Shawn Tully
As much as any other single influence in the economy, merger mania was the force that shaped the Fortune 500 in 1998. And even if it seemed that certain CEOs had grown obsessed with empire building at the expense of their business--well, who could argue with the numbers? Deals seemed invariably to gussy up future earnings and add a particular gloss to that perennial touchstone of managerial excellence: return on equity.
Chance are, though, that those numbers are less the product of great synergies than of two sweetheart accounting provisions. Known as pooling of interests and write-offs for in-process research and development, these provisions have become wildly popular in the recent surge of deals. For example, in the early 1990s less than 5% of the deal volume (by dollars) used pooling-of-interests accounting. Last year pooling accounted for 55% of the volume, including deals by such giants of the Fortune 500 as Exxon (No. 4 in the 500), Citigroup (No. 7), BankAmerica (No. 11), SBC (No. 35), and McKesson (No. 59). Significantly, both pooling and in-process R&D write-offs are almost unheard of outside the U.S. Accounting standards in every other country either outlaw the provisions outright or severely restrict their use. Why? For the same reason that U.S. dealmakers find them so irresistible: By inflating reported earnings and covering up the true cost of an acquisition, they can make even a dog of a deal look brilliant.
It's important to remember that pooling and in-process R&D write-downs, like any accounting guidelines, are just rules for keeping score. They have absolutely no power over the real economics of a deal. They can't make a bad deal work or keep a good deal from paying off. But what they can do is frame how a merger is perceived, keep shareholders in the dark, and at the worst drive executives to gamble on dicey corporate couplings that they would never consider under stricter accounting standards.
None of this is any secret to accounting authorities. The Financial Accounting Standards Board, the industry body that sets the rules in the U.S., has already proposed axing in-process R&D write-offs, and it is leaning toward writing finis to pooling in as few as 20 months. (Those efforts are quite apart from the Securities and Exchange Commission's crackdown on other dubious accounting ploys; see Fortune Investor.) Not surprisingly, dealmakers are howling, particularly in financial services and technology, the two most enthusiastic users of the two loopholes. Chase, Citi, and J.P. Morgan, among others, have written urgent letters to the FASB on behalf of current standards. They say taking measures to tighten the rules will stifle innovation, lower American competitiveness, and bring the merger train to a screeching halt. And Dan Scheinman, general counsel of Cisco, waxes positively apocalyptic (in a California sort of way). "These measures," he says, "would disrupt the entire ecosystem of Silicon Valley."
To understand why they're so upset, flash back briefly to your college accounting course and to a basic principle of that science--namely, that the cost of an asset should be expensed over the asset's useful life. That idea works fine as long as the most important assets are things, like factories and equipment. In the knowledge economy, however, the old rules are about as practical as a smokestack in a chip fab. "The big wealth creation is shifting from factories to intellectual capital," says Baruch Lev, a professor at New York University's Stern School of Business. Today's most valuable assets are intangibles--brand names, customer lists, trademarks, research, and so on--to which it is hard to assign a specific value and useful life. Throwing up its hands, accounting regards these treasures as worth zero.
They're worth zero, that is, until someone pays for them. Then, suddenly, they must be accounted for at their purchase price. In a standard acquisition--known as a "purchase" transaction--the buyer is supposed to record a fair market value for everything it has bought, including intangibles. Since the market tends to consider a whole company as worth more than the sum of its parts, there's usually a gap between the company's purchase price and the value of all its assets. Accountants call this gap "goodwill." In theory, goodwill should equal the premium the buyer pays over and above the fair market value of all the acquired company's assets. In practice, however, acquirers seldom fix a value on the intangibles. Instead they appraise the tangible assets and dump everything else into goodwill.
That makes goodwill a critically important consideration in deals involving knowledge companies--especially infotechs and drugmakers--because virtually the entire purchase price of such companies shows up on the acquirer's books as goodwill. Accounting rules arbitrarily assign this catchall category a useful life that can be as long as 40 years. That means that the value of goodwill must be amortized--or written off--over that period. A dollar of amortization reduces reported earnings by a dollar. So a company that acquires a lot of goodwill is also acquiring a drag on future earnings.
That's where pooling of interests comes in. Under pooling, companies simply combine their existing assets at their historical cost. Most intangibles remain valued at zero. The bulk of what the acquirer has to amortize are the target's physical assets--which, in New Economy companies, represent a tiny fraction of the purchase price.
In short, most of the cost of acquiring a knowledge-based company simply vaporizes in a pooling merger. The buyer gets to report the earnings from the intangible assets it just bought, but it doesn't have to amortize any of the cost. That keeps reported earnings high. And the surviving company's balance sheet disguises evidence of the merger by minimizing growth in its base of assets. So compared to deals using purchase accounting, the return on equity looks as if it's on steroids.
