deal evaluation processes, prepare for a greater set of external communication challenges, and minimize time and money spent in testing goodwill for impairment.
Reevaluate internal deal evaluation processes
Rethinking the processes used to evaluate deals is a good place to start. To succeed in the post-pooling world, it will be important to understand where dilution is coming from and to focus only on what is most important to the market—the sources of true value and their impact.
Internal M&A processes frequently gauge the attractiveness of prospective deals by forecasting whether the deal will bolster or dilute EPS. This created an implicit bias toward pooling accounting. We have participated in many discussions with senior management where there appeared to be unanimous agreement regarding the strategic rationale and value creation potential for a transaction, only to see the deal killed because it looked likely to dilute near-term earnings.
The fact is, not all dilution is created equal. Earnings dilution is an important consideration in deal evaluation—but only when it is caused by two factors. The first is the premium paid in excess of clear synergy value. The other is the prospect of uncertain future growth in the acquired business. When a deal dilutes earnings for these reasons, shareholders are right to ask pointed questions. However, dilution caused by accounting treatment is irrelevant, and the market knows it. Moreover, dilution caused by choice of financing, such as how much debt is taken on or how much equity is issued, should be considered and discussed as a separate effect that does not complicate the decision to go ahead or back off from an acquisition.
Prepare for greater external communication challenges
Moving to purchase accounting will provide some companies with a valuable opportunity to improve their overall dialogue with investors. Over time, continued discussions of EPS accretion and dilution and earnings estimates are likely to prove unsatisfying. But executives can take advantage of the opportunity to engage investors on more critical topics such as cash flow, growth, and synergies. Some companies are already breaking new ground in discussing “cash earnings” or “cash EPS” with investors. Wells Fargo, for example, followed its acquisition of First Interstate by issuing a special report to shareholders focusing on “cash earnings” and disaggregating the impact of the purchase method on the transaction.
Cash EPS is a more elusive concept, with several possible definitions. Typically it is calculated as standard EPS plus goodwill amortization. The move toward cash EPS is a positive development. Still, it falls short of what every company’s aspiration should be—a robust dialogue around long-term value creation potential and the free cash flows that drive it. Briefly stated, the problem with cash EPS is that it is neither cash nor EPS.
In a mature business generating positive earnings and cash flows, a good first step would be to move toward true cash measures. Corporate America already reports substantial cash flow information. Moving the dialogue toward measures such as operating cash flow per share or free cash flow per share is just as easy and more robust than moving to cash EPS. Better yet, executives should focus discussions with investors on growth in free cash flow and the spread between return on capital and cost of capital as the simplest and truest drivers of value creation.
Minimize time and money spent in testing goodwill for impairment
Finally, executives would do well to keep an eye on the time and money they spend meeting the new FASB standards. The rules eliminate the need for companies to systematically amortize purchase accounting goodwill. Instead, they require companies to periodically test such balances for impairment and to take a charge against earnings whenever such impairment has occurred. In practice, companies will have the option of avoiding a charge to reported earnings if they can meet one key test—that the fair value of each relevant reporting entity is greater than book value, including goodwill. If this test is not met then any impairment is calculated by valuing goodwill in essentially the same manner as at the time of the initial business combination. While companies must spend some time evaluating the carrying value of goodwill, we believe that extensive and costly efforts to avoid an earnings charge should be avoided. We have found no evidence that such charges have any impact on shareholder value.
We should note, however, that executives must be mindful of what annual goodwill write-offs may suggest to investors. A high write-off could be interpreted as a signal that an acquisition has failed or as an attempt to make future profits look better against lower future write-offs. Furthermore, large goodwill write-offs could turn corporate net income into a loss, triggering debt covenants that were not constructed to consider such circumstances.
The new FASB accounting rules emerged from an uncharacteristically vocal debate over the value creation inherent in accounting methods. Now CEOs and CFOs must ensure that their companies are well positioned to continue reaping the benefits of transactions that create value, as well as reposition internal processes and external communication with investors to take advantage of the opportunity created by the new accounting landscape.