The Statement
The Statement

FASB revamps business combination accounting

By Jack Ciesielski, CPA, CFA
President, R.G. Associates, Inc.
Member, Financial Accounting Standards Advisory Committee
Member, MACPA Board of Directors

The FASB has issued an exposure draft of a standard that would radically change the way businesses account for combinations. The draft's proposed elimination of pooling has been widely discussed in the press, as has been its requirement of an earnings presentation without goodwill amortization. Vast amounts of printer's ink have been spilled on another feature of the draft: it also permits the presentation of a quasi-cash flow figure along with earnings per share. Much less fanfare has been given to the way firms would account for non-goodwill intangible assets and the extensive disclosures that would give analysts and users the power to assess post-acquisition earnings quality.

The proposed accounting promises to be controversial, because pooling has long been a part of the merger and acquisition scene — and whether or not the results of its application make for clear financial reporting, there will be acquisitive companies and their investment bankers who will argue for its continuance.

The highlights of the major changes can be broken into two categories — just like the proposed standard is composed of two parts:

Business combinations

  • Pooling-of-interests accounting ceases to be an acceptable method of recording business combinations upon issuance of the final standard — without a transition period. Thereafter, all business combinations will be accounted for as purchases of assets — without exceptions. One company must be identified as the acquirer.
  • The standard will be issued sometime in 2000, probably in the fourth quarter. The date of issuance is "ground zero" for poolings — there's no grace period for them to be phased out. Only transactions initiated before the date of the standard's issuance may be completed as poolings after that date.
  • Accounting for in-process research & development assets is unchanged from current practice: expense them upon recognition.
  • Goodwill recognized in an acquisition must be tested for impairment within two years of the date of an acquisition.
  • Overall, all disclosures regarding the nature of an acquisition and the price paid have been enhanced. One particular new disclosure will be the presentation of a target company's historical cost balance sheet at acquisition date, with a corresponding balance sheet showing the fair value allocation of the purchase price.

The allocation of purchase price to assets can be done in such a way that assets that will be consumed in the near term — for instance, inventory — may be recorded at an artificially low fair value, in order to perk up post-acquisition earnings. The same "under-allocation" can be applied to long term assets like property, plant and equipment, with a similar rousing effect on post-acquisition margins and earnings. The new disclosure should bring transparency to these kinds of allocations, and help users assess whether or not the allocation process was "strategically determined" to achieve "programmed" results in post-acquisition performance.

Intangible assets

  • The proposed standard requires a good deal of searching for all intangible assets other than goodwill. Done properly, firms will show more intangible assets and less goodwill on their balance sheets than in the past.
  • Firms will have a real reason to search for intangible assets other than goodwill. The presumed maximum useful life for all intangibles — including goodwill — is going to be 20 years, which may severely reduce earnings. That presumption of 20 year life can be beaten if the intangible asset has clearly identifiable cash flows extending beyond 20 years, and the asset can be exchanged or controlled through rights beyond 20 years. In fact, if an indefinite life can be demonstrated, there needs to be no amortization at all. Goodwill merits no such "presumption-beating" opportunity. The accompanying table (below), drawn from the exposure draft, shows examples of intangible assets and their proper accounting treatment.
  • Goodwill amortization must be presented as a separate line item on the income statement, net of any tax benefit. Optionally, it may be shown as a separate component of earnings per share. Amortization of other intangible assets does not get a similar optional treatment, though it may be presented separately in the income statement.

It's taken accounting standard setters over 30 years to revisit these issues — and perhaps just in time, as the world's capital markets become more homogenized. If adopted, the resulting U.S. accounting for business combinations will not only result in financial statements that account for the economic substance of most business combinations, but will also result in reporting that will be more similar to that of many other countries.

Description of intangible asset

 

Proper accounting

Technological know-how, such as that of plant engineers or research scientists, the fair value of which is not reliably measurable.

 

Record and amortize as part of goodwill.

A customer list of an acquired direct-mail marketing company that is expected to generate future cash flows for 7 years. While there is an observable market for this list, the enterprise has no plans to sell the asset.

 

Amortize over 7-year useful economic life.

A patent expiring in 15 years. The patent is expected to be a source of revenue and cash flows for at least 15 years.

 

Amortize over 15-year useful economic life.

A newspaper subscriber base that is expected to generate revenues and cash flows for at least 25 years. The projected cash flows are based on an analysis of past subscription renewal patterns that was used to estimate future renewal patterns that also took into account the mortality, relocation, and changing tastes of current subscribers as well as various competitive factors. While the subscription list may be an exchangeable asset, management does not believe the underlying subscriber base is.

 

Amortize over 20 years, the maximum amortization period for intangible assets that are not exchangeable.

A trademark that has a remaining legal life of 12 years and is renewable indefinitely at little cost. The trademark protects a leading consumer product brand that has been a market-share leader for the past 8 years. An analysis of product life cycle studies; market, competitive, and environmental trends; and brand extension opportunities provides evidence that the trademark will generate revenue and cash flows for 35 more years.

 

Amortize over 60-year useful economic life.

A broadcast license that expires in 5 years but that may be renewed indefinitely at little cost. The acquirer intends to renew the license indefinitely, and there is evidence to support its ability to do so. Cash flows related to that license are expected to continue indefinitely, and there is an observable market for the intangible asset.

 

Do not amortize until useful economic life becomes finite. Test annually for impairment based on fair value.


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