[House Hearing, 106 Congress]
[From the U.S. Government Publishing Office]
ACCOUNTING FOR BUSINESS COMBINATIONS: SHOULD POOLING BE ELIMINATED?
=======================================================================
HEARING
before the
SUBCOMMITTEE ON
FINANCE AND HAZARDOUS MATERIALS
of the
COMMITTEE ON COMMERCE
HOUSE OF REPRESENTATIVES
ONE HUNDRED SIXTH CONGRESS
SECOND SESSION
__________
MAY 4, 2000
__________
Serial No. 106-100
__________
Printed for the use of the Committee on Commerce
U.S. GOVERNMENT PRINTING OFFICE
64-765 CC WASHINGTON : 2000
COMMITTEE ON COMMERCE
TOM BLILEY, Virginia, Chairman
W.J. ``BILLY'' TAUZIN, Louisiana JOHN D. DINGELL, Michigan
MICHAEL G. OXLEY, Ohio HENRY A. WAXMAN, California
MICHAEL BILIRAKIS, Florida EDWARD J. MARKEY, Massachusetts
JOE BARTON, Texas RALPH M. HALL, Texas
FRED UPTON, Michigan RICK BOUCHER, Virginia
CLIFF STEARNS, Florida EDOLPHUS TOWNS, New York
PAUL E. GILLMOR, Ohio FRANK PALLONE, Jr., New Jersey
Vice Chairman SHERROD BROWN, Ohio
JAMES C. GREENWOOD, Pennsylvania BART GORDON, Tennessee
CHRISTOPHER COX, California PETER DEUTSCH, Florida
NATHAN DEAL, Georgia BOBBY L. RUSH, Illinois
STEVE LARGENT, Oklahoma ANNA G. ESHOO, California
RICHARD BURR, North Carolina RON KLINK, Pennsylvania
BRIAN P. BILBRAY, California BART STUPAK, Michigan
ED WHITFIELD, Kentucky ELIOT L. ENGEL, New York
GREG GANSKE, Iowa TOM SAWYER, Ohio
CHARLIE NORWOOD, Georgia ALBERT R. WYNN, Maryland
TOM A. COBURN, Oklahoma GENE GREEN, Texas
RICK LAZIO, New York KAREN McCARTHY, Missouri
BARBARA CUBIN, Wyoming TED STRICKLAND, Ohio
JAMES E. ROGAN, California DIANA DeGETTE, Colorado
JOHN SHIMKUS, Illinois THOMAS M. BARRETT, Wisconsin
HEATHER WILSON, New Mexico BILL LUTHER, Minnesota
JOHN B. SHADEGG, Arizona LOIS CAPPS, California
CHARLES W. ``CHIP'' PICKERING,
Mississippi
VITO FOSSELLA, New York
ROY BLUNT, Missouri
ED BRYANT, Tennessee
ROBERT L. EHRLICH, Jr., Maryland
James E. Derderian, Chief of Staff
James D. Barnette, General Counsel
Reid P.F. Stuntz, Minority Staff Director and Chief Counsel
______
Subcommittee on Finance and Hazardous Materials
MICHAEL G. OXLEY, Ohio, Chairman
W.J. ``BILLY'' TAUZIN, Louisiana EDOLPHUS TOWNS, New York
Vice Chairman PETER DEUTSCH, Florida
PAUL E. GILLMOR, Ohio BART STUPAK, Michigan
JAMES C. GREENWOOD, Pennsylvania ELIOT L. ENGEL, New York
CHRISTOPHER COX, California DIANA DeGETTE, Colorado
STEVE LARGENT, Oklahoma THOMAS M. BARRETT, Wisconsin
BRIAN P. BILBRAY, California BILL LUTHER, Minnesota
GREG GANSKE, Iowa LOIS CAPPS, California
RICK LAZIO, New York EDWARD J. MARKEY, Massachusetts
JOHN SHIMKUS, Illinois RALPH M. HALL, Texas
HEATHER WILSON, New Mexico FRANK PALLONE, Jr., New Jersey
JOHN B. SHADEGG, Arizona BOBBY L. RUSH, Illinois
VITO FOSSELLA, New York JOHN D. DINGELL, Michigan,
ROY BLUNT, Missouri (Ex Officio)
ROBERT L. EHRLICH, Jr., Maryland
TOM BLILEY, Virginia,
(Ex Officio)
(ii)
C O N T E N T S
__________
Page
Testimony of:
Bible, Peter R., Chief Accounting Officer, General Motors
Corporation................................................ 89
Dooley, Hon. Calvin M., a Representative in Congress from the
State of California........................................ 62
Goodlatte, Hon. Bob, a Representative in Congress from the
State of Virginia.......................................... 59
Hoffman, Gene, Jr., President and CEO, EMusic.com............ 98
Jenkins, Edmund L., Chairman, Financial Accounting Standards
Board...................................................... 69
Lewis, William Frederick, President and CEO, Prospect
Technologies............................................... 102
Powell, Dennis D., Vice President, Corporate Controller,
Cisco Systems.............................................. 80
Material submitted for the record by:
American Business Conference, letter dated May 3, 2000, to
Hon. Michael Oxley......................................... 134
Biotechnology Industry Organization, letter dated May 4,
2000, enclosing statement for the record................... 130
Jenkins, Edmund L., Chairman, Financial Accounting Standards
Board, letter dated May 23, 2000, enclosing response for
the record................................................. 125
National Association of Manufacturers, letter dated May 3,
2000, to Hon. Michael Oxley, enclosing material for the
record..................................................... 132
Valuing the New Economy, a white paper presented by The
Merrill Lynch Forum........................................ 136
(iii)
ACCOUNTING FOR BUSINESS COMBINATIONS: SHOULD POOLING BE ELIMINATED?
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THURSDAY, MAY 4, 2000
House of Representatives,
Committee on Commerce,
Subcommittee on Finance and Hazardous Materials,
Washington, DC.
The subcommittee met, pursuant to notice, at 10:08 a.m., in
room 2123, Rayburn House Office Building, Hon. Michael G. Oxley
(chairman) presiding.
Members present: Representatives Oxley, Tauzin, Gillmor,
Cox, Largent, Ganske, Lazio, Shimkus, Bliley (ex officio),
Towns, DeGette, Barrett, Luther, Markey, Rush, and Dingell (ex
officio).
Also present: Representatives Eshoo and Crowley.
Staff present: Brian McCullough, majority professional
staff; David Cavicke, majority counsel; Linda Dallas Rich,
majority counsel; Shannon Vildostegui, majority professional
staff; Robert Simison, legislative clerk; and Consuela
Washington, minority counsel.
Mr. Oxley. The subcommittee will come to order. The Chair
recognizes himself for an opening statement.
I would like to begin by reaffirming my belief in FASB as
an independent private sector entity is best suited to set
accounting standards. Few would want politicians without
accounting expertise making highly technical accounting
decisions. From time to time, however, FASB considers an issue
which has broad public policy implications best brought to
light through congressional hearings such as this. In such an
instance, the Congress has a responsibility to foster open
dialog on the issue. That is precisely why I have called this
hearing today.
FASB proposes eliminating the use of pooling as a proper
method of accounting for business combinations as well as
making changes to the treatment of goodwill. Many of the same
arguments have circulated for years both for and against
pooling accounting as the treatment of goodwill. The debate has
little changed. What has changed, however, is the context of
the debate. In the information economy, the magnitude of the
implications of eliminating pooling accounting has increased
dramatically. Intangible assets of knowledge-based companies
often account for most of the company's value or ability to
generate revenue in the future.
Central to this debate is the information available to
investors under each accounting method. Arguably, the benefits
the elimination of pooling accounting will provide varies. The
question we must answer is whether the information is better,
more accurate, and as useful under purchase accounting as the
information provided under the current pooling method of
accounting for these transactions.
The recording of goodwill is a good example of the
different treatment intangibles receive under pooling and
purchase accounting. Some argue pooling accounting distorts
book value because it does not amortize goodwill. The values of
the two companies are simply combined. Others argue purchase
accounting artificially reduces stated income by requiring
goodwill write-off without a negative economic event to support
it. In fact, I can understand how many intangible assets
appreciate rather than depreciate over time.
Distinct from which method is more accurate is the issue of
whether requiring a shorter amortization period for goodwill or
even require the write-off of goodwill and other intangibles
will actually make mergers and acquisitions uneconomical for
businesses. I suspect mergers will continue. However, the
possibility that such a rule change would artificially slow
economic growth without providing any marginal benefit gives me
pause.
Though I do not begin to have a solution to this debate, I
do urge those central to this debate to consider all of the
options. Perhaps we need to further examine the changing nature
of assets which is driving our economy. We need to consider
whether eliminating pooling accounting is a negative economic
impact that could diminish the competitiveness of U.S.
businesses. Finally, we must evaluate whether the proposed
changes will actually provide investors with more useful
information about a company.
Today we will hear from those closest to the debate. I
thank our panelists for appearing today and look forward to
hearing what each has to say about this important issue.
The Chair's time has expired. I recognize the ranking
member, the gentleman from New York, Mr. Towns.
Mr. Towns. Thank you, Mr. Chairman, for holding this
hearing.
A number of concerns have been raised about the elimination
of pooling as a method of accounting for business combinations.
Eliminating pooling accounting, it is argued, could slow the
pace of business combinations and hinder the growth of high-
tech industry then by reducing the number of jobs its industry
creates. High-tech companies in particular say that with
pooling accounting, many of the mergers in the high-tech
industry which have boosted our economy and the stock market
might not have ever happened.
As a New Yorker and the ranking member of this Subcommittee
on Finance, I am concerned about the potential adverse effects.
On the other hand, a number of other companies, investors,
consumer groups and accounting experts argue that pooling is
flawed, that it distorts financial reporting, and that it
adversely affects the allocation of economic resources by
creating an unlevel playing field for companies that compete
for mergers and acquisitions.
Still others have concluded that both the pooling method
and purchase method of accounting for business combinations are
flawed, and that we need to go back to, should go back to, the
drawing board before moving forward.
There has been some concern lately about traditional
accounting. This is because intangible assets have replaced
traditional bricks and mortar as the backbone of business
today. Information, knowledge, and human capital are difficult,
if not impossible, to value. They simply do not depreciate the
same way tangible assets do. In fact, they often appreciate.
We should not be forcing companies with mostly intangible
assets to apply the accounting method which does not accurately
reflect the value of their assets. It seems to me we should be
moving toward a framework that more accurately reflects the
value of companies in this information day and age.
Consistency in accounting standards is a desirable goal and
one that I support vigorously, but consistency will not be
beneficial if investors cannot rely on the valuation that the
consistent approach provides.
On that note, Mr. Chairman, I yield back.
Mr. Oxley. The Chair recognizes the chairman of the full
committee, the gentleman from Richmond, Mr. Bliley.
Chairman Bliley. Thank you. I commend you, Mr. Chairman,
for holding this hearing today.
The draft rule proposal issued by the Financial Accounting
Standards Board will have a significant impact not only on
high-tech and other companies, but also on our economy. I
commend the FASB's work in seeking to ensure that accounting
rules provide an accurate and fair picture of a company's
financial status.
In this instance, important questions have been raised as
to whether the Board's proposal would actually do that, or
whether it would, on the contrary, make it more difficult for
investors and creditors to understand the true status of a
company that has resulted from a business combination.
It is not an easy job to get companies to clarify their
financial status. The job has become increasingly difficult.
Bricks-and-mortar assets share the same balance sheet as
creativity, innovation and other intellectual assets. High-
tech, biotech, financial, and other companies thrive on these
intangible values. Measuring these intangible values is very
difficult, and I recognize that FASB does not have an easy job
to do.
An accounting framework that functions effectively in this
new economy is an important goal we must achieve. There are
good arguments both for and against the FASB proposal. Hundreds
of comment letters were received, and the FASB heard from
witnesses at hearings in California and New York. I am
interested to know how this information has been received.
I am concerned by claims that FASB's proposal does more
harm than good. If the proposed changes have a negative effect
on our economy, then these changes become a public policy
matter that Congress must consider. I hope that is not the
case, but I do not think the picture is clear enough at this
time to advocate the changes contemplated in the FASB proposal.
I look forward to hearing the views of our witnesses today,
and I hope that we can begin to answer these important
questions.
Thank you, Mr. Chairman.
Mr. Oxley. I thank the gentleman.
The Chair recognizes the gentleman from Massachusetts Mr.
Markey.
Mr. Markey. Thank you, Mr. Chairman, very much. Thank you
so much for having this very important hearing here today so we
can air out the concerns that I think many of the people who
are right now representing new economy districts such as mine,
the concerns which are being raised by many of the companies
which we represent.
The critics of FASB raise concerns that purchase accounting
may fail to accurately value some of the mergers. These
concerns have been particularly intense among many of the new
economy companies whose worth may be less a function of their
physical assets, earnings, or capital, and more a product of
intellectual property or other more intangible assets and
goodwill.
Some have advocated that eliminating pooling would
discourage many new e-commerce startup companies from doing a
merger because of the cost purchase accounting would impose on
such a transaction.
Today, Mr. Chairman, you have wisely invited Ed Jenkins as
well as a very distinguished panel of corporate leaders with
varying perspectives on FASB's proposal to eliminate pooling. I
greatly respect Ed Jenkins. I admire Ed Jenkins. I think he is
an excellent head of FASB, and I welcome him here today.
I am going to be particularly interested in hearing
constructive ideas on options that FASB may or should consider
to address in terms of their concerns that had been raised
about the impact of purchase accounting on the new economy, and
at the same time assuring that investors get the full and fair
disclosure which they deserve. I think this is an excellent
forum to have that discussion in.
Obviously, we are, as a Nation, in a transformation that is
reflected in the earliest stages by particular east coast and
west coast congressional districts, but without question, it is
time for us to have this important discussion.
Mr. Chairman, since we are on the subject of accounting, I
would also suggest to the Chairman that we consider holding a
further oversight hearing on another issue affecting the
accounting profession, the disturbing conflicts of interest
arising from the fact that some firms wish to simultaneously
serve as consultants to or business partners of companies that
they are also auditing simultaneously.
This practice is very disturbing to me. When my brother
John was graduating from Boston College as one of the
outstanding finance majors, I asked him why he was not an
accounting major instead. He said to me, well, the finance
majors play the game, and the accountants keep score. In this
new era, accountants want to play the game and keep score at
the same time, and it does build in tremendous conflicts that I
believe this committee should look at.
I know that you, Mr. Chairman, and several other members of
the majority have recently written to Arthur Levitt on this
subject, criticizing him as he tries to clamp down on such
practices, and I would hope that we could have a public hearing
on that issue as well so that we can discuss the propriety of
accountants also having financial interests in the firms they
are allegedly auditing for public consumption. I think that
would be important.
I look forward to this hearing. It is a central issue in
the development of the new economy. I thank everyone who has
come here today. I think it is going to illuminate the
understanding of the subcommittee.
Mr. Oxley. The gentleman from Illinois Mr. Shimkus.
Mr. Shimkus. Thank you, Mr. Chairman. I will be brief. I
have only been a Member for 4 years, two terms. I have never
seen a submission of testimony this large before. It gives
members a great excuse, those who have not covered it prior to
the hearing. If more hearings would have this type of
documentation, I would have better excuses for not doing all my
homework, Mr. Chairman.
Mr. Oxley. There are pictures in there, though.
Mr. Shimkus. We appreciate pictures.
I do have great respect for FASB, too. I understand the
complexity of trying to determine market value in a new era of
services, information services, and how do you value that. I am
here to listen and learn. I thank my colleagues for appearing,
and also the members of the next panel.
With that, Mr. Chairman, I yield back my time.
Mr. Oxley. The Chair is now pleased to recognize the
ranking member of the full committee, the gentleman from
Michigan Mr. Dingell.
Mr. Dingell. Mr. Chairman, thank you for that courtesy.
Mr. Chairman, I commend you for holding this hearing. It is
a valuable one, and it will be a useful device in achieving the
best judgments as to what should be done on the matters under
consideration.
Mr. Chairman, there is probably no stronger defender of the
Financial Accounting Standards Board, or FASB, and the
independent setting of accounting standards than I have been
over my congressional career. I say this even though I don't
always agree on every last detail on every accounting standard
that FASB has set.
Making us happy, however, is not their task. Their job is
quite a different one. That is to promulgate standards of high
quality that do not favor any particular interest group and
maintain the credibility of our financial reporting system.
They have an even greater responsibility, and that is to
see to it that our accounting system reports truthfully,
factually, fairly, and correctly to all involved, to the
companies, to the shareholders, to the regulators and everybody
else.
Where we have not seen that happen, and I have seen several
instances in this committee, including some railroad mergers
where the reporting of the accounting system was not reliable,
major scandals and major troubles occurred.
The unparalleled success of our capital markets are due in
no small part to the high quality of the financial reporting
and accounting standards promulgated by FASB. I would note that
this is very much in contradistinction to what we have seen
with regard to some of the foreign accounting systems and some
of the standards that are promulgated through their mechanisms,
referring very specifically to countries in and around the
Pacific Rim and in Asia.
If I have any criticism of FASB, and I would note that I
do, it is that they seem to have a political tin ear and to
make a lot of powerful enemies. Their decisionmaking process is
supposed to be neutral and thorough and open and informed, and
it is all of that.
They do have a tough job to do. I respect that, and I
welcome them here today, as I do all of our witnesses.
On the substance of this hearing, I have not made up my
mind as to what is the right answer. I am not an accounting
expert. I would note that my experience in accounting is
bottomed somewhat on the practice of law and the fact that I
once took a mail order course in accounting to understand what
I was dealing with when I addressed this particular subject in
the practice of law.
The 1970 compromise by the FASB to allow both purchase and
pooling accounting for business combinations has been highly
controversial, strongly dissented from, and showed serious
fault lines during the merger boom of the 1980's.
After several years of deliberation and debate, at the
urging of affected parties, FASB has issued an exposure draft
that proposes replacing the pooling of interests method with
the purchase method for almost all business combinations.
Currently companies can use pooling if they meet 12
criteria. I suspect if there is a criticism of what has
happened heretofore, it has been that the industry has gotten
the assumption, correctly or incorrectly, from FASB that they
have arrived at a decision that this is what is going to occur,
and that nothing further is going to be done on the matter. I
think that is unwise, and certainly politically so.
Under the purchase method, an acquiring company records the
value of the acquired company at the cost it actually paid.
Under pooling of interests, the combining companies simply add
together the book value of their assets, leaving investors with
no way to determine what price was actually paid or tracking
the acquisition's subsequent performance.
In an example cited at page 5 of FASB's prepared remarks
involving a $10 billion transaction that was accounted for
under the pooling method, the book value of the company being
acquired was only $500 million. The acquisition was reported as
$500 million in the financial statements of the acquired
company, and $9.5 billion in value simply disappeared. Where
did it go?
Despite no real change in cash-flows, the pooling method
also creates a false measure of increased earnings, say its
critics. Dramatically different results are produced by the two
accounting methods, making it difficult for investors to
compare companies, or indeed even to understand whether or not
the accounting system is producing a reliable and truthful
result. This will have another curious result, and that is
possible serious competitive advantages or disadvantages.
High-tech companies and financial institutions oppose the
FASB proposal, saying if pooling is eliminated or curtailed, it
will destroy their industries, the M&A market, the stock
market, and the U.S. economy. It seems every time anybody has a
bad case, they come in and make these charges. The Congress and
everybody else is supposed to panic.
It may well be that this is the case. If that is so, then
maybe we had better take a hard look at these high-tech
companies and see whether they have any real viability at all.
Other companies such as General Motors, whose chief
accounting officer will testify today, the respected rating
agency Moody's Investors Service, and the Council of
Institutional Investors, the Consumer Federation of America,
and other groups representing investors and consumers support
the FASB proposal.
Me, I think that we probably ought to just support the
gathering of the truth and seeing to it that accounting,
accounting standards, and things of this kind tell us the
truth. Perhaps maybe if we get that, we will have accomplished
our purpose in this particular matter.
In May 1999, a study by Goldman Sachs concluded that the
proposed accounting standards will not have a material adverse
impact on future business consolidations, although the study
identified some industries that might be adversely affected.
I would ask unanimous consent, Mr. Chairman, that that be
inserted in the record.
Mr. Oxley. Without objection.
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Mr. Dingell. I also note that most foreign countries
prohibit pooling or allow it only as an exception.
For example, the United Kingdom and the International
Accounting Standards Committee permit pooling only when both
companies are the same size or the acquiring entity cannot be
identified. Canada is considering a proposed standard much like
FASB.
As the managing director of corporate finance at Moody's
noted in his comment letter to FASB, ``Moody's supports the
objectives of accounting standards setters to improve the
harmonization of accounting standards globally, and welcomes
FASB's proposal to eliminate the pooling of interests method.
We believe that a single method can improve analytic
efficiency, especially in cases where a single transaction or
essentially identical transactions would produce dramatically
different accounting results, and thus enhance the ability of
cross-border capital participants to compare, easily and
accurately, alternative investments.''
As I said at the beginning, I have not made up my mind on
the FASB proposal. It raises a lot of questions, including
those relative to the treatment of goodwill and the valuation
of intangible assets. The FASB is in the process of sifting
through better than 400 comment letters, along with the
testimony it received in its public hearings, and is
redeliberating all the issues.
I urge the Board to proceed cautiously and carefully in
weighing the costs and benefits to try to achieve the greatest
possible good. I would also urge my friends in the high-tech
industry to work with FASB to develop a compromise or an
approach that eliminates current biases and distortions and
meets the legitimate concerns of all parties. On that note, I
look forward to today's testimony on this important and complex
matter.
Mr. Chairman, I again commend you and thank you for calling
this hearing.
Mr. Oxley. The gentleman's time has expired.
The gentleman from California Mr. Cox.
Mr. Cox. Thank you, Mr. Chairman. Thank you for holding
this hearing today. It is obvious from the comments of the
members of our panel thus far that it is very important for us
to examine FASB's current proposal to eliminate pooling.
As a member of this subcommittee and a former securities
lawyer, I am anxious to hear from our witnesses on their
perceptions of the consequences, both intended and unintended,
of FASB's decision to eliminate the pooling method for mergers.
I would not expect that Congress would want to legislate
specific financial accounting rules for reporting companies,
although that is clearly Congress's prerogative. I do believe
it is important that several important concerns that have been
raised about the current exposure draft have a complete airing
in Congress. I also believe it is important that FASB's process
be both deliberative and transparent.
The purpose of the 1933 and 1934 acts is full and fair
disclosure in order to build and maintain confidence of the
public in our capital markets. Congress in the 1933 and 1934
acts made it plain that the standards of financial reporting
and financial statements issued under these acts are defined
pursuant to congressional authority. I prefer to see this
authority exercised through delegation to the SEC and to the
FASB.
When, as in this case, the consequences of a change in the
rules go far beyond a determination of the quality of publicly
disclosed financial information and would, in addition, have a
potentially significant impact on the entire economy, Congress
cannot abdicate its responsibility. So we are doing today the
minimum, I think, that is required of us. We are beginning a
hearing process.
Many questions remain as to why FASB is eliminating pooling
at this time and in this way. Our current reliance--our current
national reliance on pooling and purchase as the two means of
accounting for goodwill intangibles is as reliable as a two-
legged stool. What FASB appears to be proposing here, rather
than an examination of how better to account for intangibles,
is to cut out one of the two legs of the stool, giving us a
one-legged stool.
I would hope that in this hearing process we can go beyond
the exposure draft and examine some of the questions that our
experience over the last 20 years has raised for us, because
over that last 20 years market-to-book value ratios have
increased threefold because of intangible assets.
As it has been pointed out by many of our colleagues here
this morning, ideas and intangible assets are an enormous part
of today's economy not because these things are illusory, but
because they are very real and more important than some of the
things that go into making book value a hallowed and very
reliable method of accounting for many, many years.
I think Congress needs to keep our focus. Ideas and
intangibles are driving this economy, and we are responsible,
much more than FASB, to ensure that we do not derail the
economy in the United States.
A recent U.S. Department of Commerce study found that the
Internet economy is alone responsible for 35 percent of the
real economic growth in the United States in the last 5 years.
So I am interested in our witness's views as to how FASB's
proposal to eliminate pooling will impact capital flows in this
sector of our economy.
Last, Mr. Chairman, I would observe that the pooling method
has been around for decades. It makes it puzzling, therefore,
to me to understand why FASB is changing the rules at this
particular time.
Not very long ago, in 1994 when already I had been in
Congress for 6 years, the AICPA, the American Institute of
Certified Public Accountants, through its Special Committee on
Financial Reporting, addressed this very topic. This Special
Committee on Financial Reporting of the AICPA included among
its members the current FASB Chairman Mr. Jenkins.
Here is what their report said, the report from Mr. Jenkins
and his colleagues just a few years ago: ``While it is true
that some users prefer the purchase method and some prefer the
pooling method, most also agree that the existence of the two
methods is not a significant impediment to users' analysis of
financial statements. A project to do away with either method
would be very controversial, require a significant amount of
FASB time and resources, and in the end, is not likely to
improve significantly the usefulness of financial statements.''
So I would like to know why Mr. Jenkins has changed his
view and what has happened in just these last few years to turn
that statement on its head.
FASB does not make its decisions in a vacuum. The
accounting rules it adopts can and in this case surely will
have a significant impact on our economy.
Mr. Chairman, I thank the committee for holding this
hearing on this important issue, and I look forward to hearing
from our witnesses.
Mr. Oxley. The gentleman from Illinois Mr. Rush.
Mr. Rush. Thank you, Mr. Chairman.
Mr. Chairman, I look forward to today's hearing on U.S.
accounting rules for business combinations.
This discussion is certainly a timely one. Today we have
seen an unprecedented increase in market activity, which has in
turn fueled the booming economy that we currently enjoy. Within
the midst of such growth, there has also been a market increase
in mergers and acquisitions.
This brings us to the problem at hand. The pooling of
interests versus the purchase accounting method is intriguing
for several key reasons. Before we have the pooling method,
which reflects the uniqueness of the high growth economies in
that today the merging of two high-tech companies does not
necessarily involve the acquisition of depreciating machinery
or office furniture.
Instead, in today's high-tech market, ideas themselves have
value, and over time that value increases. However, this
accommodation for this new asset apparently comes with a price.
That price is transparency. While I am certainly in favor of
measures which sustain and encourage market growth, I remain
mindful that the United States has been at the forefront in
encouraging transparencies of markets worldwide. I am of the
belief that we should be consistent in our support of that
policy on the domestic front.
Aside from this public policy concern, I am at present most
concerned that when the economic climate in this country is not
so robust, fiscally weak companies which undergo mergers will
use the pooling method to, if you will, sucker in unwary
investors.
There is little doubt in my mind that we need uniformity in
the merger and acquisition information made available to the
weekend warrior who signs onto E*TRADE or any other of the
assortment of easily accessible trading venues. But it is
important that in protecting the average investor, the very
factor which has encouraged such high market participation is
not damaged.
I am confident that with a sober discussion and analysis by
FASB and others, there can be some reasonable compromise which
will result in clear and uniform means by which investors can
make crucial decisions. At the very least, there should be some
examination of whether requiring the purchase method across the
board will, as many argue, deliver a severe blow to our surging
economy.
The challenge is up to the financial pundits to strike this
important balance. I certainly hope that we and they will meet
this important challenge.
Mr. Chairman, I yield back the balance of my time.
Mr. Oxley. The gentleman from New York Mr. Lazio.
Mr. Lazio. Thank you, Mr. Chairman, for holding the
hearing. I want to thank you for assembling a great list of
witnesses, including our colleagues and Mr. Jenkins, the FASB
Chairman Mr. Jenkins.
I want to make mention of a couple of things. First of all,
the gentleman from Michigan made reference to a factual setting
which, ironically or coincidentally, is the same involving AOL
and NetScape, the merger affecting the--the $900 billion
merger, only $500 million of which was accounted by tangible
assets.
That merger would likely never have occurred if they were
forced to use purchase accounting because of the write-down of
$9.5 billion over 20 years under purchase accounting. The
economy would have been deprived of the synergy of that merger,
like many others, Travelers and Citi and several others who may
well have foregone the option of merging if they were forced to
use purchase accounting.
There are some who argue that we need to have a single
accounting method, we need to have harmony with our
international neighbors. First of all, even among our
international neighbors, and including the U.K., there are
situations where pooling is allowed.
Second of all, why should we harmonize if we are not
harmonizing based on the right principles? Why should they not
harmonize with us if we have the superior model? If our economy
is making all of the right moves, and the synergies that are
being created by our combinations through IT and biotechnology
are leading the world, why shouldn't they be following us?
There are people who say, why is it that we shouldn't use
purchase accounting, because you can identify the value of the
transaction better through purchase accounting? Hogwash. The
market determines the value of mergers and acquisitions. In the
end, the market knows far more than any accounting method and
any law that we can create. We need to have some trust in them.
There are some people who say that the purchase method is a
superior method for giving investors more information. Some
would argue that the information is less relevant, that
increasingly the market is looking for cash-flow valuations and
not economic value analysis, neither of which rely on
accounting methods.
There are people who say investors cannot tell how much is
invested in a particular transaction, and they cannot track any
subsequent performance. Again, the value in the end is
determined by the market. Under any methodology, investors
often find it very difficult to track subsequent performance
based on individual combinations.
Some people say we should have one accounting method
because companies who are merging should have only one
accounting method. Why should they? Businesses even within the
same sectors are often using maybe different accounting methods
for different purposes, including inventory and depreciation
and other costs.
In a May 2 letter from the Financial Accounting Foundation,
which funds FASB and helps support its members, they opined
something that I am concerned about. I will quote briefly, if I
can: ``at the present time, a few constituents are
unfortunately encouraging Members of Congress to intervene in
the independent private sector standards-setting process. While
full public debate of the technical merits of a proposed
standard is encouraged and appropriate, we do not believe that
the standard-setting process should be subject to governmental
intervention when appropriate and extensive due process
procedures have been followed by the FASB.''
I would say, first of all, that I hope this does not have a
chilling effect in terms of people who want to express their
first amendment right to speak to Members of Congress,
especially when economic impact is taken into account; it seems
to me, to this Member, more some of us at the podium than those
in FASB, with all due respect, first of all.
Second of all, I am concerned that the FAF and FASB say on
one hand that their standard-setting process should be free
from intervention by Congress, while on the other hand FASB is
citing SEC staffing burdens as one of the reasons for
eliminating pooling. Does that mean that it is wrong for us to
inquire into FASB's process, but it is okay for the SEC to
actually drive the process?
Third, I am interested in hearing from FASB how they
proceeded in considering the elimination of pooling. I want to
compliment them and commend them on the notice and comment
process, but I would much prefer if they look at purchase
accounting first, figure out how it can be improved to account
for all the intangible assets that companies possess,
especially in the IT and biotech sectors. I am interested in
hearing why purchase accounting cannot be retooled for the new
economy, and then we can consider the use of pooling.
I am hoping that FASB Chairman Ed Jenkins can touch on some
of these when he testifies.
Thank you, Mr. Chairman.
Mr. Oxley. The gentleman's time has expired.
The Chair is now pleased to recognize the gentlewoman from
California, who is technically not a member of this
subcommittee, although we hope perhaps that will change soon.
We are glad to have her with us. The Chair recognizes Ms.
Eshoo.
Ms. Eshoo. Thank you very much, Mr. Chairman, first of all
for extending your courtesy to me to join with your
subcommittee today for this very important hearing, and I
salute you for bringing this hearing into reality, because it
is a discussion of an issue that we all believe, given the
excellent opening statements of members of the subcommittee--it
really is a hearing about our national economy, what has made
it so, what has contributed to it, and the examination of the
proposal that the FASB Board has brought about.
When I first came to the Congress in 1993, I introduced
legislation relative to an FASB proposal. It was legislation
that respected the independence of the Board, but it also was
legislation regarding the potential decision of the FASB Board
to prohibit a method of accounting for the value of stock
options.
I believe that the conclusion that the FASB came to at the
end of the 1994 was fortuitous because it was good for our
national economy. It spoke to a method of offering stock
options that I think has moved on to be very important for
workers and for companies in our country.
Back then I might say that you could count on one hand the
number of Members that even knew what an FASB was. Today there
are more and more Members that know and really look closely to
what the FASB Board recommends. This hearing today again
involves a potential decision of that Board, and I think that
it is a proposal that needs to be examined very, very
carefully.
There have been some very important developments that have
taken place since I first came here and was introduced. There
was a different Chairman of FASB at that time and some
different issues.
Dennis Powell is going to be speaking today representing
Cisco Systems. Since FASB made its stock option decision and
its proposed standard on then business combinations, Cisco
Systems has become one of the most admired, if not the most
admired, businesses in America. I say this not just as an
advertisement for Cisco. I think every member wants to examine
very carefully what has given rise to what Cisco represents.
We also have Gene Hoffman who is going to be testifying
today, president of EMusic, an Internet digital music company.
When I was making the case back in 1993 and 1994 about stock
options, I don't think Gene Hoffman's business even existed.
So these are not flukes of our national stage or national
economy. As I respect the independence of FASB, I also believe
that the Congress has a responsibility to weigh in about issues
that affect or that we think could have a detrimental effect on
our national economy.
Mr. Lazio has spoken to and quoted the Financial Accounting
Foundation's letter that is here before each member of the
subcommittee. I, too, would like to underscore that. I think it
is very important for people to weigh in with their opinions,
but I have to tell you that I feel a certain rub, because I
don't think they are just a few constituents. Even if they
were, if there were just a few constituents, I was elected to
give voice to my constituents.
Members of the House of Representatives are very unique in
that we enjoy, under the Constitution, direct representation.
The Presidency does not enjoy that because the Vice President
can move into the Oval Office based on the prerogatives of the
Constitution. The members of the United States Supreme Court
are appointed. If someone dies over in the U.S. Senate, or they
decide to step down, there can be appointment. We and we alone
under the Constitution of the United States of America enjoy
direct representation, so if I die or step down or I am removed
from office, there will be a special election held so that
there will be a direct voice of the people of the 14th
Congressional District of California.
So while I welcome the comments of the Financial Accounting
Foundation, I have to say that in paragraph 5, I think they
have a little overstepped their interpretation or their view of
Members of the Congress.
Mr. Chairman, I really welcome this hearing today. Thank
you for inviting me to join with the subcommittee for this
hearing, not being a member of the subcommittee. I do hope to
be a member in the next Congress. I was before the
jurisdictions of the subcommittee were split in a previous
Congress.
I hope that the Financial Accounting Board representatives
will attempt at least to make the case as to why we would blend
with a European standard when we are the envy of the entire
world relative to our economy, how the proposed standard really
serves our national economy well, who has been hurt by the
pooling accounting standard that you are making the
recommendation about, and see how those voices that have
weighed in and questions--if, in fact, FASB sees today a better
and a newer way of approaching this.
Some of my colleagues have suggested a compromise. I hope
that you will cover that in your testimony. Thank you to
everyone that is here today that is going to enlighten us.
Again, Mr. Chairman, thank you for your leadership. I could
not mean that more.
[The prepared statement of Hon. Anna G. Eshoo follows:]
Prepared Statement of Hon. Anna G. Eshoo, a Representative in Congress
from the State of California
Thank you, Mr. Chairman, for extending to me the courtesy of
joining your subcommittee today for this hearing. I commend you for
your leadership in holding this important hearing on this issue which
is so critical to our economy.
Mr. Chairman, when I first came to Congress in 1993 I raised
questions about the actions of the Financial Accounting Standards Board
(often referred to by its acronym, FASB). I may have been the first
Member of Congress to offer legislation addressing FASB and their
proposal to prohibit a method of accounting for the value of stock
options.
Back then, one could count on one hand how many Members of Congress
knew what a FASB was, and still fewer knew that FASB was a private
organization that exercised a strong influence on our economy through
its standard-setting decisions. I spent just as much time explaining
who FASB was to our Colleagues as I did explaining how its decision
could have a tremendously negative impact on the New Economy and the
technology industries that drive it.
Today this hearing is about an issue--again involving a potential
decision by FASB. This time it doesn't involve prohibiting an
accounting method for the valuation of stock options, but rather FASB's
intention to prohibit an accounting method for business combinations
and intangible assets.
I find myself again warning of the implications this decision could
have and the potential negative impact on the New Economy and the
industries that are still driving it. As Yogi Berra said, ``It's deja
vous all over again.''
However, there have been some important developments between 1993
and today, and they are seated before this subcommittee this morning.
Mr. Dennis Powell is here today representing Cisco Systems. Since
the time FASB made its stock option decision and its proposed standard
on business combinations Cisco Systems has become the most admired
business in America.
FASB's business is to set standards. Let me point out some
standards Cisco has set: In the past three years, IndustryWeek chose
Cisco as one of the best-managed companies in the nation; and Fortune
ranked it as one of the best companies to work for in America.
We welcome Gene Hoffman, President of Emusic, an Internet digital
music company. When I was making the case that FASB's proposal on stock
options could hamper the growth of Internet companies, Mr. Hoffman's
company didn't exist. Since 1993, an entire technology industry has
been created by entrepreneurs like Mr. Hoffman.
I raise these examples to demonstrate that the issues we're
discussing today are not dry and mundane theoretical questions. They
are decisions that effect entire industries and our national economy.
This leads me to the issue of FASB's responsibility and the role it
plays in setting accounting standards. During my legislative career,
I've become familiar with the process FASB goes through in its
standard-setting and I respect the work its leadership and staff does
in developing proposals.
But I remain deeply concerned about FASB's perception regarding its
process of private-sector standard setting, and the Federal
government's role of steward of the nation's economic health.
FASB is not the exclusive forum for the due process given to
business standards. What may appear to the leadership of FASB as
threats of government intervention may, in fact, be the Federal
government fulfilling its responsibility as guardian of the national
economy.
Put simply: FASB is a private board and accountable to its
leadership and its profession. The Congress is a public institution and
accountable to the American people.
Again, Mr. Chairman, thank you for holding these hearings and
allowing me the opportunity to participate. I look forward to an
interesting and thoughtful discussion regarding these issues and I
welcome all of the witnesses here today.
Mr. Oxley. The Chair recognizes the gentleman from Iowa Mr.
Ganske.
Mr. Ganske. Thank you, Mr. Chairman. I will be brief
because I want to hear the testimony. I am hear to listen and
learn, primarily.
I was intrigued by a quote from Mr. Jenkins on page 3 of
his testimony where he quotes an article by Floyd Norris called
``Can Regulators Keep Accountants From Writing Fiction?''
He says, ``Pooling accounting is ridiculous because it
allows corporations to pretend that they paid much less for an
acquisition than they did. Let's say company A buys company B
for $100 million in stock and then a few years later sells
company B for $50 million. In reality, it was a disastrous
acquisition for company A. But, thanks to the magic of pooling,
company A would have shown the original acquisition as costing
not the $100 million it paid, but a number that would be far
lower, say $20 million, reflecting the book value of company B.
Presto, company A reports a profit of 30 million when it
actually lost $50 million.''
I don't know whether this is true or not. I am anxious to
listen to the testimony and find out. I yield back.
[Additional statement submitted for the record follows:]
Prepared Statement of Hon. W.J. ``Billy'' Tauzin, a Representative in
Congress from the State of Louisiana
Thank you Mr. Chairman.
We are here today to answer one question: Should Pooling of
Interest be completely eliminated as an accounting method for Business
Combinations?
Well, without a whole lot of thought, I can answer that question
fairly easily. The answer is No, unless either purchase accounting as
we know it is improved or we can all agree on an alternative method of
accounting that does not suffer from the same shortcomings that
purchase accounting suffers from.
I have four primary concerns with the FASB proposal to require all
merging companies to use purchase accounting.
First, I am not convinced that purchase model accounting makes much
practical sense in today's new economy. For new economy companies,
intangibles make up a major portion of purchase price allocation not
adequately addressed by purchase model accounting. Put simply, this
method provides inadequate guidance on how to identify and value
intangible assets. To the contrary, purchase accounting seeks to
amortize goodwill to expense over a 20 year period in a way that just
doesn't reflect economic reality.
So essentially, there is a real incompatibility between purchase
accounting and the mechanics of many business combinations that are
taking shape in our country.
If FASB's real concern is ensuring that companies are accurately
valued for the benefit of capital market investors . . . a concern I
might add that the SEC shares as well . . . then it should be promoting
an accounting method that makes clear how best to appraise
intangibles--technology, intellectual property, brand identification,
patents, and the like--as opposed to asserting that purchase accounting
must carry the day despite that it is defunct in its treatment of
intangibles. Furthermore, if FASB wants accurate valuations, then it
should propose something more creative than simply forcing companies to
amortize goodwill over an arbitrary 20 year period--which we all know
often results in synthetically, or artificially, reducing reported
income.
The bottom line here then is that purchase accounting is designed
for old world brick and mortar outfits, and therefore must be revamped
itself before I will concede that it is a better alternative to
pooling.
Second, I am afraid that eliminating pooling in favor of present-
day purchase accounting will significantly reduce merger activity in
this country. In 1998, there were 11,400 mergers in the Unite States
alone which accounted for $1.62 trillion in aggregate value.
Significantly, the pooling of interest method was used in 55% of these
mergers.
Over half of the mergers in 1998 relied on the pooling method, and
it certainly makes sense as to why. The ability for a company to deal
in stock is what in fact has enabled many companies to grow, provide
more jobs, and eliminate inefficiencies in our economy. Without the
ability to offer stock in exchange for ownership interest in another
entity, many acquiring companies would not even consider some of the
business combinations that they have pursued or achieved to date. This
to me is quite troublesome.
Third, I feel that eliminating pooling at this juncture imposes
somewhat of a retroactive hardship on many businesses that have relied
upon pooling for years. The two accounting methods in question have
been around for years, and I think, have effectively served as
alternatives to one another--kind of a natural Yen and Yang, if you
will. Precisely because the economics of these methods is so different,
companies have always been afforded the opportunity to make a business
decision of going one way or another, depending on the nature of the
deal in question. To take pooling off the table at this juncture,
without any attempt to retain the flexibility afforded by a two method
regime, amounts to nothing more than changing the rules on business
mid-stream.
As a lawmaker, I have always had serious reservations about
changing laws in a retroactive manner. My experience is that this
usually leads to harming established industries and businesses in ways
that Congress never intends.
Fourth, and finally, I have grave concerns about process in this
debate. FASB contends that its administrative process is modeled after
the APA, and that it fiercely adheres to that process. FASB also states
that it will make no final decision about the proposal or consider
whether to issue a final standard until it is satisfied that all
substantive issues raised by all parties have been considered. Well,
despite that most of the comments received, as far as I can tell,
oppose making purchase accounting the sole method for business
combinations, FASB continues to publicly make the case for the
elimination of pooling.
In addition, its actions suggest that FASB is paying little mind to
the interested parties' recommendations for either retaining pooling or
improving purchase accounting in some reasonable fashion.
Furthermore, upon learning that some of its constituents were
``unfortunately, encouraging Members of Congress to intervene in the
independent private-sector standard setting process,'' the Financial
Accounting Foundation (FAF) issued an open letter criticizing the very
notion that Congress should have some say so in the process of deciding
how American businesses disclose financial information. While I do not
deny that FASB's independence is central to its mission, much like the
Federal Reserve's, the FAF letter gives the impression that
independence in this context means ABSOLUTE independence.
Well, I'm here to say that it is entirely appropriate for Congress
to oversee the FASB and the SEC's supervision and delegation of its
authority to set accounting standards. After all, this very authority
is derived from the '34 Act, a piece of legislation that was drafted by
this very Committee.
In the end, I hope that the FASB will take my concerns to heart and
respond with a plan that makes the most sense for today's business
world.
With that, Mr. Chairman, I yield back the balance of my time. Thank
you.
Mr. Oxley. The Chair is pleased to recognize our
distinguished panel of Members, and as I understand it, you
prefer to go first, Mr. Goodlatte, because you have a markup?
Mr. Goodlatte. Mr. Chairman, if I may, we are in the middle
of another issue of great interest to the Internet economy, and
that is the tax moratorium extension that I know this committee
has also held hearings on. If I can get back, my substitute is
on the floor of the committee right now.
Mr. Oxley. The Chair is pleased to recognize the gentleman
from Virginia, Mr. Goodlatte.
STATEMENT OF HON. BOB GOODLATTE, A REPRESENTATIVE IN CONGRESS
FROM THE STATE OF VIRGINIA
Mr. Goodlatte. Thank you, Mr. Chairman.
Mr. Chairman, I very much appreciate your holding this
hearing and allowing me to testify this morning. As you know,
the Internet has fueled our economic growth at such a rapid
pace over the last 5 years.
According to the Department of Commerce, traffic volume on
the Internet doubles every 100 days. By October of last year,
U.S. Web pages averaged $1 billion cumulative hits per day. In
comparison to other forms of communication, the U.S. Postal
Service delivered 101 billion pieces of paper mail in 1998.
Estimates for e-mail messages sent in 1998 ranged from $618
billion to 4 trillion. The impact of the Internet on our daily
lives is mind-boggling.
For businesses, the impact is equally great. The Internet
economy has grown to $507 billion in 1999 from $301 billion in
1998. It is expected to grow to $1 trillion in 2001 and $2.8
trillion by 2003. The Internet economy accounts for 2.3 million
jobs, that was last year, 35 percent of the U.S. real economic
growth between 1995 and 1998, and its share of the U.S. economy
nearly doubled between 1977 and 1998, growing from 4.2 percent
to 8.1 percent.
This development has been spurred by the ability of
companies to innovate, and the growth of the new economy has
occurred because startup companies have been able to combine
creative thinking with low barriers to entry in the form of low
costs and regulations. These characteristics of the new economy
must be protected in order for small companies to continue
reacting and adjusting.
One way in which these characteristics are threatened is
the ongoing review by the Financial Accounting Standards Board
of accounting rules governing business combinations. In today's
rapidly growing technology and information markets, the need
for maintaining an accounting system that is best suited to
handle the growing trend of the technology sector mergers is
key.
The pooling system of accounting has made possible some of
the most important mergers of our time, creating innovative new
companies and benefiting consumers. If the use of pooling had
not been permitted, the unifications of NetScape and America
Online, CitiCorps and Travelers, NationsBank and Bank of
America and the Daimler-Chrysler merger quite possibly would
never have taken place.
Current regulations allow many high-tech companies to use
the pooling method by allowing corporations to easily merge
without attaching a goodwill accounting charge. This charge is
the amount paid in an acquisition that is added to the fair
market value of a company's tangible assets.
If the Financial Accounting Services Board proposal is
implemented, it would require that all mergers be viewed not as
the melding of separate entities, but as a direct purchase,
forcing companies to accept the purchase method of accounting.
That would be a big mistake. This system may have worked for
the bricks-and-mortar corporations of the past, but in the age
of high-tech companies whose value lies in information, the
purchase method of accounting has no place. Forcing these high-
tech, high-performance companies to use the direct purchase
accounting system will only serve to stifle growth and limit
our country's edge in this information age.
We should take every opportunity to support and ensure
continued innovation and expansion in this technology sector
that has done so much to energize our economy.
I support clear and understandable accounting rules, which
do need adjustments from time to time. I agree with those who
believe that we should thoroughly examine possible adjustments
to current standards. However, the type of wholesale changes
currently under consideration should be abandoned.
I therefore believe that the Commission designated by
Geoffrey Garten, Chairman of the Securities and Exchange
Commission, to study the role of intangible assets in the new
economy should be allowed to complete its work. We should then
examine the Commission's conclusions in the broader context of
how intangible assets are reported in a rapidly changing
economic environment.
I would urge the FASB to follow its stated mission to
ensure that its standards ``reflect changes in methods of doing
business and changes in the economic environment.'' However,
single-shot, piecemeal changes to accounting standards should
not be the mode of operation. Pooling accounting is essential
for small startups and new online businesses. These ventures
act as a magnet for capital investment, lower costs, create new
jobs, and fuel economic growth. Acting in a piecemeal manner to
alter existing accounting principles could threaten this growth
by limiting the availability of capital and restricting the
expansion of this new sector of our economy.
I am hopeful that the FASB will step back, take a deep
breath, and see the forest that is the new economy rather than
the trees that are the individual accounting standards. I look
forward to working with you and others who are concerned that
our system of accounting standards should move along with the
rest of the economy into the new century, Mr. Chairman.
I might add that while we are enjoying and experiencing
tremendous dynamic growth with many of the companies in this
new Internet economy, there are others who are struggling,
others with good ideas, with good intellectual property, but
who should nonetheless have the ability to make sure that if
there is an appropriate merger that can strengthen their
situation, as I think the AOL-NetScape merger is an excellent
example, we should have the opportunity to do that with
accounting principles that support that kind of combination and
take into account that the value of intellectual property in
this information economy is very, very different.
I am being signalled that my vote is needed in the
Committee on the Judiciary. Thank you for allowing me to
testify.
[The prepared statement of Hon. Bob Goodlatte follows:]
Prepared Statement of Hon. Bob Goodlatte, a Representative in Congress
from the State of Virginia
Thank you for allowing me to testify before you this morning. As
you know, the Internet has fueled our economic growth at such a rapid
pace over the last five years. According to the Department of Commerce,
traffic volume on the Internet doubles every 100 days. By October of
last year, U.S. web pages averaged one billion cumulative hits per day.
In comparison to other forms of communication, the U.S. Postal Service
delivered 101 billion pieces of paper mail in 1998. Estimates for e-
mail messages sent in 1998 range from 618 billion to 4 trillion. The
impact of the Internet on our daily lives is mind-boggling.
For businesses, the impact is equally great. The Internet Economy
has grown to $507 billion 1999 from $301.4 billion in 1998. It is
expected to grow to $1 trillion in 2001, and $2.8 trillion by 2003. The
Internet Economy accounts for 2.3 million jobs last year, 35% of U.S.
real economic growth between 1995 and 1998, and its share of the U.S.
economy nearly doubled between 1977 and 1998, growing from 4.2 percent
to 8.1 percent.
This development has been spurred by the ability of companies to
innovate, and the growth of the new economy has occurred because start-
up companies have been able to combine creative thinking with low
barriers to entry in the form of low costs and regulations. These
characteristics of the New Economy must be protected in order for small
companies to continue reacting and adjusting. One way in which these
characteristics are threatened is the ongoing review by the Financial
Accounting Standards Board of accounting rules governing business
combinations.
In today's rapidly growing technology and information markets, the
need for maintaining an accounting system that is best suited to handle
the growing trend of technology sector mergers is key. The ``pooling''
system of accounting has made possible some of the most important
mergers of our time, creating innovative new companies and benefitting
consumers. If the use of ``pooling'' had not been permitted, the
unifications of Netscape and America Online, Citicorp and Travelers,
NationsBank and Bank of America, and the Daimer Chrysler merger quite
possibly would have never taken place.
Current regulations allow many high-tech companies to use the
pooling method by allowing corporations to easily merge without
attaching a goodwill accounting charge. This charge is the amount paid
in an acquisition that is added to the fair market value of a company's
tangible assets. If the Financial Accounting Standards Board proposal
is implemented, it would require that all mergers be viewed not as the
melding of separate entities, but as a direct purchase, forcing
companies to accept the purchase method of accounting. This system
worked for the bricks and mortar corporations of the past, but in the
age of high-tech companies whose value lies in information, the
purchase method of accounting has no place.
Forcing these high-tech, high performance companies to use the
direct purchase accounting system will only serve to stifle growth and
limit our country's edge in this information age. We should take every
opportunity to support and ensure continued innovation and expansion in
this technology sector that has done so much to energize our economy. I
support clear and understandable accounting rules which do need
adjustments from time to time, and I agree with those who believe that
we should thoroughly examine possible adjustments to current standards.
While we should should step back and determine the benefits and
disadvantages of the various methods of business reporting, we should
avoid the type of wholesale changes currently being considered.
I therefore believe that the commission designated by Jeffrey
Garten, Chairman of the Securities and Exchange Commission, to study
the role of intangible assets in the New Economy should be allowed to
complete its work. We should then examine the Commission's conclusions
in the broader context of how intangible assets are reported in a
rapidly changing economic environment. I would urge the FASB to follow
its stated mission--to ensure that its standards ``reflect changes in
methods of doing business and changes in the economic environment.''
However, single-shot piecemeal changes to accounting standards should
not be the mode of operation.
Pooling accounting is essential for small start-ups and new online
businesses. These ventures act as a magnet for capital investment,
lower costs, create new jobs, and fuel economic growth. Acting in a
piecemeal manner to alter existing accounting principles could threaten
this growth by limiting the availability of capital and restricting the
expansion of this new sector of our economy. I am hopeful that the FASB
will step back, take a deep breath, and see the forest that is the New
Economy, rather than the trees that are individual accounting
standards. I look forward to working with you, Mr. Chairman, and others
who are concerned that our system of accounting standards should move
along with the rest of the economy into the new century. Mr. Chairman,
thank you for having me here today.
Mr. Oxley. Thank you. Thank you for your leadership on this
issue.
Our very patient colleague and good friend, the gentleman
from California, who has been here for a long time and listened
to a lot of opening statements, we appreciate your patience,
and the Chair is now pleased to recognize the Honorable Cal
Dooley from California.
STATEMENT OF HON. CALVIN M. DOOLEY, A REPRESENTATIVE IN
CONGRESS FROM THE STATE OF CALIFORNIA
Mr. Dooley. Thank you, Chairman Oxley. I was privileged to
hear the statements of the various members of the committee. I
really am in agreement with most of the sentiments that were
expressed.
I would also at this time like to ask unanimous consent
that two letters that myself and Anna Eshoo and others have
sent to Chairman Levitt of the Securities and Exchange
Commission as well as Chairman Jenkins of FASB be included in
the record.
What might well appear to be an arcane accounting matter
could prove to be something that has significant public policy
implications. That is why I commend you for having this hearing
today.
In many ways, the issue we are touching on today really is
a reflection of how we are changing from an industrial-based
economy to an information-based economy, and how many of the
companies that are now providing the engine and the energy for
the growth of jobs as well as the creation of wealth are doing
so not necessarily by the production of hard assets and taxable
assets that would characterize a lot of the older industries
within the United States.
I think what we have to understand is some of the
accounting systems that were developed back in the industrial
age are no longer as effective in identifying and accounting
for the real value of the companies in this new economy. There
has not been an accounting system that has been developed that
can accurately measure the precise value of human and
intellectual capital. Yet, in the new economy businesses, it is
human and intellectual capital that are the foundations and the
most important elements in assessing a company's true worth.
I am concerned that FASB's decision draft takes the
approach that you can define the value of goodwill and
intangible assets. Furthermore, it goes as far to assume that
they are wasting assets and that they should be depreciated,
and that they will lose all value in a period of no more than
20 years.
Intellectual capital is critical to the success of any
company. In this information age, many of these companies would
be most adversely impacted by FASB's draft proposal. Their
value is to be intellectually innovative, their ability to
bring products to market very quickly, their ability to adapt
and have market penetration, and it puts a premium on these
companies that are the entrepreneur innovators that have the
ability to match up and coordinate innovations quickly with
well-executed product delivery effort.
I think we are at the point now where we have to be
concerned about making a change in the way that we account for
mergers and acquisitions that would have some significant
adverse impacts. The potential impact, I think, was identified
to some extent by an article that was in the Wall Street
Journal today which talked about in the first quarter of this
year, there was over $22 billion in investment and 1,557
startup companies. That was an increase over the first quarter
of 1999 of $6.1 billion.
What I am concerned about is that if you make this change
in accounting practices, you can have a significant adverse
impact on the dollars. There is venture capital and risk
capital going into these startups. These startups we are
talking about, not every one is going to mature to the point
that they are going to have IPOs. Some are going to be acquired
or assimilated through mergers.
If we are not allowing pooling to be utilized, there is a
great concern that the real intellectual capital, the goodwill
that is identified with those companies, will not be able to be
recognized. We will put downward pressure on the values of
these companies that will make them less attractive to
eventually be acquired or merged into others. What that has the
potential of doing, I think, is harming the United States'
clear superiority and having the greatest relative advantage in
the technology sector.
FASB and others have talked about trying to make our system
more consistent with other international standards. Why would
we want to do that? It is clear that the United States is the
leader in this area. I don't think we ever want to adopt a
system that could impede the flow of venture capital into the
technology sector, which is so very, very important. What we
have to be concerned with in the public policy issue here is
make sure we do not have a reform in our accounting practice
which reduces or impedes the flow of capital into high-risk
investments.
It also is going to have the impact of decreasing the
ability of a lot of these startup companies to attract
employees and human intellectual capital. I also think it has
the risk of almost contributing to greater consolidations,
because E*TRADE probably would not have purchased Teledyne if
we did not have the ability to use pooling. It probably would
have resulted in that company being purchased by one of the
bigger financial institutions. I don't think that is something
we want to encourage by adopting an accounting practice.
Just in closing, I also want to make it clear that pooling
is not a system without some imperfections. It has some
imperfections. We also at the same time have to acknowledge
that purchase accounting also has some major imperfections.
Before we move forward with eliminating pooling, I think we
have to step back and say, is it time for us to start from a
broader context in trying to determine what is the most
effective way to value our companies. I am very concerned we
are taking a piecemeal approach here.
I also want to commend Mr. Jenkins for his openness and
willingness to have a dialog with a lot of us who have spent a
lot of time on this. I am hopeful through this issue and
continued discussion and dialog that we can come up with a
system that will ensure that we can continue to have the most
robust venture capital system in the world which is leading to
some of the greatest advancements in technology and the
creation of some of the most exciting companies in the world.
[The prepared statement of Hin. Calvin M. Dooley follows:]
Prepared Statement of Hon. Cal Dooley, a Representative in Congress
from the State of California
Mr. Chairman, Ranking Member Towns, distinguished colleagues and
friends on the Finance Subcommittee, I want to thank you for the
opportunity to appear before you today to talk about a matter of great
importance in the economy--the question of how companies account for
mergers and acquisitions. I would also like to submit for the record
two letters that a number of us have sent to Chairman Levitt of the
Securities and Exchange Commission and Chairman Jenkins of the
Financial Accounting Standards Board with our concerns about this
issue.
As I am sure you are all aware, the tremendous performance we have
seen in the technology sector in the past decade is attributable not
only to the wealth of creative ideas in this country, but also to the
capital that helps to turn those ideas into products and services and
brings them to the market. It is the technology community's success at
combining these two essential ingredients that has turned it into the
powerful economic engine it is today. That engine, in turn, has helped
to propel the entire economy into the longest expansion in U.S.
history. Furthermore, it is changing the complexion of the economy.
More and more, we are realizing the value of intangible assets, not
just at Internet start ups, like ``eGM'' for instance, but at bricks
and mortar companies like . . . GM! Put simply, the ``Old Economy'' is
becoming the ``New Economy.''
FASB's Proposal
Mergers and acquisitions, or business combinations, are an
important means by which ideas and capital are paired in the technology
sector and throughout the economy. FASB, the Financial Accounting
Standards Board, is currently considering a proposal that will alter
the method by which many businesses account for business combinations.
This proposal would require companies to account for all such
combinations as purchases, with the acquiring company being forced to
write off any goodwill included in the purchase price as a charge
against earnings over the course of several years.
Naturally, this proposal poses serious concerns for the technology
sector because of the large difference that often exists between
technology companies'' book and market values. This is a legitimate
concern and I think that FASB, by only addressing part of the issue
through the elimination of pooling, is still not addressing the core
problem. If they are going to take on this issue, they need to take a
more comprehensive approach.
Pooling and Purchase are Both Flawed
Experts can and do argue over whether, as FASB has determined in
its Exposure Draft on Business Combinations, all business combinations
are purchases and should be accounted for as such. What really concerns
me and a number of others in Congress and the private sector is the
process that FASB has followed. It is moving to force the use of
purchase accounting for all mergers and acquisitions without giving due
consideration to the fact that purchase does not adequately account for
so many of the intangible assets that companies possess today. In other
words, FASB is considering the elimination of pooling in a vacuum and
neglecting to consider the fact that many consider both pooling and
purchase to be flawed and inadequate methods of accounting for business
combinations. This is an important point that has been lost in all of
the rhetoric about how the tech sector is seeking special treatment
from FASB by urging them to keep pooling, so I want to reiterate it:
pooling and purchase are both flawed and inadequate methods of
accounting for business combinations. This is especially true for
companies with large amounts of intangible assets, such as financial
and pharmaceutical companies. It's not just about the technology
sector.
Given that many believe that neither method adequately accounts for
many of the intangible assets one finds in today's businesses, the
development of a method of accounting that does effectively deal with
intangibles should be pursued before we scrap the old ones. The
elimination of pooling without paying any attention to what's left over
is like blowing up the old bridge that gets us across the river before
the new one is built.
The Need for Oversight
FASB's process illustrates why it is so important that the Finance
Subcommittee is exercising its congressional oversight authority today.
I feel confident in saying that none of us here wants to compromise the
integrity and independence of FASB. At the same time, however, it is
appropriate for us to focus on the potential economic consequences of
FASB's proposals; to think about whether or not the benefits of their
proposals outweigh the costs; and to ask the hard questions. In the
end, congressional oversight on contentious issues doesn't weaken the
process, it strengthens it. What weakens the process and its product is
when FASB stubbornly ignores the concerns of its constituents; and when
the Financial Accounting Foundation, which oversees, funds, and
appoints the members of FASB, characterizes congressional interest and
concern about a FASB project as ``Explicit or implicit threats, . . .''
as they have in a May 1, open letter.
I remain convinced that if FASB has ears to hear, we can still
persuade them to address the serious concerns we have about the flaws
in purchase accounting first before abolishing pooling.
In closing, I want to thank you again for allowing me to appear
today to discuss this issue. I commend you for holding this hearing. I
also want to commend FASB Chairman Ed Jenkins for his patience and
thoughtfulness in dealing with others and me on this issue. In fairness
to him, FASB is not a committee of one, and I know we all recognize
that he has a tough job. I believe that his continued openness and
willingness to discuss our concerns is key to coming to some sort of
resolution on this matter.
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Mr. Oxley. Thank you, Mr. Dooley, for your excellent
testimony.
The committee will stand in brief recess while we empanel
the next group.
[Brief recess.]
Mr. Oxley. The subcommittee will reconvene.
Let me introduce our distinguished panel, second panel; Mr.
Edmond L. Jenkins, Chairman of the Financial Accounting
Standards Board; Mr. Dennis D. Powell, vice president,
corporate controller from Cisco Systems, San Jose, California;
Mr. Peter R. Bible, chief accounting officer for General Motors
Corporation from Detroit; Mr. Gene Hoffman, Jr., president and
CEO of EMusic, Redwood City, California; finally, Dr. William
Frederick Lewis, president and CEO, Prospect Technologies, here
in Washington, DC, on behalf of the U.S. Chamber of Commerce.
Gentlemen, welcome to all of you. Mr. Jenkins, we will
begin with you.
STATEMENTS OF EDMUND L. JENKINS, CHAIRMAN, FINANCIAL ACCOUNTING
STANDARDS BOARD; DENNIS D. POWELL, VICE PRESIDENT, CORPORATE
CONTROLLER, CISCO SYSTEMS; PETER R. BIBLE, CHIEF ACCOUNTING
OFFICER, GENERAL MOTORS CORPORATION; GENE HOFFMAN, JR.,
PRESIDENT AND CEO, EMUSIC.COM; AND WILLIAM FREDERICK LEWIS,
PRESIDENT AND CEO, PROSPECT TECHNOLOGIES
Mr. Jenkins. Thank you, Mr. Chairman. I certainly
appreciated all of the comments from the members of this
committee this morning. Please be assured at the outset that
those comments are important to me and to my fellow Board
members at the FASB, and we will be considering them carefully
as we proceed with our redeliberations on this important
subject.
I am Edmond Jenkins, Chairman of the Financial Accounting
Standards Board. Behind me is Kim Petrone, the project manager
on the subject of today's hearing.
I am very pleased to be with you today. I plan to discuss
something about the due process of the FASB and our proposed
standard to improve the accounting for business combinations. I
have brief prepared remarks, but I would respectfully request
that my full statement and supporting materials, referred to as
the biggest package ever, be entered into the public record.
Mr. Oxley. With some trepidation, it is so ordered.
Mr. Jenkins. Thank you, Mr. Chairman. I wouldn't want to
have to carry them all back.
Mr. Chairman, the FASB is an independent organization, one
that is funded entirely by the private sector. Our mission is
to set accounting and reporting standards to protect the
consumers of financial information. Most notably, those
consumers are investors and creditors. Those consumers rely
heavily on credible, transparent, and comparable financial
information for effective participation in our great capital
markets.
To quote a recent letter from the Association of Investment
Management and Research, the leading organization of investment
professionals in the United States with over 40,000 members,
``The `lifeblood' of United States capital markets is financial
information that is: (1) comparable from firm to firm; (2)
relevant to investment and financing decisions; (3) a reliable
and faithful depiction of economic reality; and (4) neutral,
favoring neither supplier nor user of capital; neither buyer
nor seller of securities.''
This notion of neutrality is a fundamental element in our
standard-setting process. To create or tolerate financial
reporting standards that bias or distort financial information
to favor a particular transaction, a particular industry or
special interest group undermines the credibility and value of
that information and the proper functioning of the capital
markets and impairs investors' capital allocation decisions.
It is important to remember that our standards affect all
public and private nongovernmental organizations, not just
companies in one or two industries.
Our decisionmaking process is thorough. It is open to
public observation and provides numerous opportunities for all
interested parties to actively participate in and express their
views. The issues that the FASB addresses are necessarily
difficult ones for which reasonable people can and do hold
differing views. As you know, we have often made significant
changes to our proposals in response to concerns that have been
raised.
The subject of this hearing is our proposal to improve the
accounting for business combinations. The current accounting in
this area was established in 1970. That accounting requires
that business combinations be reported using either of two very
differing methods, the purchase method or the pooling of
interests method. Those two methods produce dramatically
different financially reporting results for essentially the
same or similar economic transactions.
Under the purchase method, the acquiring company records
the net assets of the acquired company at the price paid,
including any intangible assets, that have so often been
referred to this morning as the most important assets of the
new economy companies, to the extent that they can be
separately identified and reliably measured. The excess of the
purchase price paid over the fair value of the acquired
company's net assets is recorded as an asset called goodwill.
The purchase method is consistent with the accounting for
all other acquired assets. All purchases, whether a piece of
machinery or a patent or a royalty right, are recorded at the
price paid and are generally charged against earnings over
their useful economic life.
An alternative to the purchase method, the pooling method
is only available if 12 specific criteria are met. A key
criterion is that the consideration exchanged must take the
form of stock rather than cash or debt. However, it is
important to note that stock can also be used as consideration
in a purchase accounting acquisition.
In contrast to the purchase method, under the pooling
method the book values of the combining companies are simply
added together. There is no recognition of the full price paid
and, therefore, no charge in the recorded amount of the
acquired company's net assets to reflect their fair value, no
recognition of these important intangible assets not previously
recorded, and no resulting goodwill, and thus the true cost of
the transaction is not reflected in the income statement.
Congressman Ganske referred to the article in the New York
Times by Floyd Norris. Congressman, let me confirm for you that
this is a real transaction. The numbers have been changed, but
it is a real transaction, and, in fact, under pooling of
interests accounting, the company did record a profit of $30
million in our example when it really lost $50 million. That is
a true example.
As you are aware, a key requirement of our proposal is that
all business combinations would be accounted for under one
method, the purchase method, and that the pooling of interests
method should be eliminated.
The rationale for that proposed decision includes the
following points: First, the pooling method ignores the values
exchanged in a business combination, while the purchase method
reflects them.
Second, having two disparate methods of accounting for
essentially the same transaction makes it difficult for
investors to compare companies that have used different methods
to account for their business combinations.
Third, because future cash-flows are the same, whether the
pooling or purchase method is used, a boost in earnings under
the pooling method reflects artificial accounting differences
rather than real economic differences.
The important point is that under either purchase or
pooling accounting, the future cash-flows are the same, and the
impetus to have an acquisition or not should really not be
influenced at the end of the day by the method of accounting.
Fourth, under the pooling method, financial statement users
cannot tell how much was invested in the transaction, nor can
they track the subsequent performance of that investment in
future years.
Congressman Dingell made reference to my testimony in the
reference to the $9.5 billion that simply disappeared in the
transaction. That is, as Congressman Lazio pointed out, the
AOL-NetScape transaction, and there was, in fact, no reporting
of the $9.5 billion in the financial statements of the combined
company. Thus, it was impossible for investors to relate
subsequent performance against 95 percent of the purchase price
paid for the acquired company.
I would also like to emphasize a couple of things that our
proposal does not do. First, our proposal does not preclude
companies from entering into business combinations that are
stock-for-stock transactions. Second, our proposal does not
make significant changes to the current basic accounting model
where accounting for intangible assets.
Congressman Goodlatte in his testimony referred to the
Garten panel, the panel set up by Chairman Arthur Levitt to
look at value creation in the new economy. I would like to read
from the enabling article with respect to that panel because
intangibles are nowhere mentioned in it.
``The purpose is to assemble a panel of experts and other
thoughtful individuals to assess the capital markets'
understanding of the recent changes in the economy attributable
to technological innovation and globalization; it is to
identify the changing forces now driving the value creation of
business enterprises; it is to assess whether the investment
community and the financial markets adequately understand these
changes based on the information currently being made available
in the marketplace.''
There is no recognition in that of intangibles whatsoever.
Since first adding our project on business combinations to
its agenda in 1996, the Board has held over 40 public meetings.
We have issued two preliminary documents, an exposure draft for
public comment that has been referred to here this morning, and
carefully analyzed and discussed at public meetings over 400
comment letters received from a broad range of companies,
investors, and other constituents.
In February of this year, we held 4 days of public hearings
to discuss the proposal with interested constituents. Over 40
individuals testified.
In April we began our redeliberations of all of the issues
contained in the proposal. This redeliberation process will
include numerous public meetings held over the next several
months. At those meetings, the Board will carefully consider
the comment letters, the public hearing testimony, what we
learn from this hearing, and all other relevant information
provided by interested parties. Let me assure you that no final
decisions will be made until that process is completed.
We presently expect to complete our work and be in a
position to issue a final standard by no earlier than the end
of the year 2000. That estimate may change depending on the
progress of our deliberations. We will not rush to a
conclusion.
In closing, I want to be clear that the FASB understands
and supports the oversight role of the subcommittee. We will
carefully consider what we learn from this hearing, from the
testimony of Congressmen Dooley and Goodlatte.
Let me assure you again, Mr. Chairman and members of this
subcommittee, that our open due process and our independent and
objective decisionmaking will be carefully and fully carried
out. To do otherwise would jeopardize the very foundation upon
which the FASB was created and for which it has proven
invaluable to the U.S. capital markets and to investors and
creditors, the consumers of financial information.
Thank you very much, Mr. Chairman.
[The prepared statement of Edmund L. Jenkins follows:]
Prepared Statement of Edmund L. Jenkins, Chairman, Financial Accounting
Standards Board
Summary
A key requirement of our proposal to improve the accounting for
business combinations is that all business combinations would be
accounted for under one method, the purchase method, and that the
pooling-of-interests method (``pooling method'') should be eliminated.
The proposal's requirement to eliminate the pooling method will
benefit investors, creditors, and other financial statement users by
providing more information and more relevant information about all
business combinations. The proposal's provisions also will benefit
those consumers by improving the comparability of financial reporting,
thereby making it possible to more easily contrast companies that
participate in business combinations.
The proposal will also benefit companies that prepare financial
statements and the auditors of those statements by providing a single
method of accounting for all business combinations. Having one method
will reduce certain costs to companies and auditors, both monetary and
nonmonetary, which are currently related to the existence of the
pooling method. In addition, having one method benefits companies by
leveling the playing field for competition among companies in the
business combinations market.
In April, we began our redeliberations of all of the issues
contained in the proposal. As part of that process, we will carefully
consider the comment letters, public hearing testimony, what we learn
from this hearing, and all other relevant information provided by
interested parties. No final decisions will be made until that process
is completed.
Mr. Chairman, Members of the Subcommittee, I am Edmund Jenkins,
chairman of the Financial Accounting Standards Board (``FASB'' or
``Board''). With me is Kim Petrone, the project manager on the subject
of today's hearing. I am pleased to be here today. I plan to discuss
the due process of the FASB and our proposed standard to improve the
accounting for business combinations (``Proposed Standard''). I have
brief prepared remarks, and I would respectfully request that my full
statement and supporting materials be entered into the public record.
What Is the FASB and What Does It Do?
The FASB is an independent private-sector organization. We are not
part of the federal government and receive no federal funding. We are
funded entirely from private-sector sources, primarily voluntary
contributions and sales of publications.
Our mission is to establish and improve standards of financial
accounting and reporting for both public and private enterprises. Those
standards are essential to the efficient functioning of the economy
because investors and creditors rely heavily on credible, transparent,
and comparable financial information.
The FASB's authority with respect to public enterprises comes from
the US Securities and Exchange Commission (``SEC''). The SEC has the
statutory authority to establish financial accounting and reporting
standards for publicly held enterprises. For over 60 years the SEC has
looked to the private sector for leadership in establishing and
improving those standards. Therefore, the FASB may be viewed as an
independent private-sector alternative to government regulation.
The focus of the FASB is on consumers--users of financial
information such as investors, creditors, and others. We attempt to
ensure that corporate financial reports give consumers an informative
picture of an enterprise's financial condition and activities and do
not color the image to influence behavior in any particular direction.
To quote a recent letter from the Financial Accounting Policy
Committee of the Association for Investment Management and Research,
the leading organization of investment professionals in the United
States with over 40,000 members:
The ``lifeblood'' of United States capital markets is
financial information that is: (1) comparable from firm to
firm; (2) relevant to investment and financing decisions; (3) a
reliable and faithful depiction of economic reality; and (4)
neutral, favoring neither supplier nor user of capital, neither
buyer nor seller of securities.
The notion of neutrality is a fundamental element of our standard-
setting process. The FASB's Rules of Procedure explicitly require that
the Board be objective in its decision making to ensure the neutrality
of information resulting from its standards.
Neutrality is an essential criterion by which to judge financial
reporting standards, because information that is not neutral loses
credibility and value. For example, surely, we would all agree there
would be little value to Congress or the federal government of
purposely altered and manipulated information about the rate of
inflation or about unemployment.
Similarly, to create or to tolerate financial reporting standards
that bias or distort financial information to favor a particular
transaction, industry, or special interest group undermines the proper
functioning of the capital markets and impairs investors'' capital
allocation decisions.
As former SEC Chairman Richard C. Breeden stated in testimony
before Congress almost a decade ago:
The purpose of accounting standards is to assure that
financial information is presented in a way that enables
decision-makers to make informed judgments. To the extent that
accounting standards are subverted to achieve objectives
unrelated to fair and accurate presentation, they fail in their
purpose.
The FASB sets standards only if, in the Board's independent
judgment after carefully considering the input from all interested
parties, there is a significant need for the standard and the costs the
standard imposes are justified by the overall benefits. The objective,
and implicit benefit, of issuing an accounting standard is increased
credibility and representational faithfulness of financial reporting.
However, the value of that improvement to financial reporting is
usually impossible to measure and the Board's assessment of an
accounting standard's benefit to companies that prepare financial
reports and to investors and creditors that use financial reports is
unavoidably subjective.
The US capital markets are the deepest, most liquid, and most
efficient markets in the world. The unparalleled success and
competitive advantage of the US capital markets are due, in no small
part, to the high-quality and continually improving US financial
accounting and reporting standards. As Federal Reserve System Chairman
Alan Greenspan stated in a June 4, 1998 letter to SEC Chairman Arthur
Levitt:
Transparent accounting plays an important role in maintaining
the vibrancy of our financial markets . . . An integral part of
this process involves the Financial Accounting Standards Board
(FASB) working directly with its constituents to develop
appropriate accounting standards that reflect the needs of the
marketplace.
What Process Did the FASB Follow in Developing Its Proposed Standard?
Because the actions of the FASB affect so many organizations, its
decision-making process must be thorough. The FASB carefully considers
the views of all interested parties--users, preparers, and auditors of
financial information. Our Rules of Procedure require an extensive due
process that was modeled on the Federal Administrative Procedure Act,
but it is broader and more open in several ways. It involves public
meetings, public hearings, and exposure of our proposed standards to
external scrutiny and public comment. The Board makes final decisions
only after carefully considering and understanding the views of all
parties.
The FASB's due process for developing a new financial reporting
standard is best illustrated by describing the process followed in
developing the Proposed Standard:
When we began the project in 1996, we established a business
combinations task force comprising individuals from a number of
organizations representing a wide range of the Board's
constituents. (Attachment 12 lists the members and their
affiliations.) The first public meeting of the task force was
held in February 1997.
In June 1997, we published for public comment a Special Report
that contained some of the Board's initial tentative decisions
about the project's scope, direction, and content. We received
54 comment letters in response to the Special Report.
In November 1998, we held the second public business
combinations task force meeting to discuss issues related to
the project.
In December 1998, we published for public comment, in
participation with other members of an international
organization of accounting-standard-setting bodies, a Position
Paper that addressed a number of issues related to the methods
of accounting for business combinations. We received 148
comment letters in response to the Position Paper.
We held over 40 public meetings since 1997 to address the
issues associated with the methods of accounting for business
combinations and the accounting for goodwill and other
purchased intangible assets and to consider constituent
comments.
After each meeting, we updated a paper that summarized all of
the Board's decisions. The updated paper was available on the
FASB webpage and was sent by mail to anyone who requested it.
Our weekly newsletter, Action Alert, announced each meeting in
advance and reported a summary of the results of each meeting.
(In addition, press reports of some of the meetings were
available in certain business publications.)
The Board and staff discussed the project on business
combinations and intangible assets with representatives of
companies and trade associations and with investors and
creditors at dozens of liaison meetings, public conferences,
and forums throughout the US and the world.
In September 1999, we published for public comment an Exposure
Draft (the Proposed Standard) that contains proposed changes to
the existing standards of accounting for business combinations
and intangible assets. We received approximately 200 comment
letters in response to the Exposure Draft.
In connection with the issuance of the Exposure Draft, we
prepared and issued the following explanatory documents to
assist constituents in understanding the Board's proposed
decisions: ``September 1999 FASB Exposure Draft, Business
Combinations and Intangible Assets: An Overview'' (Attachment
4); ``FASB Business Combinations Project: September 1999 FASB
Exposure Draft, Business Combinations and Intangible Assets:
Frequently Asked Questions'' (Attachment 9); FASB Viewpoints,
``Why Eliminate the Pooling Method?'' (Attachment 7); and FASB
Viewpoints, ``Why Not Eliminate Goodwill?'' (Attachment 8). All
of the documents were available on the FASB webpage and were
sent by mail to anyone who requested them.
We held four days of public hearings in February 2000 (two
days in San Francisco and two days in New York City) to discuss
the Exposure Draft with interested parties. More than 40
individuals and organizations testified.
In March 2000, the business combinations task force met with
members of the Board and staff to discuss a number of issues
raised in the comment letters and at the public hearings.
What's Wrong with the Present Accounting for Business Combinations?
There are few areas in the current accounting literature that
need reform more than business combination accounting . . .
Jack T. Ciesielski, CPA, CFA, President, R.G. Associates,
Inc.,
Investment Research/Investment Management, 11/29/99.
The current accounting for business combinations is governed by the
requirements of APB Opinions No. 16, Business Combinations, and No. 17,
Intangible Assets, which were issued in 1970 by the Accounting
Principles Board (``APB'') of the American Institute of Certified
Public Accountants.
Under APB Opinions 16 and 17, business combinations are reported
using either of two very disparate methods--the purchase method or the
pooling-of-interests method (``pooling method''). Those two methods
produce dramatically different financial reporting results for
essentially the same or similar economic transactions.
Under the purchase method, the acquiring company records the net
assets of the acquired company at the price paid, including any
intangible assets to the extent they can be separately identified and
reliably measured. The excess of the price paid over the fair value of
the acquired company's net assets is recorded as an asset called
goodwill, which is subsequently charged against earnings over time.
The purchase method is consistent with the accounting for all other
acquired assets--all purchases, whether a piece of inventory or a
patent, are recorded at the price paid and are generally charged
against earnings over their useful economic life.
In contrast to the purchase method, under the pooling method, the
book values of the combining companies are simply added together. There
is no recognition of the full price paid. There is, therefore, no
change in the recorded amount of the acquired company's net assets to
reflect their fair value, no recognition of intangible assets not
previously recorded, and no resulting goodwill, and thus the true cost
of the transaction is not reflected in the income statement. By not
recognizing that cost, the future earnings of the newly combined
company are artificially inflated.
In commenting on what's wrong with the pooling method, a September
10, 1999 article in the New York Times entitled ``Can Regulators Keep
Accountants from Writing Fiction?'' by Floyd Norris, states:
Pooling accounting is ridiculous because it allows
corporations to pretend that they paid much less for an
acquisition than they did. Let's say Company A buys Company B
for $100 million in stock, and then, a few years later, sells
Company B for $50 million. In reality, it was a disastrous
acquisition for Company A. But thanks to the magic of pooling,
Company A would have shown the original acquisition as costing
not the $100 million it paid but a number that could be far
lower--say, $20 million--reflecting the book value of Company
B. Presto: Company A reports a profit of $30 million when it
really lost $50 million.
In addition, an article entitled ``Big Banks Debunked,'' by Amy
Kover, in the February 21, 2000 edition of Fortune describes what's
wrong with the use of the pooling method in several recent business
combinations in the financial services industry:
Used just for stock transactions, pooling of interest allows
the acquirer to add to its books only the book value of the
acquired company--not the full price it paid for the target.
That's a pretty neat trick if you've paid a fat premium for an
acquisition, as Banc One did for First USA (43% over the market
value), First Union did for CoreStates (18% over), and
NationsBank did for Barnett (37% over). In the magic of
pooling-of-interest accounting, those premiums simply vanish.
What's so useful about that? Well, because the acquisition
appears to add little to the surviving company's equity base--
even as it captures all the extra earnings from the acquired
company--the new bank's return on equity looks as if it's on
steriods. The effect is anything but trivial. For example, when
Michael Mayo of Credit Suisse First Boston recalculated each
bank's cash return on average tangible equity as if it had used
purchase accounting, Bank One's 1998 return on equity went from
27% to 12%. At First Union, it fell from 35% to 11.8%. And Bank
of America's 29% return on equity dropped to about 10.8%. As
Dale Wettlaufer of Legg Mason says, ``The end result is that
the cash return on tangible equity is a totally bankrupt
measure.''
To use the pooling method, 12 specific criteria must be met; a key
criterion is that the consideration exchanged takes the form of stock
rather than cash or debt. The vast majority of business combinations
today, including the many stock-for-stock transactions that fail to
meet one or more of the pooling method criteria, are accounted for
using the purchase method.
As the pace of business combinations has increased over recent
years, the availability of two different accounting methods for very
similar transactions that produce dramatically different levels of
information to the market has become more and more problematic. A study
of business combinations of public corporations over the period 1992-
1997 found that the quantity and dollar magnitude of pooling method
transactions rose dramatically from 105 transactions valued at $16.9
billion in 1992 to 321 transactions valued at $213.8 billion in 1997
(Attachment 6). A letter from the Consumer Federation of America to the
FASB commented on that phenomenon:
Over the last decade, a tidal wave of merger activity has
swept through nearly every corner of the American economy.
According to the Federal Trade Commission, the number of
federal pre-merger filings has nearly tripled since the
beginning of the decade, from 1,529 in 1991 to an estimated
4,500 last year. The market value of those mergers has risen
even more dramatically, from $600 billion in the previous peak
year of 1989 to more than $2 trillion in 1998. And several
factors, not least passage this year of the financial
modernization legislation, lead us to conclude that this
activity is unlikely to abate any time soon. Ensuring that
investors get complete and accurate information about the
effects of mergers is, thus, a timely and important issue for
the Financial Accounting Standards Board to tackle.
Beginning in the early 1990s, the Financial Accounting Standards
Advisory Council (``FASAC''), a group composed of over 30 senior-level
individuals from business, public accounting, professional
organizations, and the academic and analyst communities, consistently
ranked a possible project on improving the accounting for business
combinations as a high priority for the Board. (Attachments 10 and 11
provide a listing of the members of FASAC and their affiliations and a
description of FASAC, respectively.) At the July 1996 FASAC meeting,
members indicated overall support for adding a project on improving the
accounting for business combinations to the Board's agenda.
The Board agreed with the recommendation of FASAC and, in the fall
of 1996, decided to add to its agenda a project on accounting for
business combinations. Among the more significant reasons that led the
Board to reach that decision included the following:
The Board wanted to address perceived flaws and deficiencies
in APB Opinion 16. One significant flaw is the fact that two
economically similar business combinations can be accounted for
using different accounting methods that produce dramatically
different financial results. The availability of two methods
makes it difficult for financial statement users to compare the
financial reports of companies that use different methods of
accounting for business combinations.
Many believe that having two accounting methods affects
competition in markets for business combinations. Companies
that cannot meet all of the conditions for applying the pooling
method believe they face an unlevel playing field in competing
for a target against those that can apply that method. Because
companies that can use the pooling method do not have to
account for the cost of the investment or its subsequent
performance, some believe those companies are willing to pay
more for a target than companies that cannot use that method.
There has been a continuous need to interpret APB Opinion 16.
Despite the fact that APB Opinion 16 was issued almost 30 years
ago, the volume of inquiries about its application remains
high, an indication that the existing literature might be in
need of significant repair. Many of those inquiries are
concerned with whether a specific transaction meets the
criteria for use of the pooling method.
Because of the rapidly accelerating movement of capital flows
globally, there is a need for financial reporting to be
comparable internationally. Part of the Board's mission
includes promoting international comparability of financial
reporting, and accounting for business combinations is one of
the most significant areas of difference in accounting
standards. In most parts of the world, the pooling method is
either prohibited or used only on an exception basis.
Finally, the Board took note of the historical justification
of the pooling method. (Attachment 4 contains a summary of the
history of the pooling method.) The Board observed that the
pooling method has been regularly challenged since the term
pooling-of-interests was first coined in the 1940s. The APB
considered eliminating the pooling method when APB Opinion 16
was developed in the late 1960s. Although the pooling method
was retained, the slimmest possible majority approved Opinion
16--six members of the APB dissented from the decision. Three
of the six dissenters to APB Opinion 16 stated:
[Opinion 16] seeks to patch up some of the abuses of pooling.
The real abuse is pooling itself. On that, the only answer
is to eliminate pooling.
What Does the Proposed Standard Require and Why?
Three of the key requirements of the Proposed Standard and a brief
summary of the Board's basis for those requirements are described
below. Paragraphs 92-366 of the FASB's Exposure Draft provide a
detailed description of the basis for all of the Board's decisions.
Proposed Requirement #1: The purchase method of accounting would be
required for all business combinations. Use of the pooling method would
be prohibited.
Basis: In current practice, the underlying economics of the
transactions to which the pooling method is applied are often similar,
if not identical, to the underlying economics of those transactions
that are accounted for by the purchase method. Under the pooling
method, however, investors and creditors are being provided with less
information--and less-relevant information--than is provided by the
purchase method. That is because the pooling method ignores the values
exchanged in a business combination transaction, whereas the purchase
method records those values on the face of the balance sheet. As a
result, the pooling method does not provide users of financial reports
with full information about how much was invested in the combination.
More important, because the investment is not fully recorded in the
financial reports, the pooling method does not provide investors and
creditors with the information they need to assess the subsequent
performance of that investment and compare it with the performance of
other companies.
For example, in one very visible acquisition that was accounted for
under the pooling method, the value of the stock issued as
consideration by the acquiring company was about $10 billion. The book
value of the company acquired was only $500 million. The acquisition,
therefore, was reported at $500 million in the financial statements of
the combined company, and $9.5 billion of value ($10 billion less $500
million) simply disappeared. There was no reporting of the $9.5 billion
in the financial statements of the combined company; thus, it is
virtually impossible for investors to relate subsequent performance
against 95 percent of the purchase price paid for the acquired company.
The example is not unique, a study of a sampling of 756 pooling
method transactions of public corporations entered into over the period
1992-1997 found that $267 billion of assets, constituting about 66
percent of the total acquisition price, went unreported in the
financial statements (Attachment 6).
The information that the pooling method provides about individual
assets and liabilities is also less complete and less comparable than
that provided by the purchase method. It is less complete because the
pooling method does not record any acquired assets or liabilities that
were not previously recorded, including valuable trademarks, customer
lists, and other intangibles, and thus ignores their presence, even
though they were acquired at a cost and can be separately identified
and reliably measured.
In contrast, the purchase method reveals those hidden assets and
liabilities by recording them. Moreover, the acquired assets and
liabilities that the pooling method does record are not measured on a
basis that is comparable with how acquisitions generally are measured
(that is, at the values exchanged in those transactions), as does the
purchase method. Because the values exchanged are not recorded,
subsequent rate-of-return measures are artificially inflated.
Proposed Requirement #2: The maximum goodwill amortization period
would be reduced from the current 40 years to 20 years.
Basis: The Board based this proposed requirement on a number of
factors. The Board observed that the rapid pace of technological change
was shortening product life cycles and requiring enterprises to
reinvent themselves more regularly in order to survive. Thus, in
general, the average useful economic life of goodwill has been
diminishing since 1970. That observation was supported by evidence
provided by companies, including those that participated in limited
field tests.
The Board also observed that in current practice the amortization
period used by many companies, including those in the technology and
financial services industries, is generally less than 25 years.
Finally, the Board observed the relatively recent decisions of
several other national accounting standards-setting bodies that have
addressed this issue. Those bodies have generally concluded that
goodwill should have a presumptive useful life of 20 years or an
absolute maximum amortization period of 20 years.
Proposed Requirement #3: Companies would be required to present
goodwill amortization as a separate line item on the income statement,
preceded by a subtotal, to make the charge to earnings more transparent
to investors and creditors.
Basis: The Board decided that goodwill amortization should be
presented as a separate line item in the income statement because
goodwill is a unique asset, the useful life of which cannot be
determined precisely. In addition, some investors and creditors often
weigh goodwill amortization differently from other expenses in their
financial analysis, and the proposed presentation would benefit those
users.
Intangible Assets: It is important to note that the Proposed
Standard would not require the separate valuation, reporting, and
amortization of intangible assets that are not reliably measurable,
such as many forms of knowledge-based intangible assets so often
associated with technology companies. A review of the comment letters
and public hearing testimony reveals that this point has continued to
be a source of some confusion for some constituents. To clarify, under
current accounting standards and the Proposed Standard, only purchased
intangible assets that can be separately identified and reliably
measured, like many trademarks and customer lists, are required to be
separately valued, reported, and amortized over their useful economic
lives.
Unlike current accounting, however, the Proposed Standard does
provide certain circumstances in which intangible assets are not
amortized. The Proposed Standard provides that, if an intangible asset
has an indefinite useful economic life and meets certain other
criteria, the asset shall not be amortized until its life is determined
to be finite. Thus, if an intangible asset was increasing in value, the
Proposed Standard would provide circumstances in which that asset would
not be amortized.
The Board is aware of, and the FASB staff is actively participating
in and monitoring, various studies and research currently being planned
or performed by various constituent groups that might be relevant to
the accounting for intangible assets. In addition, the FASB staff is
currently performing independent research in this area. The scope of
our research involves determining whether changes in the US economy
should result in changes in the type of information included in
financial statements and the manner in which that information is
presented and delivered to users. That research includes a review of
the accounting treatment for intangible assets.
The Board will carefully evaluate the results of the studies and
research of the constituent groups and FASB staff. We anticipate that
those results might help us expand our understanding of financial
reporting issues related to accounting for intangible assets. Those
results might also assist in developing future formal agenda projects
of the Board.
Who Will Benefit from a Change in the Accounting for Business
Combinations and How?
The Proposed Standard will benefit the public--investors,
creditors, and other users of financial statements--as well as
companies that prepare and audit those reports.
The Proposed Standard's requirement to eliminate the pooling method
will benefit investors, creditors, and other financial statement users
by providing more information and more relevant information about all
business combinations. The Proposed Standard's provisions also will
benefit those consumers by improving the comparability of financial
reporting, thereby making it possible to more easily contrast companies
that participate in business combinations.
Many consumers have expressed support for elimination of the
pooling method. As one example, a letter from the Financial Accounting
Policy Committee of the Association for Investment Management and
Research states:
The FAPC is unequivocal in its support of the FASB's proposal
that there be only one method of accounting for business
combinations in the United States. We also agree that the
purchase method is the one that reflects properly the economics
of all business combinations, and that pooling-of-interests
should be eliminated . . .
The pooling method fails to revalue the assets and
liabilities of the acquired enterprise at fair value and the
excess, commonly called ``goodwill,'' is not recorded. Hence,
pooling does not faithfully represent the values of the assets
and liabilities exchanged, nor does it reveal the actual
premium paid by the acquirer in the transaction. Users of
financial statements are thus impeded in their attempts to
understand the underlying economics of the business
combination.
Many companies that prepare financial reports also agree. Those
companies that have written letters to the FASB supporting the
elimination of the pooling method include IBM Corporation, Eaton
Corporation, American Electronic Power, General Motors, Caterpillar,
Inc., IMC Global, and PPG Industries, Inc., to name a few. The IBM
Corporation letter stated:
IBM agrees with the FASB that all business combinations are
acquisitions and, thus, we support the FASB's proposal to
eliminate the pooling-of-interests method of accounting for a
business combination. We believe that financial statement users
are ill-served by the existence of two methods to account for
the same economic transaction. We agree with the FASB that
using the purchase method to account for all business
combinations will increase the comparability of financial
statements and will reflect the true economics of the
transaction, that is, an arm's length investment that should be
accounted for at the fair value of the assets and liabilities
that are acquired.
The Proposed Standard will also benefit companies that prepare
financial statements and the auditors of those statements by providing
a single method of accounting for all business combinations. Having one
method of accounting for all business combinations will reduce certain
costs to companies and auditors that are currently related to the
existence of the pooling method.
For example, the availability of the pooling method often puts
companies and their auditors under pressure to employ that method
because it typically produces higher reported earnings and rates of
return subsequent to a business combination than the purchase method.
Moreover, because the pooling method is applied retroactively, the
comparative earnings reported for periods preceding the combination are
also higher than under the purchase method--even before the companies
were, in fact, combined.
As a result of those pressures, companies often must bear
significant costs, both monetary and nonmonetary, in seeking to use the
pooling method. In positioning themselves to try to meet the 12
criteria for applying that method, companies may refrain from engaging
in appropriate economic actions that they might otherwise undertake,
such as asset dispositions or share reacquisitions. They also may incur
substantial fees from auditors and consultants in seeking to meet those
criteria. The efforts to meet those criteria also may lead to conflicts
between companies, auditors, and regulators with respect to judgments
about whether the criteria have been met, thereby adding uncertainties
and their attendant costs to the process and raising questions about
the operationality of those criteria.
A report published by the Silicon Valley office of McKinsey &
Company, an international consulting firm, stated:
The fear that purchase accounting, by lowering reported
earnings, will destroy shareholder value is a myth. In fact the
opposite is true. Efforts to qualify for such treatment
actually destroy value. FASB's proposal to eliminate pooling
accounting is a blessing in disguise. Why? Because the
transition to purchase accounting will require corporations to
adopt more robust deal evaluation processes and enhance their
shareholder communications.
Similarly, a letter to the FASB from the Financial Institutions
Accounting Committee of the Financial Managers Society (``FIAC''), a
group of 15 financial professionals working in executive level
positions in the thrift and banking industries, stated:
Formal research supports the proposition that reporting firms
consume substantial resources in structuring transactions
solely to achieve a favorable financial reporting outcome. Lys
and Vincent (1995) report that AT&T paid at least $50 million
(and possibly as much as $500 million) to achieve pooling-of-
interests accounting for its acquisition of NCR. . . . A single
method of accounting for business combinations would redirect
these corporate resources into more productive areas.
In addition, having one method of accounting for business
combinations benefits companies by leveling the playing field for
competition among companies in the business combinations market. The
ability--or inability--to use the pooling method often affects whether
a company enters into a business combination and also affects the
prices they negotiate for those transactions. Companies that cannot use
the pooling method because they cannot meet the criteria required for
its use (for example, criteria that prohibit certain share
acquisitions) often conclude that they cannot compete for targets with
those that can meet the criteria.
Many companies that cannot use the pooling method believe that
companies that can use it often are willing to pay higher prices for
targets than they would if they had to use the purchase method because
they do not have to account for the full cost of the resulting
investment. Thus, by using the pooling method, they can understate the
income statement charges (primarily related to goodwill and other
intangible assets).
In a letter to the FASB, KeyCorp explained:
Since most publicly-traded companies are gauged by EPS
performance, there is a strong incentive to use the ``earnings-
friendly'' pooling method. The desire to avoid the earnings
consequences of the purchase method has almost certainly
resulted in uneconomic behavior. It is well understood in the
investment banking community that a company is willing to
``pay'' more for a target if the pooling method is available
for the resulting transaction. Clearly, there is a view that
the pooling method results in a type of accounting arbitrage .
. .
Even though using the pooling method rather than the purchase
method might result in being able to report higher per-share earnings
following the combination, the fundamental economics are not different
because the actual cash flows generated following the combination will
be the same regardless of which method is used. As a result, the added
earnings reported under the pooling method reflect artificial
accounting differences rather than real economic differences.
To the extent that the markets respond to artificial differences,
they direct capital to companies whose financial reporting benefits
from those differences and they direct capital away from companies
whose financial reporting does not benefit. As a result, markets
allocate capital inefficiently rather than efficiently. While
inefficient allocation of capital may benefit some companies and even
some industries, it imposes added costs on many others, depriving them
of capital that they need and capital they could employ more
productively. The outcome is detrimental to those companies--but more
important, to the capital markets as a whole.
What Happens Next?
On April 12, 2000, the Board began the next significant stage of
its work on the business combinations project. That stage will involve
redeliberation of all of the issues contained in the Proposed Standard.
As part of that redeliberation, the Board will carefully consider the
feedback it has received through the comment letters, public hearing
testimony, the testimony at this hearing, and any and all relevant
information provided by interested parties.
The Board will hold as many public meetings as necessary to
thoroughly discuss all of the feedback received and to decide what
modifications or clarifications to the Proposed Standard are
appropriate. The Board will not make any final decisions about the
Proposed Standard or consider whether to issue a final standard until
it is satisfied that all substantive issues raised by all parties have
been considered.
The Board presently expects to complete its work and be in a
position to issue a final standard by no earlier than the end of the
year 2000. That estimate may change depending on the progress of the
Board's redeliberations. Any final standard will be effective no
earlier than the date of its issuance.
In closing, I want to be clear that the FASB understands and
supports the oversight role of this Subcommittee. We will carefully
consider what we learn from this hearing. Let me assure you, Mr.
Chairman and members of the Subcommittee, that our open due process and
our independent and objective decision making will be carefully and
fully carried out. To do otherwise would jeopardize the very foundation
upon which the FASB was created, and for which it has proven invaluable
to the US capital markets and to investors and creditors--the consumers
of financial information.
Thank you, Mr. Chairman. I very much appreciate this opportunity
and would be pleased to respond to any questions.
Mr. Oxley. Thank you, Mr. Jenkins. Once again we appreciate
your cooperation and openness throughout this entire process.
As the other member said, it has been a pleasure to work with
you in such a manner.
Before I introduce our next witness, let me introduce our
good friend Joe Crowley, from New York, who is not a member of
the committee, but is interested in this subject and has agreed
to be with us this morning. Welcome.
Mr. Powell?
STATEMENT OF DENNIS D. POWELL
Mr. Powell. Good morning. Thank you for inviting me to this
hearing.
I am vice president and corporate controller for Cisco
Systems. Cisco is the worldwide leader in networking, with
revenues currently approximating $17 billion per year. We are a
multinational corporation with more than 28,000 employees and
200 offices in 55 countries. In the U.S. we have significant
operations in California, Texas, Massachusetts, and North
Carolina.
The two methods of accounting that we are discussing today,
purchase and pooling of interests, have been generally accepted
in practice since 1945. In 1970, the Accounting Principles
Board studied and discussed the pros and cons of the two
accounting methods and issued APB16 entitled ``Business
Combinations,'' which reaffirmed the validity of both the
purchase and pooling of interests method.
This viewpoint was again reaffirmed in 1994 by a task force
commissioned by the American Institute of Certified Public
Accountants, as we heard earlier, to study the usefulness of
financial reporting. This report, entitled ``Improving Business
Reporting, a Customer Focus,'' concluded after 3 years of study
that a project to do away with either method would be very
controversial, require a significant amount of FASB time and
resources, and at the end is not likely to improve
significantly the usefulness of financial statements.
So the arguments for and against the pooling and purchase
methods of accounting haven't changed for the past 30 years. We
are still debating the same issues.
However, the problems with the purchase method are still
with us, but the implications today are much more severe than
they were in 1970. In 1970, most of an acquisition price was
allocated to tangible, hard assets. Today, for knowledge-based
technology companies, most of the acquisition price is
allocated to intangible assets and very little to hard assets.
For example, since 1993, Cisco has acquired over 50
companies amounting to over $19 billion. Of these acquisitions,
only $900 million or 5 percent is attributed to hard assets;
$18 billion or 95 percent of the acquisitions would be left to
allocate to intangibles or goodwill. So the limitations of the
purchase method have become much more problematic. Yet the new
FASB proposal would force all acquisitions to be accounted for
under the purchase method, without having solved its defects.
The most significant defect of the purchase method is the
accounting for goodwill once it is recorded as an asset on the
balance sheet. The FASB proposal requires that goodwill be
treated as a wasting asset and requires that it be amortized
over 20 years. This model incorrectly assumes that goodwill
declines in value over time, which artificially reduces net
income and misrepresents economic reality.
For example, we studied four technology mergers that
occurred in 1996 and 1997. The results of the four companies in
the study are summarized in attachment B to my testimony. As
you can see from that exhibit, the purchase accounting model
significantly reduced actual earnings by an average of 48
percent because of the amortization of goodwill. This would
suggest that goodwill has declined in value. However, over the
same period, goodwill actually increased from the date of the
merger by an average of 43 percent.
Based on the above study, it is clear that in successful
mergers, the presumption that goodwill is a wasting asset is
not valid. Goodwill increases in successful acquisitions and
declines rapidly in unsuccessful acquisitions. Goodwill does
not decline radically over 20 years. The FASB model simply does
not report true economic performance.
The FASB argues that the pooling of interests method
provides investors with less information and less relevant
information than provided by the purchase method because the
pooling method ignores the values exchanged, whereas the
purchase method records these values on the face of the balance
sheet.
I disagree that the pooling method provides less
information. At the time of a merger, the number of shares
exchanged and the related share values are known, so the value
of the transaction is known. Furthermore, the pooling method of
accounting reports a more conservative balance sheet, reports
the results of operations more accurately, and presents
investors and creditors with more relevant information to
assess subsequent performance of the combined entities than the
purchase method.
If I could refer you to attachment C as an illustration, if
companies A and B would combine, the pooling method would
report a combined equity of zero dollars, in the example that I
provided. However, the purchase model creates an inflated
equity of $4,000, giving the impression that these two anemic
companies have been made well simply by combining.
Furthermore, because the purchase method incorrectly
assumes that goodwill reported on the balance sheet declines
over 20 years, the combined companies' operations are
artificially reduced from the actual performance under purchase
accounting. The pooling method more faithfully reports true
economic performance as illustrated in the attachment C.
Finally, application of the purchase method would mislead
the reader of the financial statements, the combined financial
statements, into believing that the revenues had increased 100
percent from $2,500 in year 1 to $5,000 in year 2. However, the
pooling method would correctly reflect the true view that sales
had been flat between the 2 years because this method requires
that previously reported financial statements be restated to
report the combined operations as if they had always been
together. In this case, both years 1 and 2 would reflect sales
of $5,000.
In summary, the pooling method reports a more conservative
balance sheet, more accurate income, and a better comparison of
operations and a truer picture of sales trends.
In conclusion, the U.S. accounting rules for business
combinations, which includes both the pooling and the purchase
methods, has for the past 50 years generated and supported the
strongest capital markets in the world. Before the FASB
radically changes these accounting rules to a model that will
certainly stifle technology development, impede capital
formation, and slow job creation in this country, the FASB
should make sure that the new proposed method is without
question the absolute correct answer.
In reality, the FASB's proposed standard does not improve
financial reporting, it merely changes it. Worse yet, the
proposed changes require companies to use a purchase model that
does not work for companies in the new economy, where most of
the acquisition value cannot be attributed to hard assets,
forcing companies to report an arbitrary net income number that
is irrelevant and misleading.
We believe that, first, the FASB should retain the pooling
of interests method of accounting. The pooling method of
accounting continues to have broad support, as evidenced by
two-thirds of the respondents to the current FASB exposure
draft, and all of the Big 5 accounting firms disagreed with the
FASB's plan to eliminate pooling accounting.
Second, revise the purchase method to correct its
deficiencies, such as charge purchased goodwill directly to
shareholders' equity, or amortize it through comprehensive
income, or reduce goodwill only when it has actually declined
in value, or the impairment method; and then limit the
allocation of purchase price only to those intangibles that can
be objectively and reliably valued; and third, engage a task
force which would include evaluation experts to develop
adequate guidance on how to identify, value and account for
intangible assets for new economy companies.
I agree with Mr. Jenkins in his statement with respect to
the Garten Commission. It was not commissioned to address this
point. As a member of that commission, I can verify that. What
that means, though, I think, is that someone needs to address
this issue, because it is not being addressed today. I think
that is the FASB's job. I think they should do that before they
issue their pronouncement.
Thank you very much.
[The prepared statement of Dennis D. Powell follows:]
Prepared Statement of Dennis D. Powell, Vice President, Corporate
Controller, Cisco Systems, Inc.
introduction
My name is Dennis Powell. I am Vice President and Corporate
Controller for Cisco Systems, Inc.
Cisco is the worldwide leader in networking with revenues currently
approximating $17 billion per year. We are a multinational corporation
with more than 28,000 employees in 200 offices and 55 countries. In the
U.S., we have significant operations in California, Texas,
Massachusetts and North Carolina.
background
The two methods of accounting--``Purchase'' and ``Pooling of
Interests''--have been generally accepted in practice since 1945. In
1970, the Accounting Principles Board studied and discussed the pros
and cons of the two accounting methods, and issued APB16 ``Business
Combinations'', which reaffirmed the validity of both the purchase and
pooling of interests methods.
This viewpoint was again reaffirmed in 1994 by a task force
commissioned by the American Institute of Certified Public Accountants
to study the usefulness of financial reporting. This report, entitled
``Improving Business Reporting--A Customer Focus'' concluded, after
three years of study, that, ``A project to do away with either method
would be very controversial, require a significant amount of FASB time
and resources, and in the end is not likely to improve significantly
the usefulness of financial statements.''
The arguments for and against the pooling and the purchase methods
of accounting haven't changed over the past 30 years--we are still
debating the same issues.
However, the problems of the purchase method are still with us, and
the implications today are much more severe than they were in 1970. In
1970, most of an acquisition price was allocated to tangible, hard
assets. Today, for knowledge-based technology companies, most of the
acquisition price is allocated to intangible assets--and very little
allocated to hard assets. For example, since 1993, Cisco has acquired
over 50 companies amounting to $19 billion. Of these acquisitions, only
$900 million, or 5%, is attributed to hard assets--$18 billion or 95%
would be left to allocate to intangible assets or goodwill. So the
limitations of the purchase method have become more problematic. And
yet the new FASB proposal would force all acquisitions to be accounted
for under the purchase method, without having solved its defects.
goodwill amortization
The most significant defect of the purchase method is the
accounting for goodwill once it is recorded as an asset on the balance
sheet. The FASB proposal requires that goodwill be treated as a wasting
asset, and be amortized ratably over 20 years. This model incorrectly
assumes that goodwill declines in value over time, which artificially
reduces net income and misrepresents economic reality. In reality, the
value of goodwill is dependent upon the success of the merger, and is
not a function of time.
For example, we studied four technology mergers that occurred in
1996 and 1997, which were reported as poolings. We then recast the
poolings as if they were purchases, and restated the financial
statements for periods after the acquisition to show the impact of
goodwill amortization. The results of all four companies in the study
are summarized on Attachment B. The purchase accounting model
significantly reduced actual earnings by an average of 48% because of
the amortization of goodwill. This would suggest that goodwill has
declined in value. However, over this same time period, goodwill has
actually increased from the date of the merger by an average of 43%.
Based on the above study, it is clear that in successful mergers,
the presumption that goodwill is a wasting asset is not valid. Goodwill
increases in successful acquisitions and declines rapidly in
unsuccessful acquisitions. Goodwill does not decline ratably over
twenty years--the FASB model simply does not report true economic
performance.
intangibles
Regarding valuation of other intangible assets, the FASB proposal
obligates companies to identify and value all intangible assets,
without giving adequate guidance on how these assets should be
separately identified and valued. There are no standards in the
valuation community to provide any consistency or reliability around
the valuation of these intangibles.
At risk is a loss of credibility in financial reporting. FASB must
provide more guidance and tools around how their requirements should be
implemented.
comparability
The FASB has stated that elimination of pooling solves a
comparability issue between purchase transactions and pooling
transactions. But elimination of pooling simply trades one
comparability issue with a set of new comparability problems. First,
mandating the purchase method creates significant comparability issues
between companies who grow from internal organic development and those
who grow through acquisition.
For example, a company that generates significant goodwill from its
internal operations will report no goodwill value while the company
that acquires goodwill through a merger will report the ``value'' of
the goodwill at the time of the acquisition. So, while both companies
may have the same value of goodwill, only the company who obtained the
goodwill through a merger will report any amount on its balance sheet.
Secondly, elimination of pooling prevents comparability within the
same company--in comparing operations before the acquisition, which do
not include the activities of the acquired company, to operations after
the acquisition, which do include the activities of the acquired
company. Eliminating pooling does not solve the comparability issue.
I believe the comparability issue would be more effectively
addressed by correcting the inherent problems of the purchase method
than by eliminating pooling accounting as an option.
defense of pooling accounting
The FASB argues that the pooling method provides investors with
less information--and less relevant information--than provided by the
purchase method, because the pooling method ignores the values
exchanged whereas the purchase method records these values on the face
of the balance sheet. I disagree that the pooling method provides less
information. At the time of a merger, the numbers of shares exchanged
and related share values are known, so the value of the transaction is
known. Furthermore, the pooling method of accounting reports a more
conservative balance sheet, reports results of operations more
accurately and presents investors and creditors with more relevant
information to assess subsequent performance of the combined entities
than the purchase method. Using Attachment C as an illustration, if
Companies A and B would combine, the pooling method would record a
combined equity of $0. However, the purchase method would create an
inflated equity of $4,000, giving the impression that these two anemic
companies had been made well by simply combining.
Furthermore, because the purchase method incorrectly assumes that
the goodwill recorded on the balance sheet declines over 20 years, the
combined company's operations are artificially reduced from its actual
performance under purchase accounting. The pooling method more
faithfully reports true economic performance as illustrated in
Attachment C.
Finally, application of the purchase method would mislead the
reader of the financial statements of the combined financial statements
into believing that the revenues had increased 100%, from $2,500 in
Year 1 to $5,000 in Year 2. However, the pooling method would correctly
reflect the true view that sales had been flat between the two years,
because this method requires that previously reported financials be
restated to report the combined operations as if they had always been
together; in this case both Years 1 and 2 would reflect sales of
$5,000.
In summary, the pooling method reports a more conservative balance
sheet, more accurate income, a better comparison of operations and a
truer picture of sales trends.
summary
In conclusion, the U.S. accounting rules for Business Combinations,
which includes both the pooling and purchase methods, has for the past
50 years, generated and supported the strongest capital markets in the
world. Before the FASB radically changes these accounting rules to a
model that will certainly stifle technology development, impede capital
formation and slow job creation in this country, the FASB should make
sure the proposed new method is without question, the absolute, correct
solution. In reality, the FASB's proposed standard does not improve the
accounting--it merely changes it. Worse yet, the proposed changes
require companies to use a purchase model that does not work for
companies in the New Economy, where most of the acquisition value
cannot be attributed to hard assets, forcing companies to report an
arbitrary, artificial net income number that is irrelevant and
misleading.
We believe the FASB should:
(1) Retain the pooling of interests method of accounting. The pooling
method of accounting continues to have broad-based support.
Two-thirds of the respondents to the current FASB exposure
draft and all of the Big 5 accounting firms disagreed with the
FASB's plan to eliminate pooling accounting.
(2) Revise the purchase method to correct its deficiencies, such as:
(a) Charge purchased goodwill directly to shareholders' equity, or
amortize it through comprehensive income, or reduce
goodwill only when it has actually declined in value; and
(b) Limit the allocation of purchase price to only those
intangibles that can be objectively and reliably valued;
(1) Engage a task force, which would include valuation experts, to
develop adequate guidance on how to identify, value and account
for intangible assets for New Economy companies.
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Mr. Oxley. Thank you.
Mr. Bible?
STATEMENT OF PETER R. BIBLE
Mr. Bible. It is a pleasure to be with you here today,
especially a fellow Buckeye, Mr. Chairman. In the land of
Wolverines and Spartans, it is kind of lonely up there.
To put my comments in context, Mr. Chairman, I think it is
important to understand that the General Motors Corporation is
a participant in both the new and the old economy. Some of our
new ventures, eGM, Trade Exchange, Hughes Electronics, are
among some of the darlings on Wall Street as the high-tech
industry. Those businesses have been built on purchase
accounting acquisitions.
Presently there is an exchange offer for $9 billion for GM-
1 and 2 shareholders to exchange their one and two-thirds
shares for shares of Hughes. I am not sure how their growth
through nonpooling transactions has impeded their value.
Now to my written testimony.
The act of bringing together two or more independent
businesses to function as one business is known by many names
on Wall Street and in the media. For purposes of my testimony
here today, I will use the term ``business combinations'' to
refer to that act.
A business combination can be and often is a very
significant financial and cultural event in the life of a
business. That financial significance is the very heart of the
topic of your hearings, and that is the combined income
statement of the businesses subsequent to the business
combination.
Why the income statement, you ask? The answer is, that is
where investors and other users of financial statements look to
see if the business combination was accretive, a good thing, or
dilutive, a bad thing, to net income and earnings per share,
two of the key determinants for stock price for many
businesses.
Why is this the very heart of the topic of your hearings,
you ask? The answer is, under purchase accounting, the
difference between the amount paid for a business and the
historical net book value of that business's net assets or
equity find its way to the income statement over time as
expenses. This dilutes net income and earnings per share of the
combined businesses.
Under the pooling method, however, that difference between
the amount paid for a business and the historical net book
value of that business is never recognized in the financial
statements of the combined businesses; thus, the game.
Therefore, at worst, net income of the combined businesses is
equal before and after the business combination. Accordingly, a
business combination on an economic basis could be and often is
dilutive, but that dilution is never reflected in the income
statement of the businesses.
The contrarion to this view would tell you that investors
and analysts are not ignorant, and they can see through the
differences between purchase and pooling of interests
accounting. This may be true, but in today's world of ``you're
as good as your last quarterly results,'' memories fade fast.
The Accounting Principles Board in their Opinion 16
recognizes that there are business combinations that represent
a uniting of shareholders' interests, or what is referred to in
today's world as a merger of equals, that would be best
accounted for by combining the historical financial statements
of the combined businesses.
To define this type of business combination, the Accounting
Principles Board put in place 12 tests to be passed. Since its
issuance in August 1970, Wall Street and others have been
gainfully employed navigating around the 12 tests in AB16.
This has given rise to countless interpretations of the
pooling of interests rules by the Accounting Principles Board,
the Financial Accounting Standards Board, the Emerging Issues
Task Force, and the Securities and Exchange Commission.
Do mergers of equals really exist? Sure, just like Michael
Jordan and Jack Nicklaus exist, but they are rare, and to
define them is close to impossible.
I mentioned earlier in my testimony the cultural
significance of business combinations. Perhaps that is why the
term ``merger of equals'' is often used in the press to
describe an acquisition. I would be shocked if you do not hear
today that the Financial Accounting Standards Board's Proposed
Statement on Business Combinations will bring a plague on high-
tech and startup businesses. You should ask those testifiers on
what basis the stock of a high-tech or startup business trades:
net income or revenue?
Not being in the proposed standard affects the recognition
of revenue. If your concern is there, talk to the SEC on their
staff accounting bulletin 101.
Historically, many acquisitions have been accounted for
using the pooling of interests method because of the use of
stock as the currency. It is often the case that, for tax
reasons, stock is a more efficient currency than cash.
In closing, as you will see in my written testimony, there
are several provisions of the proposed standard that I do not
agree with. However, I do support the elimination of the
pooling of interests method.
Thank you very much.
[The prepared statement of Peter R. Bible follows:]
Prepared Statement of Peter R. Bible, Chief Accounting Officer, General
Motors Corporation
The act of bringing together two or more independent businesses to
function as one business is known by many names on Wall Street and in
the media. For purposes of my testimony here today, I will use the term
``business combinations'' to refer to that act. A business combination
can be, and often is, a very significant financial and cultural event
in the life of a business. That financial significance is at the very
heart of the topic of your hearings, and that is the combined income
statement of the businesses subsequent to the business combination. Why
the income statement you ask? The answer is: that is where investors
and other users of the financial statements look to see if the business
combination was accretive (a good thing) or dilutive (a bad thing) to
net income and earnings per share, which are two of the key
determinants of stock price for many businesses. Why is this at the
very heart of the topic of your hearings, you ask? The answer is: under
purchase accounting, the difference between the amount paid for a
business and the historical net book value of that business' net assets
or equity finds its way to the income statement over time as expenses.
This dilutes the net income and earnings per share of the combined
businesses.
Under the pooling of interests method, however, that difference
between the amount paid for a business and the historical net book
value of that business is never recognized in the financial statements
of the combined businesses. Therefore, at worst, net income of the
combined businesses is equal before and after the business combination.
Accordingly, a business combination on an economic basis could be, and
often is, dilutive, but that dilution is never reflected in the income
statement. The contrarion to this view would tell you that investors
and analysts are not ignorant and can see through the differences
between purchase and pooling of interest accounting. This may be true
but, in today's world of ``you're as good as your last quarterly
results,'' memories fade fast. The Accounting Principles Board in their
Opinion No. 16 recognized that there are business combinations that
represent a uniting of shareholders interest, or what is referred to in
today's world as a merger of equals, that would best be accounted for
by combining the historical financial statements of the combined
businesses. To define this type of business combination, the Accounting
Principles Board put in place twelve tests to be passed. Since its
issuance in August 1970, Wall Street and others have been gainfully
employed navigating around the twelve tests in Opinion No. 16.
This has given rise to countless interpretations of the pooling of
interests rules by the Accounting Principles Board, the Financial
Accounting Standards Board, the Emerging Issues Task Force, and the
Securities and Exchange Commission. Do mergers of equals exist? Sure
they do, just like Michael Jordan and Jack Nicklaus exist, but they are
rare and to define them is close to impossible. I mentioned earlier in
my testimony the cultural significance of business combinations.
Perhaps that is why the term ``merger of equals'' is used so often in
the press to describe an acquisition. I would be shocked if you did not
hear today that the Financial Accounting Standards Board's Proposed
Statement on Business Combinations will bring a plague on high-tech and
start-up businesses. You should ask those testifiers on what basis the
stock of a high-tech or start-up business trades: net income or
revenue? The topic of your hearing has no affect on revenue.
Historically, many acquisitions have been accounted for using the
pooling of interest method because of the use of stock as the currency.
It is often the case that, for tax reasons, stock is a more efficient
currency than cash.
In closing, as you will see in my written testimony, there are
several provisions of the Proposed Standard that I do not agree with.
However, I do support the elimination of the pooling of interests
method.
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Mr. Oxley. Thank you, Mr. Bible.
Mr. Hoffman.
STATEMENT OF GENE HOFFMAN, JR.
Mr. Hoffman. Mr. Chairman, thank you very much for holding
the hearing. Thank you very much for inviting me and giving me
the opportunity to speak. I will submit my written testimony
for the record, and speak quickly, hopefully remaining in my
time here, on some of the various topics that are brought up.
First of all, let me tell you what EMusic is and where I
came from and what I do. We have a unique perspective on
intangibility, as we are one of the few companies that actually
sells no physical goods whatsoever. We actually sell
downloadable music in the form of bits over the Internet for 99
cents a song or $8.99 an album.
We also own or operate, or I should say operate,
RollingStone.com, to which we sell advertising and sponsorship
revenues and drive downloadable music sales from the Internet
at that magazine's Web site.
Because of this, we are uniquely impacted by intangible
accounting. Unlike Cisco, which is probably one of the tech
leaders, frankly, we do not even ship a box. When we make or
made approximately $2.8 million in gross profits last quarter,
all of that was directly delivered over the Internet; no
physical goods; no pick, pack and ship; no warehouses. We are
always in stock.
It is interesting when we look at these issues, because
what we are really concerned with overall is the handling of
intangible accounting. I think my associate from Cisco said it
well. My concern is that the purchase method accounting has yet
to really well understand those issues that are fully
intangible.
One of the issues I would like to point out specifically
is--and before I go too deep in this, I want to say that again,
I have a different and unique perspective. I am the son of an
accountant, hard-
ly an accountant myself, and the youngest NASDAQ CEO, so I look
at this, again, from a very different perspective than many
companies in the space.
There seems to be a prevalence of a concern that this is
just a technology company situation. I want to challenge any
company to admit that they are not a technology company. Every
single company is a technology company. Even my associate here
from General Motors admits to the fact that GM is a technology
company, a very good and successful technology company. Even
the auto division strives with Armstrong and other programs to
become more of a service and an intangible asset-based
business.
So these are issues for any company that looks at strong
growth and the ability to monetize, the ability to be weighed
against their intangible assets.
I want to make an interesting point and bring the tangible
assets a little bit more home to the everyday American. Twenty
years ago a song was written by Don McLean called American Pie.
Well, that song as an asset. It faded from memory, so in some
ways, yes, it absolutely decreased in value, but with no
expenditure by the original songwriter, a small artist we all
have heard of once in a while called Madonna decided to
rerelease that song. That intangible asset, the ownership of
the copyright in American Pie, has tremendously increased in
value without any expenditure of asset, any expenditure of
cash, any expenditure of promotion by the original copyright
owner. That is an important aspect, now, very specific to my
industry, but telling in the same way that this happens in
software companies and others.
Brand names and other pieces, part of which--for example,
our own public disclosures are heavily laden with the write-
down of goodwill for the acquisition of Tunes.com,
RollingStone, the EMusic name, the music rights themselves are
heavily laden with.
One other important point I want to make, we have heard
from various people who have had quite a bit more accounting
experience than I do, but anyone who does a pooling acquisition
absolutely shows a cost. When AOL acquired NetScape, there was
a dilutionary cost. It was a direct impact to earnings per
share.
This brings me to what I think is the most important issue
facing us. I personally do not really concern myself with
whether or not pooling will really be an available and
acceptable accounting method in the future. What concerns me is
is it truly transparent to not have it.
Let me make my point here. Currently when the average
mother and father, a 40-year-old, tries to evaluate my company
and other companies in technology space, and I will use the
company Excitehome, which actually did a purchase method
acquisition of Excite, there are now two different disclosures
that are looked at. There are cash basis pro forma and earnings
per share.
For the not-as-sophisticated investor who does not have
access to sell and buy side analysts and equities analysts and
all the other levels of information that your mutual funds and
pension funds have, it is very difficult to understand the
difference between pro forma and actual EPS.
Most people are used to AT&T in the classic sense, where
EPS was the No. 1 way they judged a company. Growth in EPS,
actual EPS, was how they looked at companies. The elimination
of pooling means a direct double charge in some senses to EPS,
both dilutionary and then the write-down of the goodwill, the
acquisition itself. That is the issue. The issue really is not
how we account for it, it is are we providing the level of
disclosure and the level of transparency to the individual
investor.
I am not concerned about California Teachers Pension Fund.
I am quite sure that with the type of assets they bring to
bear, they will be able to easily evaluate my firm and other
firms quite like me to figure out whether or not we are
actually performing and whether or not that merger was actually
a good, positive, accretive merger, or simply a bad mistake and
something that should never have happened before.
What I am concerned with is the person who today bought
1,000 shares at the opening of the market because they thought
that what we were doing was the right thing, and they looked at
our EPS and were concerned, how could they lose this much cash,
because your average individual investor does not know the
difference between losing cash and losing goodwill, frankly.
That really is the summation of my concerns. As long as we
look at this issue in a careful and slow manner, because this
is a very important change, we are talking about changing 40-
some plus years of generally accepted accounting principles, as
long as we first tackle the issue that has arisen around
intangible assets--and again, I put my company to the table
here and say that very few companies that ever come before you
have no tangible assets, period. Even Cisco has inventory,
chips and boxes and various pieces that they are going to sell.
I can show you a hard drive. That is my inventory. Is it the
value of the hard drive itself, or is it the 8 percent of the
U.S. music market that is represented by the files included in
that which, in the offline world, generated $1.2 billion?
That is an interesting question. As long as we address that
question first and then tackle how we do business combinations,
I am comfortable.
But as an entrepreneur, I am not comfortable if there is a
significant disincentive for a smaller, but larger than my
firm, company to have a disincentive because of the EPS impact
that a buying company like mine would have to acquiring my
company. That is a disservice to my shareholders, as much as it
would be a positive service to say this is a write-down in my
income statement.
Thank you.
[The prepared statement of Gene Hoffman, Jr. follows:]
Prepared Statement of Gene Hoffman, Jr., Founder, President, and CEO,
EMusic.com, Inc.
Introduction.
It is a pleasure to take part in this morning's hearing on FASB and
the important issue of purchase and pooling accounting. My remarks
today will focus on public policy and not accounting technicalities. I
am not a CPA. I am an entrepreneur. First, let me take a few moments to
tell you about EMusic. Since it was founded in January 1998, EMusic has
established itself at the forefront of how new music will be
discovered, delivered and enjoyed in the next decade. In addition to
having the Internet's largest catalog of downloadable MP3 music
available for purchase, EMusic operates one of the Web's most popular
families of music-oriented Web sites--including RollingStone.com,
EMusic.com, DownBeatJazz.com, and IUMA. The company is based in Redwood
City, California, with regional offices in Chicago, Los Angeles, New
York and Nashville.
EMusic.com is the Web's leading site for sampling and purchasing
music in the MP3 format, which has become the standard in the digital
distribution of music. Through direct relationships with leading
artists and exclusive licensing agreements with over 650 independent
record labels, EMusic.com offers music fans an expanding collection of
more than 100,000 tracks for purchase--individual tracks for 99 cents
each or entire downloadable albums for $8.99. EMusic.com features top
artists in all popular musical genres, such as Alternative (Bush, Kid
Rock, They Might Be Giants, Frank Black), Punk (Blink-182, The
Offspring, Pennywise), Jazz (Duke Ellington, Dizzy Gillespie, Louis
Armstrong, Concord Records), Blues (John Lee Hooker, B.B. King, Buddy
Guy), Hip Hop (Kool Keith, The Coup), Country (Willie Nelson, Merle
Haggard, Patsy Cline), Rock (Phish, Goo Goo Dolls, David Crosby), World
(Nusrat Fateh Ali Kahn, Lee ``Scratch'' Perry) and Vintage Pop (Liza
Minnelli, Eartha Kitt, Judy Garland).
To give you an idea of how fast the downloadable music industry is
growing, the company has now sold over 1 million songs in the popular
MP3 format since its launch. This total includes single-track sales as
well as tracks included as part of albums and special collections. In
addition, EMusic.com's catalog has grown to offer more than 100,000
high-quality MP3s for sale from over 650 independent labels.
I am the youngest CEO in NASDAQ. I am twenty-four years old. I am
one of those freaks of nature in the high tech world--but in a very
good sense. I am very proud of the fact that I have taken ideas and
created companies with my friends and with many new people that I have
been fortunate to meet along my journey. EMusic is my third company. My
first, PrivNet, I created while in college. I sold it to PGP, Inc., and
went to work for PGP. PGP was sold in 1997 to Network Associates. While
at EMusic I have bought four companies. Creating companies, jobs,
economic wealth--all depend on sound accounting principles supported by
well thought out public policy. EMusic is a young company that has
grown by acquisition. So far EMusic has done purchase transactions
because we are not poolable. But I will come back to that point
shortly.
It is important to understand that EMusic represents significant
intangible assets. Many companies in the New Economy do not nor will
not have any physical assets. Their value is either between the ears of
their employees or on the hard drives of their computers and networks.
EMusic digitally delivers music to consumers. Our only physical asset
is a farm of computer servers; but frankly, I prefer to outsource that
to a vendor who really knows that business better than I do and can do
it for me more cheaply than I can on my own. So far my earnings are not
too significant; they are increasing however. I am in a loss basis. I
can tell you that my intangible losses are much more significant than
my cash base losses because I do write down a lot of intangibles.
Purchase vs. Pooling
I don't think good public policy here should make this an either or
discussion. There are problems with both purchase and pooling
accounting. At the high level the overall process has flaws. FASB needs
to fix purchase accounting first before it can go after pooling. There
is a large problem in the high tech community: the growing disparity
between book value and market value. FASB has yet to effectively engage
the high tech community on this issue. I have testified to FASB on this
issue and invite them here today before this Committee to meet with me
at my offices in Silicon Valley to continue the conversation after this
hearing is over. We really need a better method for measuring
intangibles. As more economic wealth moves into intangibles, the
accounting methods and their supporting public policy have to keep up.
By not fixing purchase accounting and by eliminating pooling accounting
FASB only makes matters worse for the New Economy. Moreover, there will
be no improvement in the flow of information about companies out to the
markets and investors. As we all know the past few years have enabled
more Americans to directly invest in the stock market and individual
companies. Many Americans do so via the Internet; many have stock from
their employers; many have their retirements and investments in stocks
and mutual funds. Transparency and the flow of information are critical
to the success of democracy; the same is true in an increasingly
democratic, egalitarian and participatory stock market.
The Entrepreneur's Dilemma: An Example.
As an entrepreneur I have two options to perform a transaction. I
can utilize purchase accounting method and I have to take an EPS impact
in the future, or I can do pooling, which obviously has positive
benefits for myself as a high tech company and an intangible asset
company. Those companies who have built their intangible assets from
ground zero don't have that hit against their earnings, frankly,
because those intangible assets have never been valued. But when I buy
a company that has valued its intellectual property assets (i.e., its
intangible assets), that value is against my doing business. Simply
put, the valuation process is not black and white. A company can see
the value of its assets increase without doing anything. For example,
an artist such as Madonna can perform an old song and increase its
value even though the song is owned by a company unrelated to Madonna
and her record label. The problem is that valuation is confusing, and
if it is confusing to companies in the business who know or should know
as much as there is to know about valuing intangibles, then where does
this leave the individual investor and institutional investors? One of
my biggest concerns here is how intangible assets are valued because I
am not sure that the public really knows what stated assets are really
worth or are not worth. Institutional investors may be able to get down
into the details and ascertain from their own perspective what value
may be but the average Josephine is not likely to decipher what is and
what is not included in a company's pro forma presentation of earnings
before they make their personal investment. Notwithstanding the great
amount of information available to individual investors via the
Internet the average individual investor simply does not have access to
the analysts that companies and institutions do.
This touches upon an even larger public policy issue. And this
issue underscores why it is so important for the Congress to increase
its scrutiny of FASB and how it changes the accounting rules. This
larger public policy issue is a matter of who gets the information, in
what form and when. Individuals may not get all the information at all,
in a useable form, or at the last moment after others have seen it and
made their move in the market. This is an increasing market
inefficiency given the expanding amount of capital flowing into the
market from individuals and the growth of margin debt.
Conclusion.
When so much of the value of the American economy is tied up in
intangibles, in intellectual property, how the pieces of intellectual
property are perceived is really the driver of value and not the
methodology of some accounting practice or rule. If the market is being
driven more by perception than by the principles and rules that
government, industry and professionals have set out, then effective
governance no longer works and the anarchy of the market has taken
over. This is not fair to individuals and is not reflective of our
nation's democratic values. Intellectual property is an extremely
important part of our nation's export economy. Jack Valenti of the
Motion Picture Association of America (MPAA) and others have testified
to Congress that movies and other content products have contributed to
America's economic bottom line. Whether it is Hollywood in southern
California or Silicon Valley in northern California, ideas and
intellectual property are drivers of our nation's economic growth and
international economic influence. Valuation of intangibles like
intellectual property must be grounded on sound public policy and
democratic values.
In closing, I want to leave a clear impression with you. The
current process is flawed and FASB needs to fix purchase accounting
first before they should do anything with regard to pooling or other
rules. The big problem for high tech companies is the fact that current
purchase rules do not provide investors with better or more useful
information. The high tech community has been engaged on this issue
through organizations such as TechNet but to date the feed back from
FASB has been less than satisfactory. While I am not in favor of any
new governmental role here or in any new body charged with setting
accounting standards, we do need to work together in a new way to
develop a better method for measuring intangibles such as intellectual
property. FASB's proposal to require all companies to use purchase
accounting will only make these issues worse and will not improve the
flow of information to investors, especially the individual. I am
pleased that Congress is exercising its proper oversight over the FASB
process on this important economic issue and look forward to working
with the Congress in the future on this issue.
Mr. Oxley. Thank you, Mr. Hoffman.
Mr. Lewis?
STATEMENT OF WILLIAM FREDERICK LEWIS
Mr. Lewis. Mr. Chairman and members of the committee, my
name is Bill Lewis. I come to you today as president and chief
executive officer of Prospect Technologies, an advanced
computer technology and international Web-based firm providing
numerous computer solutions to governments, associations, and
commercial firms. I also appear today as a member of the United
States Chamber of Commerce Small Business Council.
Mr. Chairman, I appreciate this opportunity to comment on
the FASB's proposal, and I commend you for holding these
hearings. I also ask that my full written testimony be included
in the record.
Mr. Oxley. Without objection, all statements will be made
part of the record.
Mr. Lewis. Thank you, sir.
When firms combine, there are two long-standing accounting
methods for combining financial statements, the pooling method
and the purchase method. Historically each has worked
reasonably well and has given firms the opportunity to
accurately reflect to their shareholders their balance sheet
and income statements.
I believe that FASB's proposal to eliminate the pooling
method is unjustified. Remember, again, with the pooling method
the balance sheets of each partner in the merger is simply
added together. Furthermore, its adoption may have a dramatic
negative impact on our economy.
I strongly disagree with FASB's assertion that all of
business combinations should be accounted for as purchases
rather than mergers. This fact ignores the reality that
business combinations may vary substantially as to the traits
of the combining entities and aspects of the combining
transactions. Clearly many of today's combinations do not meet
FASB's assertion that one firm necessarily gains control over
the other.
Furthermore, forced use of purchase accounting, with its
creation and amortization of goodwill, can result in misleading
financial statements. Often the benefit, the very synergy of
combining two companies, continues and grows over time, rather
than depreciating.
I can speak extensively to this point as 2 years ago
Prospect Technologies merged with a computer hardware
manufacturing service support firm. Once this marriage,
marriage of our two firms, occurred, Prospect Technologies, now
formed from two firms, was able to enter into markets which
heretofore it was impossible for either company to enter and
penetrate by themselves.
To arbitrarily force the financial statements to reflect a
write-off of goodwill, an item which can significantly distort
an Internet or .com, if you will, firm, distorts financial
information, giving misleading indications of the combined
firms' profitability. It understates the firm's bottom line,
which in turn would hamper a firm's ability to attract outside
capital, go public, or, in more simple terms, grow and make
jobs.
With this ruling, as CEO of Prospect Technologies, I would
look very carefully at merging with another firm to expand our
growth, form new jobs, and help fuel the American economy.
One FASB rationale for eliminating pooling is to reduce the
SEC's staff time devoted to mergers and acquisitions using this
method. Another is to harmonize or force convergence of our
accounting standards with international conventions.
Staffing constraints should not force the rejection of a
useful and workable accounting approach, nor should the
international ``standards'' for which universal consensus is
lacking be a motivating or driving force on this.
Mr. Chairman, it is my opinion that over the past several
years United States technology and information-based firms have
been the preponderance of buyers of firms. It appears that the
world looks to us in terms of getting accurate or reasonable
pictures in terms of what the accurate portrayal of a financial
statement is, not vice versa.
I am not asking Congress today to adopt accounting
standards or even to establish an official oversight board over
Mr. Jenkins and his fine work that he has done at FASB, but
rather to encourage FASB to rethink this rush to judgment.
There are no egregious market failures driving this proposal
for change. However, as pointed out by many on this panel,
including my colleague Mr. Hoffman, there are legitimate
concerns over the proper accounting for intangibles or goodwill
especially prevalent in the high-tech Internet, the .com
companies.
To ameliorate this situation, various groups and
commissions have been delegated to examine this issue. I
believe you will find under way studies currently done by the
Brookings Institute and another one done by a graduate school
of business. Clearly, as the owner of a high-tech Internet
company creating jobs and fueling this economy, I ask you not
to take action until these study groups have come back--these
study groups I mentioned before have come back and helped us
understand the nature of this problem by shedding light on the
wide disparity that has been pointed out by Mr. Powell in his
testimony here as well as in the Senate between what the market
value of the firms are and what the book value is.
As a small business owner, I believe we have time to wait
and evaluate. Prudence dictates that this is the action we
should so take.
Mr. Chairman, thank you very much for having me here today.
[The prepared statement of William Frederick Lewis
follows:]
Prepared Statement of Wm. Frederick Lewis, President and Chief
Executive Officer, Prospect Technologies, on Behalf of the U.S. Chamber
of Commerce
Mr. Chairman and members of the committee, I am Bill Lewis,
President and Chief Executive Officer of Prospect Technologies a small
business headquartered in the District of Columbia. Our firm employs 23
individuals dedicated to providing information solutions for
corporations and government agencies both here in the United States and
internationally. Our business includes computer hardware manufacturing,
computer software, and Internet and Web based solutions. I also come
before you as a member of the U.S. Chamber of Commerce's Small Business
Council.
Working with organizations like the U.S. Coast Guard, the Federal
Maritime Commission, the Department of Defense, Princeton University,
Enterprise Rent-a-Car, the Government of the District of Columbia and
McGraw Hill, we provide solutions that help to dramatically improve
business processes through the use of technology and the Internet. Our
work has received a great deal of recognition including winning Vice
President Gore's Golden Hammer Award for streamlining government,
cutting through red-tape, and improving the quality of customer
satisfaction that is delivered by the Federal Government. This year we
have been nominated again for this prestigious award by the Federal
Maritime Commission for automating all of the FMC's service contracts
and amendments filings via the Internet and the Web.
Mr. Chairman, we appreciate the opportunity to testify on the issue
of accounting for business combinations, in particular the question of
whether the pooling-of-interests method of accounting should be
eliminated. We commend you for holding these hearings.
We oppose the decision of FASB to prohibit the use of the
``pooling-of-interest method of accounting'' for all business
combinations and to force the use of the ``purchase method'' with the
subsequent amortization of goodwill over, at most, a twenty-year
period. Not only will changes in this longstanding practice and the
adoption of new standards not further the goals of providing more
accurate, transparent and reliable financial statements, but they also
may well have a substantial negative impact both on the economy's and
my company's ability to grow.
Prospect Technologies
I am the CEO of a thriving private company, Prospect Technologies,
and I am looking for opportunities to expand my business. Two years ago
I merged with PC's & Systems, Inc., a computer hardware manufacturing
and services company. The transaction was reported using the pooling-
of-interests of both companies and combination of our two historical
balance sheets. However, in spite of Prospect Technologies recording
this on its balance sheet as a simple sum of the assets of the two
firms, the result of the merger created a synergy that allowed us to
bid and win contracts that would not have been possible by either of
the two previous companies individually.
Due to the positive results that the recent merger has had on the
growth of my business, I am looking to combine with other businesses in
the near future, especially with other Internet firms--``dot com''
related businesses--whose assets may be largely made up of
``goodwill.'' If I am required to use the purchase method of
accounting, with its adverse effects on reported earnings, I may have
second thoughts. If the combination results in a company that is
required to amortize a large amount of goodwill, then the emerging
enterprise will have a diminished capacity to access capital. For a
growing company that reinvests most of its cash flow into its future
revenue, even the smallest variance in its apparent profitability could
have a major impact in capital formation. Moreover, if in the future, I
were to decide to ``go public,'' artificial reductions of net income
due to the use of purchase accounting could make such an offering less
appealing.
Pooling-of-interests vs. Purchase Accounting
When firms combine, there are two alternative methods for computing
and reporting for financial statement purposes the combined entity: the
pooling-of-interest method and the purchase accounting method. Each
combination is evaluated according to a 12-factor test. Those
combinations that meet all 12 factors must use the pooling-of-interest
method, whereas those failing any of the 12 factors must use the
purchase accounting method.
Under the pooling method, the balance sheets of each partner in the
merger are simply added together. The new entity reports the combined
historical book value. Under purchase accounting, one firm must be
designated the acquirer and the other the acquiree. The acquired firm's
identifiable assets are valued at current fair market value, and the
difference between the fair market value of those assets and the
purchase price is recorded as an intangible asset--goodwill. The
financial statement of the combined entity is reported as the
combination of the acquiring firm's historical book value and the
acquired firm's fair market value plus the goodwill. Thereafter, over
the years, the goodwill must be ``written-off'' or charged against
reported income. As a result, under purchase accounting, there is a
subsequent drag on reported earnings. The magnitude of this drag will
depend upon the proportion of intangible assets in the acquired firm
and the length of the amortization period--currently 40 years, but
shortened to 20 under FASB's proposal.
The pooling-of-interest method of accounting is a generally-
accepted method that has been in use for a long time. It is not, as
some recent press accounts have alluded, an artificially advantageous
method designed to bolster financial statements so that its proponents
can boost stock prices or attract outside financing. If all of the 12
requisites are present to permit its use, pooling-of-interests requires
the combining companies to add the historical book values of assets,
liabilities and shareholder equity, and presents them on integrated
financial statements. If one or more factors are not met, then use of
purchase accounting is required. In fact, because of its restrictive
nature, this pooling method can have a potential downside. For
instance, if a company that recently engaged in a pooling-of-interest
transaction found its stock price artificially depressed and good
business sense indicated a repurchase of its shares on the market, it
would be prohibited from making that repurchase.
Use of the purchase method of accounting is not without its
problems, too. The calculation and reporting of intangible assets and
goodwill is dependent upon subjective and speculative ``measurement.''
The accounting profession continues to grapple with how to properly
value intangible assets and goodwill, and, as of yet, there are no
clear-cut solutions.
Technical Issues
FASB's decision to eliminate the pooling-of-interest method and to
shorten the allowable amortization period of goodwill to 20 years is
based on two assertions: first, that all business combinations are
equivalent to a purchase where one firm acquires another and gains
control; and second, that all goodwill and other intangible assets
degenerate over time. We disagree on both counts.
Clearly, many of today's combinations do not meet FASB's assertion
that one firm gains control. For example, when the new entity has a
combined board of directors, management and staff, no clear-cut control
is established. In such cases, the exposure draft states that one firm
will be designated the acquirer based on the ``evidence available''
without stating what that evidence is or how it should be weighted in
the decision process. We do not believe that disallowing a longstanding
accounting method that addresses such an ambiguity without prejudice
against either partner, and substituting a methodology that may
ultimately rely on an arbitrary decision, is an improvement. When a
market activity does not fit an accounting model, arbitrarily forcing
it rarely achieves the desired result.
We also disagree with FASB's assertion that purchase accounting,
with its creation and amortization of goodwill, will result in more
accurate or more reliable financial statements. While some intangible
assets are definable, measurable, and have discernable lives, many do
not. For example, the same exclusive shopping mall part of a
nationally-recognized web site would have a very different value then
one as part of a simple family Web site created by any one of you or
your children. Its value--and concomitant ``goodwill''--would be
determined by ``on what Web site it was located.''
Furthermore, it is hard to see how the purchase accounting
convention--which lumps intangible assets that are unidentifiable or
identifiable but not measurable into an amorphous category called
goodwill that is immediately assumed to depreciate in value--provides
more accuracy. The excess of the purchase price over the fair market
value of the identifiable assets, i.e., the goodwill, is the result of
a complex interaction. In past times, it was interpreted as the premium
paid for the value of the ``ongoing'' concern--the brand name and the
customer and community relationships. While these factors are still
part of goodwill today, intangible assets in the new economy are much
broader and more pervasive. Education, management style, and
entrepreneurial spirit can easily represent the bulk of assets in
today's information technology-driven firms. Whereas, goodwill in the
old economy may have been a depreciating asset, goodwill in the new
economy may not be. The synergies achieved by modern combinations
create intangible assets that are designed to appreciate in value. That
is why the free market values them so highly. Plus, I have seen this
first hand when I merged my firm Prospect Technologies with another
firm two years ago.
While purchase accounting may have been useful for acquisitions of
firms with a large percentage of physical assets, it is inadequate for
combinations of firms composed primarily of intangible assets,
especially when those intangible assets are largely unidentifiable,
immeasurable and of indeterminate lives. It is hard to see how
combining the historical book values of an arbitrarily designated
acquiring firm with the estimated market value of an arbitrarily
designated acquired firm and some dubious measure of goodwill yields a
more reliable financial statement than a combination of book values,
especially if the combined entity engages in successive combinations.
Moreover, resorting to the approach of forcing a ``write-off'' of an
intangible asset merely because accountants cannot understand or
quantify it, is unacceptable.
A better course of action might be to examine the issues
surrounding the accounting of intangible assets and goodwill, and to
develop suitable methods for addressing this problem before prohibiting
a longstanding and well-understood accounting method. We urge FASB to
adopt this more cautious approach.
General Policy Considerations
In addition to the previously discussed technical objections, we
believe that the proposed action by FASB has broad economic
ramifications as well. We understand that FASB should, indeed must, be
concerned primarily with the ``relevance'' and ``reliability'' of
financial information, and not the economic consequences. However, the
Exposure Draft states two reasons for undertaking this project, neither
of which are relevance and reliability concerns. One concern was the
increasing amount of staff time at both the SEC and FASB being devoted
to mergers and acquisitions using the pooling-of-interest method. The
other concern was a desire to achieve international convergence of
accounting standards given the increase in international capital flows.
We believe proposals to change accounting standards undertaken for
staffing and/or international policy considerations ought to also
include domestic economic considerations in the evaluation process.
The fact that SEC staff are being asked to devote more time to
business combinations using the pooling method is as much an indication
of the increased importance of the high technology sector in today's
new economy, as it is an indication of excessive use of what some might
call a ``loophole.'' Today's high technology firms are composed
primarily of intangible assets. They are in many cases relatively cash
poor and, as such, are not in a position to buy other firms. They do,
however, wish to create synergistic value through business
combinations, and the financial markets have voted their approval.
While we share FASB's belief that accounting standards must remain
credible and reliable, the current method is well established and
widely understood and, in our view, clearly meets that standard.
Staffing constraints should not be sufficient cause for changing a
useful and workable approach.
We find FASB's other rationale equally non-compelling. There is no
plan currently in place to achieve convergence of accounting standards
for business combinations. Some countries allow the pooling method,
some do not, and others allow it in fairly restrictive circumstances.
If we want to adjust our standards on the basis of achieving
convergence of international policy, then we should have assurances
from the other countries of a similar commitment in advance, and the
decision process to adopt such changes should include domestic economic
consequences.
The technology and financial services sectors have played a crucial
role in our current position as a world leader. One reason for the
success of these sectors has been their ability to grow. We do not
believe that this opportunity for economic growth should be curtailed
because of staffing constraints or the desire to adjust our standards
to conform to our international competitors, especially when there is
no consensus abroad. We should not change our standards without more
compelling reasons.
Prospect Technologies and the U.S. Chamber of Commerce urge FASB to
reconsider its position and withdraw its exposure draft on this issue
until the issues surrounding the proper accounting of intangibles has
been vetted and all concerned parties have had the opportunity to
digest the findings. The issues at stake are of great concern to our
members and to all who want to encourage the continued economic growth
we are currently enjoying.
In conclusion, I would like to add that we are not asking Congress
to adopt accounting standards or to establish an official oversight
role, but rather to encourage FASB to rethink this rush to judgment.
While having its faults, the current accounting framework has worked
well. There are no egregious or exigent market failures driving this
proposal for change. There are legitimate concerns over the proper
accounting for intangibles and various groups and commissions have been
delegated to examine this issue.
Clearly, let us not take action until these groups help us by
shedding light on this growing problem. As a small business owner, I
believe we have time to wait and evaluate. Prudence dictates that we do
so. Thank you.
Mr. Oxley. Thank you, Mr. Lewis.
Thanks to all of our panel.
The Chair recognizes himself for 5 minutes for questions.
Now I know why I avoided an accounting class, which is
literally right across the street from my fraternity house. But
I am reminded of our good friend, Dick Armey, the Majority
Leader, who was introduced recently and said that he was an
economist. His mother wanted him to be an accountant, and he
didn't have the personality.
Anyway, this has actually been an interesting debate. Let
me begin with just a general question to our panelists, and I
will go the other way this time and end with Mr. Jenkins.
This is a general question. How would the elimination of
pooling accounting make financial statements more or less
accurate for investors and creditors under those circumstances?
Mr. Lewis?
Mr. Lewis. As I understand it, one of the issues, and I
will just point to one right off the bat, is the amortization
of the goodwill issue.
We have heard today and we understand that merging and
synergy is one of the reasons why companies come together and
merge. That is considered to be a depreciable asset.
I can tell you from personal experience when I did a
merger, or a marriage as I rather call it, it was not for a
depreciable asset, it was for increased asset. Yet, by FASB
rules, I would have to take that as a depreciation expense
against my balance sheet, not over 40 years, but over now 20
years. That could significantly reduce my--artificially
significantly reduce my income statement to my stakeholders and
stockholders in my firm. That is one of the issues right off
the bat.
Mr. Oxley. So that was less accurate.
Mr. Lewis. Yes.
Mr. Hoffman. To answer that directly, less accurate.
One other consideration that factors into the
consideration, generally when we are talking about intangible
assets, the only really fair way to value this is based on the
market. That value is based on comparables.
An interesting presentation I have seen by others, I will
try to briefly describe the concept, if you have three
companies, one of which decides to do two complimentary
technologies, both in-house and build them from scratch, then
one company does part of that technology, and the third does
the other part. Two and three merge. Comparability is lost,
especially on an EPS basis and a balance sheet basis, even
though, frankly, the actual success of the business is about
the same. So basically, now, you are forced to look only pro
forma, which is a different number than what is reported
publicly in the SEC filings.
So basically now you are relying on, frankly, Wall Street
sell side analysts and the PR machines of these individual
companies to state what the reality of their competitiveness is
on a comparable basis. That is a concern because sophisticated
investors have no real issue being able to ascertain the
difference there. The unsophisticated investor, which, frankly,
I think is the SEC's larger mandate, is the one who has a
difficult time seeing the difference.
Mr. Oxley. Thank you.
Mr. Bible?
Mr. Bible . Mr. Chairman, I can make it more accurate.
There is an accounting fiction out there. That is, equity has
no cost to it. The reality is cash and stock of a company both
represent the currency.
The accounting fiction is if I use stock, I don't have to
account for the economics of that transaction, and the example
the gentleman brought up over here is a perfect example.
Mr. Oxley. Thank you.
Mr. Powell?
Mr. Powell. Mr. Chairman, I think that elimination of
pooling would make the financial statements less accurate. The
reason is that it forces companies to go through a pooling
method that is not equipped to deal with intangible assets,
which represents 90 to 95 percent of the purchase price of
acquisitions today. It assumes that they depreciate over time,
and, in fact, that is not the case. As I mentioned in my case,
if a good acquisition, it increases, it does not decrease.
Therefore, the earnings per share number that would be
reflected in purchase transactions would be inaccurately
reflected in the financial statements.
Investors would make bad decisions as result of that, and
companies would make decisions about whether they should make
that investment based on whether they could afford the hit to
their earnings that was a fictitious hit.
Mr. Oxley. Mr. Jenkins?
Mr. Jenkins. Clearly, I believe they would be more accurate
and comparable, Mr. Chairman, because all companies would
account for acquisitions in the same manner. All companies
would account for acquisitions based on the value of the
currency that they use, whether it is stock or cash or a
combination of the two.
If I could quote really from a study made by an investor,
Credit Suisse First Boston, with respect to bank acquisitions
that were accounted for as pooling of interests, Credit Suisse
First Boston recalculated each bank's cash return on tangible
equity as if it had used the purchase method of accounting
rather than the pooling method of accounting.
Bank One, for example, in its acquisition of First Chicago,
the 1998 return on equity went from 27 to 12 percent. At First
Union it fell from 35 percent to 11.8 percent. BankAmerica's
return fell from 29 percent to about 10.8 percent.
The premium paid for these acquisitions ranged from 18
percent to 43 percent over the market value of those
acquisitions at the time. Without reflecting the acquisition
price paid, investors lose track of how much of their wealth,
how much of their dilution was involved in these acquisitions,
and they never can find it out again.
Mr. Oxley. Your statement is that those were bad
acquisitions?
Mr. Jenkins. No, not at all. They may not have been bad
acquisitions, but their subsequent performance with respect to
those acquisitions, their rate of return, rather than
reflecting 27 percent, really should have reflected 12 percent.
The 12 percent return may have been an appropriate and a
profitable return. It may have been a very good acquisition.
I am certainly not saying, for example, the example that we
use mostly around here, the AOL-NetScape acquisition was a bad
acquisition. All I am suggesting is that the investors needed
to have the information with respect to the excess of the
purchase price over the underlying value, underlying amounts
that were, in fact, recorded under pooling accounting.
Mr. Oxley. Aren't you in essence looking in your rear-view
mirror at this?
Mr. Jenkins. All investors need to evaluate subsequent
performance against the investment made.
Mr. Oxley. I thought that is what markets were all about,
that people made those decisions in the marketplace based on
their broker's advice, based on the particular company that was
advising them.
Mr. Jenkins. The markets do, in fact, make those decisions,
but they make them on information, on transparent information.
They cannot make it if they have no information.
Financial statements, financial presentations have been
widely acknowledged as being perhaps the single most important
area of information in assessing and keeping strong our capital
markets and providing a level playing field between investors
and sellers.
Mr. Oxley. Our time has expired.
I recognize the gentleman from Michigan, the ranking member
of the full committee, Mr. Dingell.
Mr. Dingell. Thank you, Mr. Chairman.
Gentlemen, is there anybody down there at the committee
table who would take issue with the fact that the purpose of
accounting is to get the truth so that the government
regulatory process and investors and the market may function
efficiently and correctly according to the law? You all agree
with that?
Let us take the gentleman, the second from your left, if
you please. I would like you to focus your attention, if you
please, on this question.
Two firms merge. They have the choice of using pooling, or
they have the purchase accounting for the acquisition. Are the
results going to be exactly the same in terms of their reports
and the accounting on that particular acquisition?
Mr. Hoffman. The reports as reported----
Mr. Dingell. The answer is, there will be a difference
between the two methods of accounting; will there not?
Mr. Hoffman. There will be a difference in what is
reported, yes.
Mr. Dingell. Let's take a look. One is going to say one
thing under one method, the other--the other method will give
you a different result. The two results are different. Which
will be the true result?
Mr. Hoffman. The problem is that that is not something that
is easy to say. I don't necessarily say one result is better
than the other. What my biggest concern----
Mr. Dingell. You have two statements, one of which says one
thing, one of which says another. Neither of them agree with
the other. You have two different results. Only one of two
differing results may be true. Which of the two results will be
true?
Mr. Hoffman. That is an awful assumption that one is
actually accurate at all.
Mr. Dingell. I am making the rather generous assumption
that one is correct and one is not. It may well be that both
are incorrect.
Mr. Hoffman. I think that is partially what the concern is
here, sir.
Mr. Dingell. We now, Mr. Bible, have ourselves in a
situation where we have--Mr. Bible, would you give us the
answer, your view on that?
Mr. Bible. On the question you rose with Mr. Hoffman?
Mr. Dingell. You have two statements coming in with
different results. One may be true. If it is, the other is not.
Which is true, using the----
Mr. Hoffman. What I am trying to say, I would tell you that
is too hard to answer in all cases. The reality is that the
balance in different kinds of transactions is rather complex.
Mr. Dingell. Mr. Bible, what is your comment?
Mr. Bible. The statement that reflects purchase accounting
would be the most accurate. Whether you use cash or stock to do
the acquisitions should not make a difference.
Mr. Dingell. The gentleman on the end?
Mr. Lewis. Mr. Dingell, you, like several in the room, are
not a CPA but do have a legal education.
Mr. Dingell. I also know how to find truth.
Mr. Lewis. That is what we are all trying to do, sir. One
of the things my attorney says to me is, it all depends. I
believe that is what we are saying today.
Mr. Dingell. I am like Harry Truman. I am still looking for
a one-handed economist, because I know I am going to get the
truth.
Mr. Powell. Could I answer that question, Congressman?
Mr. Dingell. Quickly, Mr. Powell.
Mr. Powell. I want to back up and say, first of all, you
don't have a choice as to which method of accounting you use.
There are rules which determine whether you have to use pooling
or----
Mr. Dingell. I am not quarrelling with that. Which am I
going to believe? My problem in a nutshell here is a very
difficult one. I don't mean to be discourteous to any of you,
but there is a vote on the floor, and our time is limited.
We have two different results. Let us say that a major U.S.
high-tech company buys another high-tech company. The investors
out there are going to see that if the high-tech acquired uses
purchase or uses the other system, they are going to have two
different results.
So then the result--the result of that acquisition is
acquired by a third high-tech company. The question is, who is
going to believe and how will they believe the resulting
accounting? You have now got accounting which can be different,
depending on the kind of accounting system used and the
assumptions made. How is an investor going to understand what
the facts might be, and how is the market going to properly
evaluate the result of that succession of three or rather two
acquisitions?
Mr. Hoffman. Mr. Dingell, the answer is, the truth is, what
is the cash situation? The reality is that most of these
companies that we are talking about, as they get more and more
layered, and various goodwill charges, and have amortization
situations, we start talking about other things.
The question is, are you continuing to generate more cash?
Are you continuing to grow your ability to generate cash
without spending significant assets?
Mr. Dingell. Some, however, you would note, are, in the
language of what I learned back in law school, committing daily
acts of bankruptcy by preferring one creditor over another,
making payments when they are incapable of addressing all of
their debts.
I am no advocate of any particular view, but you gentlemen
are here before us as a learned panel to advise us as to what
the system of accounting should be. I don't have any views on
this, but I don't think that we are here in a position where
you are able to tell us that the accounting system that you are
suggesting or not suggesting is going to arrive at the kind of
truth that we need to have a workable, transparent, intelligent
marketplace.
The problem that you confront is you are going to get
differing results, results which may or may not be believable.
But remember, I remind you, the accounting system is to produce
truthful results so that the company's management can
understand what the hell is going on in the company.
The Japanese did not do it, and as a result they have had a
continuing period of depression there that has gone on for
about 10 years. Other countries have the same situation where,
quite frankly, their accounting system lies most diligently to
all and sundry.
All I am trying to do is to have you tell me what is an
accounting system which would tell us the truth, which will
enable us to do business? You are here as a strong proponent of
one system. I am asking you to tell me, if you please, what is
that one system that is going to give me the truth?
Mr. Oxley. The Chairman would inform the members that we
have about 3 minutes left on the vote.
Mr. Dingell. I apologize, Mr. Chairman.
Can Mr. Jenkins just give us a quick answer, and we will
hear what he has to say?
Mr. Oxley. Briefly, please.
Mr. Jenkins. I believe there is one method that gives you
the truth.
Mr. Dingell. What is that?
Mr. Jenkins. That is the purchase method of accounting, I
believe, not the pooling of interests method of accounting, for
the reasons that I explained in response to Chairman Oxley's
question, that we need to reflect in the financial statements
for the benefit of investors, the consumers of that
information, the price paid for an acquisition, whether that
price be denominated in the currency called common stock or
denominated in cash. That gives the truth.
Mr. Oxley. The gentleman's time has expired.
The Chair notes there is a vote on the floor. There may be
another one subsequent. The Chair would have the subcommittee
in recess until 1 o'clock to give everybody the opportunity to
get something to eat for lunch, and then we will return at 1.
[Whereupon at 12:07 p.m., the hearing recessed to reconvene
at 1 p.m., the same day.]
Mr. Oxley. The subcommittee will reconvene.
Staff informed me a couple of our guests have to leave by
2:15, is that correct?
Mr. Hoffman. Yes.
Mr. Oxley. We will do our best. We understand if you have
to parachute out of here.
I recognize now the gentleman from Iowa, Dr. Ganske.
Mr. Ganske. Thank you, Mr. Chairman.
I thank our guests for being patient. This is the way it is
when we have votes. We go back and forth. We have to interrupt
these hearings.
Mr. Jenkins, in one of the addenda to your testimony, you
have quotes from various people in support of the change. I
notice that Warren Buffet is quoted, and he said, ``In essence,
there are some areas that I disagree with this proposed change,
but in general I firmly believe that this nongovernmental
organization ought to be the one doing this.''
First of all, what were Mr. Buffet's objections?
Mr. Jenkins. Let me paraphrase what I believe he said.
First of all, I believe he said that we should have one
method of accounting for business combinations, and it should
be the purchase method. Where he has some objections then deals
with the area of accounting for goodwill, and goodwill that
arises in a purchase business combination.
Whereas our current proposal requires that goodwill be
amortized over a period of not longer 20 years, Mr. Buffet
would suggest that it not be amortized at all but, rather,
tested for impairment. If the goodwill is concluded to have
lost some or all of its value, then a write-down should take
place at that point in time.
The difference that Mr. Buffet has with our current
proposal is completely focused on the question of amortization
of goodwill.
Mr. Ganske. Is there merit in his argument? Is there is
that something you are looking at in terms of changing?
Mr. Jenkins. It is something we are looking at. There are a
variety of ways that you could address the goodwill question,
and certainly I believe at this point in this project, in these
redeliberations, and based in particular on what we have heard
here and in our own hearings that we held, that the focal point
of the issue is on goodwill and how it should be treated once
it is recognized under a purchase business combination.
We have already allocated the majority of the time that we
expect to spend redeliberating this issue on that very
question. The issue of not amortizing goodwill at all but
testing it only for impairment is an approach that we will
consider carefully.
There are a variety of other approaches, too. One might say
not limit it to 20 years but leave it to the judgment of
management and the auditors. That is an approach. Another
approach is to recognize it but write it off immediately
someplace or another.
There are 4 or 5 different approaches. We are going to be
carefully considering all of those and balancing them against
the proposal that we made initially in our exposure draft. But
we have reached no final conclusions. We really have not begun
our redeliberations in this what I believe is the key focal
point of this discussion at this point in time.
Mr. Ganske. Okay.
Let me see if we can get agreement on this panel. Does
anyone on this panel think that Congress should get involved in
writing the regulation of this? You can just say yes or no
going right down the aisle.
Do you want Congress to--the political process to start
really getting involved?
Mr. Lewis. No.
Mr. Hoffman. We are glad Congress is showing a leadership
position in addressing the issue. I don't think there is any
real need for specific addressment of that issue.
Mr. Bible. No.
Mr. Powell. I don't believe that Congress should be
promulgating accounting principles. However, I do believe that
there is a place for congressional oversight, and that is when
it comes to when this is going to have significant implications
on the Nation's economy. FASB's role is not to do that. It is a
stated role not to do that. There has to be a forum someplace
that someone is looking at that.
Mr. Ganske. I am not arguing against a forum. I am asking
specifically, do we go to the floor of the House with a bill? I
don't know how much politically aware you are of the situation,
but, boy, some bizarre things can happen on the floor.
Mr. Powell. We are not in favor of accounting being
legislated on an issue-by-issue basis.
Mr. Ganske. I assume, Mr. Jenkins, you feel the same way?
Mr. Jenkins. I agree.
Mr. Ganske. My final question would be this, then. Let us
go back to the actual case as described by Mr. Jenkins that is
reported in the New York Times where the quote is, ``Pooling
accounting is ridiculous because it allows corporations to
pretend that they paid much less for an acquisition than they
did. Let's say company A buys company B for $100 million in
stock, and then a few years later sells company B for $50
million. In reality, that was a disastrous acquisition for
company A, but thanks to the magic of pooling, company A would
have shown the original acquisition as costing not the $100
million that it paid but a number that could be far lower, say
$20 million, reflecting the book value of company B. Presto,
company A reports a profit of $30 million when it actually lost
$50 million.''
I would just like to go down the row here. To me as an
individual investor wanting to really know how much a company
owes or has spent on an acquisition, I just want to know,
doesn't this specific case strike members of this panel as
something of concern?
Maybe we could start on this end. Isn't there some valid
concern about this type of accounting?
Mr. Hoffman. I am going to go ahead and step ahead, if you
don't mind. There are a couple pieces of data that are missing
to make a real judgment here.
One is, what were the relative valuations of the company at
the time the transaction was done? Did the market fairly value
that? The issue is the capital stock of the corporation.
Because when two companies come together you are talking about
a set of shareholders and another set of shareholders, and the
relative ownership of the entire company is diluted based on
the shares relegated to that acquisition.
Mr. Ganske. I understand that, but I am an investor out
there looking at the balance sheets.
Mr. Powell. Congressman, could I answer that question?
Mr. Ganske. Okay.
Mr. Powell. First of all, I think it is an interesting
theory, but, in reality, it rarely happens often.
I have had this question posed to me before. I had one of
the major banking firms, international banking firms, review
this to find examples of where this had happened, and they
could not locate examples where this had occurred. I think that
is the first point that I would like to make.
Mr. Ganske. But how do you respond to Mr. Jenkins, who gave
several examples of a recalculation by Swiss Credit, for
instance, on bank acquisitions, where there was a difference?
Mr. Powell. I think that the issue that Mr. Norris is
reporting is a different issue, which is you sold off assets
and reported a gain, when in fact you sold them for less than
what you paid for them. I think--so I would like to speak to
the Norris issue, if I could.
If you think about the fact that--let's suppose in the
example that I used, a company A, company B, you have twice as
much stock outstanding. If you are going to sell the company
that you expected to generate twice as much income, what
happens the day that you sell that is you have lost your
revenue stream and profit stream, and your income, in the
example that I give, is going to go from $2 a share to $1 a
share.
I don't know many management people that are going to be
around once that happens. To view that in some sort of positive
way is wrong. It is going to be viewed very negatively, and it
will have an impact on that management team.
The other thing is that if you look at one-line types of
transactions, as we see in in-process research and development
or restructuring charges, analysts have a tendency to discount
those and not give credit to those reductions.
The same thing happens on one-time gains. Management is not
going to look at that gain and give a credit to the management
team for the fact that that one-time gain occurred. They are
going to look more to what is the impact on the earning stream.
The last thing that I would say is if FASB thinks that this
is an issue that is subject to abuse, let us deal with the
abuse but not throw the baby out with the bath water. I think
that is the same position that the committee on corporate
reporting of the FDI suggested in their FASB testimony, if
there are abuses, let us fix them, but not throw out the entire
methodology.
Mr. Oxley. The gentleman's time has expired.
Mr. Ganske. Maybe Mr. Bible can answer that.
Mr. Bible. All I would say is that you all have your
constituents. Our constituents are shareholders. If I give you
a tool to make it look like you are doing better than you
actually are, would that be fair?
Mr. Oxley. It happens all the time.
Mr. Bible. We are trying to get rid of it in the accounting
world.
Mr. Powell. I would turn that around to say, should we be
penalized for a negative transaction that in reality does not
reflect the economics of what the transaction is?
Mr. Oxley. Thank you.
The Chair recognizes the vice chairman of the subcommittee,
the gentleman from Louisiana.
Mr. Tauzin. I thank the Chair.
Mr. Jenkins, I chair the Subcommittee on
Telecommunications. My interest in these high-tech companies
and what they are doing for the economy stems from that work.
Let me first ask you about our relationship, Congress, to
your agency. I am very pleased to hear you today indicate that
concerns expressed by Members of Congress about the work of
FASB, making sure that you account for those concerns, is in
fact a relevant relationship, because I hope it clarifies the
open letter that FASB sent out.
It seemed to indicate that we had no business engaging in
any legislative activity, that that might threaten the
independence of FASB. Your quote is, ``Explicit or implicit
threats of increased legislative activity create a real risk of
continued viability of private sector standards setting.''
Do you really believe that? Do you believe we don't have a
role here in oversight, in recommendations and in letters like
our chairman has sent to you, urging that you go slow and
examine some of the concerns that have been raised by the other
side or concerns about the purchase method of accounting?
Mr. Jenkins. Congressman Tauzin, I stated in my testimony,
not only here but earlier in my testimony before the Senate
Committee on Banking and Financial Services, that we support
and understand and accept the oversight responsibility of
Congress. I have no problems with that.
Mr. Tauzin. I should hope so.
Mr. Jenkins. Just as a matter of clarification, please, the
letter that you are reading from is not a letter from the FASB,
it is a letter from the trustees of the Foundation. My
understanding, having talked with the trustees about that
letter, is perhaps it is inartfully worded.
Mr. Tauzin. That is not your view?
Mr. Jenkins. I'm sorry.
Mr. Tauzin. That letter does not reflect your view?
Mr. Jenkins. No, it does not reflect my view.
Mr. Tauzin. Let me ask you, with reference to another
letter, however, that you did send to Members of the Senate who
wrote to you concerned about problems in the purchase
accounting method and addressed recommendations to you, I think
the tone of their letter was, before you go around repealing
pooling that you had better doggoned fix up the purchase
accounting. If you have two systems, neither one of which are
working good, you don't want to throw one out and accept
another equally bad. Fix that up first.
I thought that was a pretty good letter. I thought the
chairman's letter to you was excellent, particularly when he
pointed out that intangibles do not necessarily depreciate,
often they appreciate. If you set some arbitrary depreciation
schedule on intangibles in this new economy that you will, in
fact, be encouraging false and inaccurate information to the
public, when the truth is that intangibles in this new economy
may be an increasing and appreciating asset that investors
ought to know about and ought to have real information about.
But you wrote to the Senators in effect saying that, look,
we haven't made any final decision about this; we are going to
consider everything. But the only thing you did in your letter
was to cite examples of complaints about the pooling method.
As I read your letter, it seems to me you have made some
preliminary judgments that you plan to abandon it and go to
purchase accounting, with no necessary attention paid to the
flaws in that system. It seems you are saying we are not
interested in your recommendations. We insist that the pooling
method is no good. Here are the reasons why. And, by the way, a
whole range of the Board's constituents have told us that and
you have not paid attention to them yet because you did not
allow them to testify at some Committee on Banking and
Financial Services, Housing, and Urban Affairs. That is the
gist of your letter.
Is that the way you respond to congressional concerns that
the purchase accounting method has serious flaws in it that
ought to be adjusted for this new economy?
Mr. Jenkins. I think it is evident that we do intend and
have addressed concerns with respect to purchase accounting. We
will reconsider all of those decisions in our redeliberations.
With specific respect to intangibles, in our proposal we
did change--we did propose to change the current requirement
for intangibles, which is in place and has been in place since
1970, that required them all to be amortized over some common
period. We did change that to permit flexibility on the part of
management in determining the lives over which intangibles
should be amortized.
Mr. Tauzin. The point is, what happens when they are
appreciating in value? What happens when 80 percent of the
company is all about knowledge, it is all about eyeballs, about
the potential of this company attracting customers to products
that are advertised that surround a package of information, and
all of that is appreciating as more and more people come to
that site, that e-com business, and use those services and view
those advertisements and buy those products?
Are you saying that the company has no choice but to write-
down that intangible asset over some arbitrary, fixed period?
Is that not false information?
I notice the ranking minority member, Mr. Dingell, talking
about the search for the truth. But is that not the opposite of
the truth?
Mr. Jenkins. I think the first thing we have to do is get
the intangibles recognized in the first place. Recognizing
intangibles in the first place does not come about through the
use of the pooling of interests method.
The second point is to your point. Some intangibles are
going to increase, some intangibles perhaps are going to
decrease. We don't always know. But under our system of
accounting, that has been true for a long time. Some of our--
some trademarks of old line companies increase in value and
some decrease, but we generally don't recognize them.
Mr. Tauzin. Mr. Jenkins, I just want to say one thing, and
then ask you a final question.
The first is that of all the things I have seen that can
severely impact the extraordinary growth of this new economy,
what you do here may have more impact than what we do in policy
up here. How you handle this issue and how carefully you handle
it and how well you handle it may well determine whether or not
this new economy continues to grow, whether we inflate or
whether we deflate it.
We are deeply concerned about that. We have tried to
express that to you. I want to second the comments of the
chairman of our committee in his letter to you. I think it is
an excellent letter of concern that I hope you folks have taken
seriously.
In his letter he makes a request of you. He requests that
FASB commence a comprehensive study of the accounting treatment
of intangibles, and he further requests that you wait until
those results of the separate studies being conducted by the
SEC and hopefully by yourselves on this issue might be
concluded where we can all get a good handle, a good look at
it.
What is your response to his request?
Mr. Jenkins. I responded in part in my testimony when I
made the point that the one study is not really relevant to
dealing with intangibles. Mr. Powell, who was a member of that
group, concurred in that.
We are beginning in our own process to consider
intangibles. We will be giving careful thought as we go forward
as to whether or not it is or is not appropriate at the end of
the day for us to go forward with this standard without coming
to a final conclusion on accounting for all intangibles.
We do intend--with respect to the intangible that is most
significant by a long ways in respect to purchase business
combinations, goodwill, we do intend to carefully consider all
of the various alternatives that I described for the
Congressman from Iowa in open meetings before we reach a final
conclusion. We will listen carefully to what we have heard in
these meetings.
Mr. Tauzin. Can I inform the chairman as a result of our
conversation today that your answer to him is yes?
Mr. Jenkins. The answer is not necessarily yes, because I
cannot guarantee you that we will solve all of the problems of
intangibles before we go forward.
Mr. Tauzin. He simply asked that you let all these studies
happen, that we have a chance to look at all these studies and
get a chance to analyze the different outcomes of these studies
before you move. Can I inform him at least that that is a
likely outcome here?
Mr. Jenkins. We will consider those studies as we go
forward. The outcome----
Mr. Tauzin. You are going forward as the studies are being
done?
Mr. Jenkins. The timing of those studies is out of our
control.
Mr. Tauzin. So the answer to the chairman is, you may move
even before the results of the studies are in?
Mr. Jenkins. I do not even understand or know what the
nature of those studies are, with all due respect. I can't
commit myself or my board to the outcome of studies about which
I do not know their approach or anything.
Mr. Tauzin. Mr. Jenkins, with the indulgence of the
chairman, let me just say, sir, that you are inviting
legislative action when you give an answer like that. When the
chairman of our committee--and you have heard the expression, I
think, of many members of the legislature that we consider this
of such a serious note that we have asked you to make sure that
these studies are in before you make this momentous change in
the way these accounting rules--these generally accepted rules
are applied to this new economy--I think you have heard enough
of us telling you that over and over again that when you tell
us that you might not wait for the results of the studies, you
might plow ahead with some preconceived notions even, that just
invites legislative action.
Mr. Jenkins. We don't have any preconceived notions. We
will consider all of the evidence. We will consider very
carefully and take very seriously your admonitions to us and
what we have heard today from everyone on this subcommittee,
and we will do our very best to make sure that we consider all
of the evidence before we make any decision and the
applications of our decision.
Mr. Oxley. The gentleman's time has expired.
The gentleman from California, Mr. Cox.
Mr. Cox. Thank you, Mr. Chairman.
I would like to thank each of the members of our panel,
some of whom I had a chance to say thank you to during the
break, for your presence here and your willingness to indulge
the Congress' interest in this.
I think that the topic that Chairman Tauzin has gotten us
into here is worth pursuing in two respects.
First, I think, as I mentioned in an aside to Mr. Jenkins,
that the real issue here is the accounting treatment of
intangibles. There has been a lot of change in our economy over
the last many years, and the relative role played by what we
loosely call goodwill M&A is significantly larger now than ever
before.
The second issue that Chairman Tauzin raised that I think
is worth pursuing is what the Congress ought to do in this
circumstance. I think my colleague, Mr. Ganske, certainly
crystallized, at least with you, this panel, about whether
Congress should write a law and describe the proper accounting
treatment for intangibles in all cases or the proper accounting
treatment for business combinations, managers, acquisitions,
and so on.
I would not be inclined to do that myself. Although I think
the best answer to your question, Greg, as to whether it would
be a good idea for Congress to write the accounting standards
is, is the congressional proposal as bad as FASB's? If it is
not, then it would be superior, at least in that instance.
But I think your question really goes to the precedent we
would be setting and the kind of system we would inherit if we
willy nilly got into the business of writing accounting
standards.
What Congress might do, with greater restraint and wisdom,
however, is force a delay, a moratorium until the information
is in. I did that with Internet taxes, and my legislation which
I wrote with Senator Wyden is going to be on the floor next
week.
Again, we already have a moratorium in place as a result of
legislation I passed a couple of years ago, and the Internet
Tax Freedom Act moratorium as a result of what was just
reported out of the Committee on the Judiciary will now be
extended a further 5 years, assuming that we are successful on
the floor of the House and on the floor of the Senate, as we
were today on the Committee on the Judiciary, where I think the
vote was 29 to 8.
It would not be irresponsible, although it would be quite a
change from the way normally we do business, I think, for
Congress to require FASB to look at the information. And if the
information is not in before you make your rule, I think it
raises serious questions.
If you don't know what the studies are about, that scares
me right there, because that is where we ought to be focused.
The bread and butter accounting, as we all learn in
business school or wherever we first learn accounting, is based
on a paradigm in which book value is the only thing you can
really sink your teeth into. We recognize book value doesn't
represent real value, but it is a real number. We know where it
comes from, so we put a lot of our heart and soul into that
back value figure.
In that paradigm, goodwill is the fudge factor. But what
happens is that the fudge factor, which is something we never
really could get our arms around, has sort of taken over the
universe, in much the same way that the Arab mathematicians
flirted with the idea of irrational numbers when they first
tried to solve cubic equations.
Remember, Omar Khyam, for example, figured out how to solve
cubic equations but looked at this multiple of the square root
of minus one as a false root. They didn't know what to do with
it. They screwed around with it for a long time. These days,
not only are we comfortable with the square root of negative 1,
but you cannot manage an electric circuit without it.
I think we need to get a little more comfortable with
goodwill, with intangibles, because that is the 21st century.
That is really this hearing ought to be focused on. It is what
it really ought to be about.
If I were to ask you the same unfair question that Chairman
Dingell or former Chairman Dingell, Ranking Member Dingell,
asked a moment ago when he said what is the truth, purchase or
pooling, in an arbitrary transaction, the facts of which none
of us is informed, and if I were to ask you what is the
depreciable life of goodwill, Mr. Jenkins, what is the answer
to that?
Mr. Jenkins. I would acknowledge that the amortization of
goodwill as a single number is arbitrary, but that doesn't mean
that it is necessarily wrong. It is an estimate of life. We
have had goodwill being amortized for a long time over varying
lives.
While there is an outside limit, there is certainly not a
prohibition against using anything shorter than that. And, in
fact, in the many, many acquisitions in the high technology
area, for example, that have not been accounted for as purchase
transactions, they utilize goodwill life that is significantly
shorter than 20 years, or 40 years, for the most part.
I think you are correct, that the focal point of this issue
is on goodwill. I acknowledge that. I expect that we will be
spending very much of our time over the next many months as we
work on this issue trying to resolve the goodwill question.
I described several alternatives a few minutes ago that we
intend to reexplore. Many of those concerns and our attention
to this come out of this hearing and out of previous hearings
and listening carefully to our constituents.
So I agree with you. The focus is on goodwill. I think we
will address it. We have a group that has asked if they can
make a presentation to us on a methodology for dealing with
goodwill. I do not know what it is, but we certainly have
agreed to do that. We will be having a public meeting of our
board at the end of this month where that will be displayed for
us, and we will carefully consider it.
I agree with you. That is the focus and where we need to
spend our efforts as we proceed to explore this issue.
Mr. Ganske. Will the gentleman yield?
Mr. Cox. Sure.
Mr. Ganske. I am trying to get my hands around this
goodwill concept. Let me see if I can put it into a specific
example.
In Des Moines, we had a company called Pioneer which was
bought by DuPont at a premium above what the stock was selling
for. So that difference, is that what you would call goodwill?
Mr. Jenkins. No, not necessarily.
Mr. Ganske. Okay. Because I wonder whether it is part of
it.
Mr. Jenkins. It could be part of it.
Mr. Ganske. That was premised on the management for
Pioneer, which was well respected, sticking with the new,
larger company for a period of time. It did not work out that
way. Management left rather quick.
I am just wondering whether in fact there aren't some
intangibles that are always going to be intangible, and how
well you think you can actually get your hands around that
component of so-called goodwill.
Do you have a comment on that?
Mr. Jenkins. Yes, I do. I think that is a good example of
an intangible that probably cannot be specifically valued but
does get subsumed into goodwill. It is a portion of goodwill.
One could also conclude that if the entire difference
between the market value and the purchase price was due to this
management and then they left, that at that point you ought to
write off that portion of goodwill, because it is no longer
there.
That might be what we would say is one of the approaches I
suggested to you, that we recognize goodwill, we recognize this
need for superior management to stick around, but we don't
amortize it. But if they leave, you write it off.
Mr. Ganske. That is where I see that Dr. Lewis and Mr.
Hoffman and everyone else on the panel--you are all very
bright, but let's say that Mr. Hoffman's company gets scarfed
up by a bigger guy. I would want Mr. Hoffman to stick with my
company, my bigger company. The premium that I would pay for
that would include him. But if he left, I think I would be--I
wouldn't have gotten the value.
Mr. Cox. Let me add to your question another example we
might think about. Let's say that the Tribune Company and Times
Mirror combined. How much, Mr. Jenkins, did that cost?
Mr. Jenkins. I don't remember the number.
Mr. Cox. No, I mean what is the cost of that combination?
Mr. Jenkins. I think the cost is the consideration that the
Tribune Company paid for the Times Mirror.
Mr. Cox. Does it matter if they used outstanding shares or
newly issued shares?
Mr. Jenkins. It doesn't matter if they used outstanding or
newly issued, or if they use cash or shares.
Mr. Cox. So your sense--I use that because the Times Mirror
and Tribune Company are roughly comparable in size, and there
are some bragging rights going on about who got whom in the
deal. And if you are from Chicago, there is no question. If you
are from California, there is some question there.
But at least to read the newspapers, which seem to be
carrying fair and full accounts of all of this, they are really
going to combine the operations. That is really what is
happening in economic reality. What is the cost of that? What
is the economic cost of that combination?
Mr. Jenkins. I still believe that in that case, and I have
not examined it in detail, that you can determine which company
acquired the other company.
Mr. Cox. What if that is not really what happened?
Let us back off of that example, if you think that there is
a flaw in my analogy.
Let's take a situation in which, having done M&A work for a
decade, I can tell you happens fairly frequently, and you know
this better than I because you have done this for more of your
life, if you have two partners in a business transaction and
they get together--and they really get together, one did not
swallow the other--they get together, they--somebody used the
term ``marriage'' earlier, community property, let us say that
is the economic reality. What is the cost?
Mr. Jenkins. I just think in that case I think the best
answer is to say that you have a new entity. You have put two
companies together. You have created a brand new entity.
Mr. Cox. How much in economic terms--to put on your
economist's hat, in economic terms how much did that cost?
Mr. Jenkins. I would say that you would recognize the value
of the assets of both parties that have contributed to that
transaction, the fair value of the assets.
Mr. Cox. That is a different question. That is a question
of how you write up the assets on the balance sheet.
My question is, what is the economic cost? Think of this as
sort of a physics question. You have some molecules. They bump
into each other. What is the energy expended? It is that sort
of question. In economists' terms, what is the costs?
Mr. Jenkins. Again, I think it is the fair value of the
assets that they each contribute.
Mr. Cox. The assets are still there. The assets did not go
away. They are still there.
Mr. Jenkins. I understand, and you are recognizing all of
those assets from both parties at the fair value when they are
contributed.
Mr. Cox. You are making a different and valuable point,
which is that this might be a good opportunity to recognize the
current market value of those assets and not run them at the
old book value. If you come up with a better way than purchase
or pooling, probably that is one of the things you will want to
take a look at.
Mr. Jenkins. Yes, we are.
Mr. Cox. I am asking a different question. I am asking
whether or not there is a real economic cost to the
combination. Rather than trying to beat my answer out of you,
let me give you my answer to that, which is that the cost of
the combination is probably the extra lawyer fees that you paid
to file with the SEC and your Hart-Scott-Rodino fees and your
extra accounting fees to do whatever is necessary, and, you
know, if it is a big combination, that is a trivial amount.
In fact, there is no business asset lost or consumed in the
transaction. All the cash of the one company and all the cash
of the other company is still there. In fact, they probably got
a new joint bank account and you can see all the money still
there. You can keep your eyeballs on it.
So that a bias in the accounting system that absolutely
requires in that case that somebody be the acquirer and
somebody be the acquiree and that there be a cost of the
transaction and that it be a significant amount and measured in
terms of the full value of the assets of one of them, that it
seems to me to be strange to use a paradigm that is not always
the right one.
To use another one of those ancient analogies, it is like
that Procrustean bed where Procrustes stretched all of his
victims to fit. Sometimes it does not work. Purchase accounting
is designed with some paradigms in mind, and it is absolutely
perfect for some business combinations, but in other cases it
is not.
Mr. Bible has been desperate to get a word in edgewise I
think, with the chairman's indulgence.
Mr. Oxley. We will make this the last word edgewise.
Mr. Bible. I would add, Mr. Chairman, it depends on what
economic school you believe in. But the bringing together of
both, there was a decision made. That is, I can achieve the
most value for my interest by combining with you, Mr. Chairman,
in a joint venture, rather than selling to a third party. I
think that is the economic reality that Ed is speaking of.
Mr. Powell. Could I make one comment? In reality, this is
two groups of shareholders coming together and combining their
interest. No one acquired anyone else.
The reflection of that is that if I own 10 percent of that
company before, I will now own 5 percent of that company. The
cost is in the dilution of me as a shareholder. But in terms of
one company acquiring another, Congressman Cox is exactly
right. There was no cash exchanged. No company gave up assets
to purchase this. There was simply a combining of those two
companies, and that is what pooling is all about.
Mr. Bible. No, they made a decision to give up cash to a
third party sale to join with the Congressman in a merger.
Mr. Cox. I want to point out that some people think
accounting is boring, but this, you can see, it is just loaded
with interest.
Mr. Oxley. This is put on your helmets.
I recognize the ranking member for a unanimous consent
request.
Mr. Towns. Thank you, Mr. Chairman.
I ask unanimous consent that I place in the record
Congressman Crowley's statement and also questions to be
answered in writing to Mr. Jenkins.
Mr. Oxley. Without objection.
[The prepared statement and questions of Hon. Joseph
Crowley follow:]
Prepared Statement of Hon. Joseph Crowley, a Representative in Congress
from the State of New York
Thank you Mr. Chairman for holding this critical hearing and for
allowing me to be here today.
I have a serious concern about the impact of the Financial
Accounting Standards Board's (FASB) proposal, in its Exposure Draft on
Business Combinations and Intangible Assets, to eliminate the pooling
of interest's method of accounting. I am very concerned that this will
have a negative impact on the American economy, particularly on the
fast-growing companies driving our increasingly knowledge-based
economy-what people are calling the new economy.
Financial experts have said that the proposal will have the
greatest impact on the financial services, information technology, and
pharmaceuticals sectors, areas of our economy that, according the to
Commerce Department, accounted for nearly 30 percent of America's GDP
in 1998. Information technology alone was responsible for over 28
percent of U.S. real economic growth in 1997. Those percentages
represent a large number of jobs, both in those industries directly,
and in collateral and support industries.
I understand that FASB has received nearly 200 comment letters on
its Exposure Draft. In its own summary of the comment file, FASB noted
that more than three quarters of the letters addressed the proposal to
eliminate pooling. Of those, the banking and high-tech sectors strongly
disagreed, and the rest were ``split.'' This does not sound like the
kind of endorsement of a proposal that compels immediate action.
Rather, with such disagreement on the value of the proposal, I would
suggest the wiser route is to reconsider and address some of the
concerns raised.
It is also my understanding that the responses, in fact, were 3 to
1 in favor of retaining at least some form of pooling, or for not
eliminating pooling until significant other issues related to the
purchase method, the only remaining method, were resolved. And these
responses include the Big 5 accounting firms. In light of such
significant opposition and the very real concern about the impact of
the proposal on our economy, what is the rush?
The pooling method of accounting has been around for many decades.
I know of no clamor, and no crisis, which demands immediate action on
the issue. In fact, only six years ago, Mr. Jenkins, in a comprehensive
AICPA study on business reporting that he headed before he became FASB
chairman, found that ``the existence of the two accounting methods is
not a significant impediment to users' analysis of financial
statements. A project to do away with either method would be very
controversial, require a significant amount of FASB time and resources,
and in the end is not likely to improve significantly the usefulness of
financial statements.'' Why then the rush to act?
It may well be that something needs to be done regarding pooling of
interests accounting. I am not an accounting expert. But I am concerned
when so many experts in their field express the kinds of concerns I
have been hearing. In fact, I understand that eleven Members of the
Senate Banking Committee, a bipartisan majority, have written a letter
to the FASB suggesting that it defer its decision on pooling until the
concerns and issues relating to the purchase method have been resolved.
I have also joined Congressman Cal Dooley and a number of my colleagues
in sending our own letters on this topic.
FASB has stated the importance it places on international
harmonization of accounting standards as justification for this
proposal. I would only point out that the home countries of many of
U.S. companies' strongest competitors permit pooling. Britain, Germany
and Japan all permit some form of pooling. Our economy is the strongest
in the world, based in part on the ability of companies to innovate and
reach productivity through mergers. Do we really want to throw this new
hurdle in front of U.S. companies?
I would hope that FASB is taking these concerns seriously. I
certainly do. I urge FASB to take some more time to consider the very
serious concerns raised over this issue.
Mr. Chairman, once again, thank you for calling this important
hearing. I look forward to working with you and my colleagues on this
important issue.
______
Congress of the United States
House of Representatives
May 4, 2000
The Honorable Michael G. Oxley
Chairman
Subcommittee on Finance and Hazardous Materials,
Committee on Commerce
2125 Rayburn HOB
Washington, D.C. 20515
Dear Mr. Chairman: I would appreciate your assistance in including
the following questions for Mr. Edmund L. Jenkins, Chairman of the
Financial Accounting Standards Board, in the record for today's
Commerce Subcommittee Hearing on the Financial Accounting Standards
Board's proposal to eliminate the ``pooling of interests'' accounting
method. I would also like to thank you for your leadership on this
issue and for calling this important hearing.
1) Many knowledgeable people have said that FASB's decision to
eliminate pooling could have a damaging impact on economic
growth. In a recent white paper, Merrill Lynch concluded that
the change could result in a notable decline in the
consolidations that have enhanced productivity, encouraged
innovation, and stimulated dynamism in the U.S. economy. And, a
Goldman Sachs study specifically says that FASB's changes could
have a dramatic impact on certain industries, including
information technology and medical devices. Why is FASB willing
to take the chance that they are right?
2) You have received a number of thoughtful alternative proposals to
the elimination of pooling. You have a great deal of concern
about the valuation of intangibles. What is the rush to
eliminate pooling rather than looking first at the valuation
questions? If the problem with studying the issues is that it
will take some time, why not do it right the first time rather
than in a piecemeal fashion, especially when the consequences
of ``getting it wrong'' could be so severe?
3) A review of the comment letters sent to FASB shows that two-thirds
of all of those who sent comment letters and all of the Big 5
accounting firms advocated either retaining at least some form
of pooling or not eliminating pooling until significant other
issues were resolved. Why is FASB determined to abolish pooling
in light of this significant opposition to its decision?
4) Your Exposure Draft specifically states that international
harmonization is one of the reasons for your decision to
eliminate pooling. Let's assume for a minute that that is a
valid goal. Given the fact that countries like the U.K.,
France, Japan and Germany permit pooling, at least in some
form, how could eliminating pooling here increase international
harmonization? Assuming that various foreign and international
accounting rules are moving away from allowing pooling
accounting, why should the U.S. be following a trend in Europe
or elsewhere rather than encouraging the adoption of U.S.
rules?
Once again, thank you for your assistance in this important matter.
I look forward to working with you, the Committee and our colleagues
who support the burgeoning high-tech economy.
Sincerely,
Joseph Crowley
Member of Congress
cc: The Honorable Edolphus Towns, Ranking Member
Mr. Oxley. Should anyone else wish to submit written
questions, that would be acceptable, as well.
The Chair would ask unanimous consent that extraneous
materials, including a study called ``Valuing the New
Economy,'' a white paper, be made part of the record.
Without objection, so ordered.
Gentlemen, thank you very much for your appearance today.
Mr. Cox is correct. We have put a new twist on an old
profession, and that is always exciting. Thank you for your
participation.
The subcommittee stands adjourned.
[Whereupon, at 2:04 p.m., the subcommittee was adjourned.]
[Additional material submitted for the record follows:]
Financial Accounting Standards Board
Norwalk, Connecticut
May 23, 2000
Mr. Robert E. Simison
Legislative Clerk
Committee on Commerce
United States House of Representatives
Washington, DC 20515
Dear Mr. Simison: The following is our response to the questions
raised by Congressman Joseph Crowley in his May 4, 2000 letter to
Chairman Michael G. Oxley in connection with the May 4, 2000 hearing of
the Finance and Hazardous Material Subcommittee of the Committee on
Commerce (``Subcommittee Hearing''):
Question 1 Congressman Crowley writes: ``Many knowledgeable people
have said that FASB's decision to eliminate pooling could have a
damaging impact on economic growth. In a recent white paper, Merrill
Lynch concluded that the change could result in a notable decline in
the consolidations that have enhanced productivity, encouraged
innovation, and simulated dynamism in the U.S. economy. And, a Goldman
Sachs study specifically says that FASB's changes could have a dramatic
impact on certain industries, including information technology and
medical services. Why is FASB willing to take the chance that they are
right?''
Response: The Financial Accounting Standards Board (``FASB'' or
``Board'') has issued an FASB Exposure Draft, Business Combinations and
Intangible Assets (``Exposure Draft''), for public comment that has
proposed to eliminate the pooling-of-interests method (``pooling
method''). The Board will hold as many public meetings as necessary to
carefully evaluate all of the feedback received in response to the
Exposure Draft and to decide what modifications or clarifications, if
any, to the Exposure Draft are appropriate. The Board will not make any
final decisions about the Exposure Draft, including whether or not to
retain the pooling method, or consider whether to issue a final
standard, until it has completed its full due process and is satisfied
that all substantive issues raised by all parties have been carefully
considered.
The Board has proposed to eliminate the pooling method because the
Board believes that the elimination of the pooling method will benefit
consumers--investors, creditors, and other users of financial
statements--as well as companies that prepare those reports, by
providing more information, and more relevant information, about all
business combinations.
The Exposure Draft's provisions also will benefit consumers by
improving the comparability of financial reporting, thereby making it
possible to more easily contrast companies that participate in business
combinations.
Many consumers have expressed support for elimination of the
pooling method. As one example, a letter from the Financial Accounting
Policy Committee of the Association for Investment Management and
Research, the leading organization of investment professionals in the
United States with over 40,000 members, states:
The FAPC is unequivocal in its support of the FASB's proposal
that there be only one method of accounting for business
combinations in the United States. We also agree that the
purchase method is the one that reflects properly the economics
of all business combinations, and that pooling-of-interests
should be eliminated . . .
The pooling method fails to revalue the assets and
liabilities of the acquired enterprise at fair value and the
excess, commonly called ``goodwill,'' is not recorded. Hence,
pooling does not faithfully represent the values of the assets
and liabilities exchanged, nor does it reveal the actual
premium paid by the acquirer in the transaction. Users of
financial statements are thus impeded in their attempts to
understand the underlying economics of the business
combination.
In addition, Moody's Investors Services, the leading global rating
agency, stated:
Moody's supports the objectives of accounting standards
setters to improve the harmonization of accounting standards
globally, and welcomes the FASB's proposal to eliminate the
pooling of interests method. We believe that a single
accounting method can improve analytic efficiency, especially
in cases where a single transaction or essentially identical
transactions would produce dramatically different accounting
results, and thus enhance the ability of cross border capital
market participants to compare, easily and accurately,
alternative investments.
Many companies that prepare financial reports also agree. Those
companies that have written letters to the FASB supporting the
elimination of the pooling method include IBM Corporation, Eaton
Corporation, American Electronic Power, General Motors, Caterpillar,
Inc., IMC Global, Cigna Corporation, and PPG Industries, Inc., to name
a few. The IBM Corporation letter stated:
IBM agrees with the FASB that all business combinations are
acquisitions and, thus, we support the FASB's proposal to
eliminate the pooling-of-interests method of accounting for a
business combination. We believe that financial statement users
are ill-served by the existence of two methods to account for
the same economic transaction. We agree with the FASB that
using the purchase method to account for all business
combinations will increase the comparability of financial
statements and will reflect the true economics of the
transaction, that is, an arm's length investment that should be
accounted for at the fair value of the assets and liabilities
that are acquired.
The Exposure Draft's provisions will also benefit companies that
prepare financial statements and the auditors of those statements by
providing a single method of accounting for all business combinations.
Having one method of accounting for all business combinations will
reduce certain costs to companies and auditors that are currently
related to the existence of the pooling method.
For example, the availability of the pooling method often puts
companies and their auditors under pressure to employ that method
because it typically produces higher reported earnings and rates of
return subsequent to a business combination than the purchase method.
Moreover, because the pooling method is applied retroactively, the
comparative earnings reported for periods preceding the combination are
also higher than under the purchase method--even before the companies
were, in fact, combined.
As a result of those pressures, companies often must bear
significant costs, both monetary and nonmonetary, in seeking to use the
pooling method. In positioning themselves to try to meet the 12
qualifying criteria for applying that method, companies may refrain
from engaging in appropriate economic actions that they might otherwise
undertake, such as asset dispositions or share reacquisitions. They
also may incur substantial fees from auditors and consultants in
seeking to meet those criteria. The efforts to meet those criteria also
may lead to conflicts between companies, auditors, and regulators with
respect to judgments about whether the criteria have been met, thereby
adding uncertainties and their attendant costs to the process and
raising questions about the operationality of those criteria.
A report published by the Silicon Valley office of McKinsey &
Company, an international consulting firm, stated:
The fear that purchase accounting, by lowering reported
earnings, will destroy shareholder value is a myth. In fact the
opposite is true. Efforts to qualify for such treatment
actually destroy value. FASB's proposal to eliminate pooling
accounting is a blessing in disguise. Why? Because the
transition to purchase accounting will require corporations to
adopt more robust deal evaluation processes and enhance their
shareholder communications.
Similarly, a letter to the FASB from the Financial Institutions
Accounting Committee of the Financial Managers Society, a group of
financial professionals working in executive level positions in the
thrift and banking industries, stated:
Formal research supports the proposition that reporting firms
consume substantial resources in structuring transactions
solely to achieve a favorable financial reporting outcome. Lys
and Vincent (1995) report that AT&T paid at least $50 million
(and possibly as much as $500 million) to achieve pooling-of-
interests accounting for its acquisition of NCR . . . A single
method of accounting for business combinations would redirect
these corporate resources into more productive areas.
In addition, having one method of accounting for business
combinations benefits companies by leveling the playing field for
competition among companies in the business combinations market. The
ability--or inability--to use the pooling method often affects whether
a company enters into a business combination and also affects the price
it negotiates for that transaction. Companies that cannot use the
pooling method because they cannot meet the criteria required for its
use (for example, criteria that prohibit certain share acquisitions)
often conclude that they cannot compete for targets with those that can
meet the criteria.
Many companies that cannot use the pooling method believe that
companies that can use it often are willing to pay higher prices for
targets than they would if they had to use the purchase method because
they do not have to account for the full cost of the resulting
investment. Thus, by using the pooling method, they can understate the
income statement charges (primarily related to goodwill and other
intangible assets).
In a letter to the FASB, KeyCorp explained:
Since most publicly-traded companies are gauged by EPS
performance, there is a strong incentive to use the ``earnings-
friendly'' pooling method. The desire to avoid the earnings
consequences of the purchase method has almost certainly
resulted in uneconomic behavior. It is well understood in the
investment banking community that a company is willing to
``pay'' more for a target if the pooling method is available
for the resulting transaction. Clearly, there is a view that
the pooling method results in a type of accounting arbitrage .
. .
Even though using the pooling method rather than the purchase
method might result in being able to report higher per-share earnings
following the combination, the fundamental economics are not different
because the actual cash flows generated following the combination will
be the same regardless of which method is used. As a result, the added
earnings reported under the pooling method reflect artificial
accounting differences rather than real economic differences.
To the extent that the markets respond to artificial differences,
they direct capital to companies whose financial reporting benefits
from those differences and they direct capital away from companies
whose financial reporting does not benefit. As a result, markets
allocate capital inefficiently rather than efficiently. While
inefficient allocation of capital may benefit some companies and even
some industries, it imposes added costs on many others, depriving them
of capital that they need and capital they could employ more
productively. The outcome is detrimental to those companies--but, more
important, to the capital markets as a whole.
Finally, two further clarifications. First, Question 1 states that
the ``Goldman Sachs study specifically says that FASB's changes could
have a dramatic impact on certain industries, including information
technology . . .'' Unfortunately, the statement is not accurate. The
May 29, 1999 Goldman Sachs survey by Gabrielle Napolitano, CFA, and
Abby Joseph Cohen, CFA, to which the question refers, states that the
FASB's pre-Exposure Draft preliminary decisions on accounting for
business combinations may adversely affect some industries including
the ``healthcare information technology'' industry. The survey does not
conclude that the Board's decisions may adversely affect the entire
information technology industry as implied in Question 1. More
significant, the overall conclusion of the Goldman Sachs survey was
that the Board's preliminary decisions, including the elimination of
the pooling method, would ``not have a material adverse effect on
future business combinations.''
Second, Question 1 refers to conclusions of a Merrill Lynch ``white
paper'' on the impact of the Board's proposed decision to eliminate the
pooling method. For purposes of the Subcommittee Hearing record, it
should be noted that in a March 3, 1999 Merrill Lynch ``In-depth
Report'' on regional banks, Sandra J. Flannigan, CFA, first vice
president, Global Securities Research & Economics Group, Global
Fundamental Equity Research Department, concluded:
In our opinion . . . the economics of a ``purchase'' and
``pooling'' are the same. We, therefore, don't think
elimination of pooling-of-interests accounting will halt
consolidation. Indeed, ultimately, required usage of purchase
accounting could generate more transactions given greater
comparability from an international accounting standpoint and
fewer earnings reporting/share buyback constraint issues.
Question 2 Congressman Crowley writes: ``You have received a number
of thoughtful alternative proposals to the elimination of pooling. You
have a great deal of concern about the evaluation of intangibles. What
is the rush to eliminate pooling rather than looking first at the
valuation questions? If the problem with studying the issues is that it
will take some time, why not do it right the first time rather than in
a piecemeal fashion, especially when the consequences of `getting it
wrong' could be so severe?''
Response: Since first adding the project on business combinations
to its agenda in 1996, the Board has held over 40 public meetings,
issued 2 preliminary documents and the Exposure Draft for public
comment, and carefully analyzed and is still in the process of
discussing at public meetings over 400 comment letters received from a
broad range of companies, investors, and other constituents. We have
hardly rushed to complete this project, as Question 2 suggests. As
stated in response to Question 1 above, the Board will hold as many
public meetings as necessary to carefully evaluate all of the feedback
received in response to the Exposure Draft and to decide what
modifications or clarifications, if any, to the Exposure Draft are
appropriate. The Board will not make any final decisions about the
Exposure Draft, including whether or not to retain the pooling method,
or consider whether to issue a final standard, until it has completed
its full due process and is satisfied that all substantive issues
raised by all parties have been carefully considered.
With respect to the issue of the ``valuation of intangibles,''
feedback received in response to the Exposure Draft reveals that some
constituent concerns, including, possibly, the concerns raised in
Question 2, result from having misread or misunderstood the Exposure
Draft's provisions regarding intangibles. To clarify, those provisions
do not require the separate valuation of any intangible assets, such as
many forms of knowledge-based intangible assets so often associated
with technology companies, that cannot be separately identified and
reliably measured. Under current accounting standards and the Exposure
Draft, only purchased intangible assets that can be identified and
reliably measured, like many trademarks and customer lists, are
required to be separately valued, reported, and amortized over their
useful economic lives.
Question 3 Congressman Crowley writes: ``A review of the comment
letters sent to FASB shows that two-thirds of all of those who sent
comment letters and all of the Big 5 accounting firms advocated either
retaining at least some form of pooling or not eliminating pooling
until significant other issues were resolved. Why is FASB determined to
abolish pooling in light of this significant opposition to its
decision?''
Response: Many of those commentators that wanted to retain pooling
wanted it retained in only very limited circumstances. Those
circumstances were (1) where there was a true merger of equals (a very
rare occurrence) and (2) where companies under common control were
combined (a pooling-method-type result would be required under both
current accounting and the Board's proposal).
The Board is addressing and will resolve all of the ``significant
other issues'' raised in the comment letters about the proposed
accounting for goodwill and purchased intangibles before it
redeliberates whether the pooling method should be retained.
The FASB's Rules of Procedure provide for an open and thorough due
process that includes analysis and public discussion of the relevant
information and persuasive arguments contained in the comment letters,
and other feedback, received in response to an FASB proposal. The
Board's mandate is to establish and improve standards of financial
accounting and reporting that result in credible, transparent, and
comparable financial information for the efficient functioning of the
US capital markets.
As former US Securities and Exchange (``SEC'') Chairman Richard C.
Breeden stated in testimony before Congress almost a decade ago:
The purpose of accounting standards is to assure that
financial information is presented in a way that enables
decision-makers to make informed judgments. To the extent that
accounting standards are subverted to achieve objectives
unrelated to fair and accurate presentation, they fail in their
purpose.
The US capital markets are the deepest, most liquid, and most
efficient markets in the world. The unparalleled success and
competitive advantage of the US capital markets are due, in no small
part, to the high-quality and continually improving US financial
accounting and reporting standards. As Federal Reserve System Chairman
Alan Greenspan stated in a June 4, 1998 letter to SEC Chairman Arthur
Levitt:
Transparent accounting plays an important role in maintaining
the vibrancy of our financial markets . . . An integral part of
this process involves the Financial Accounting Standards Board
(FASB) working directly with its constituents to develop
appropriate accounting standards that reflect the needs of the
marketplace.
As stated in response to Question 1 above, the Board will hold as
many public meetings as necessary to carefully evaluate all of the
feedback received in response to the Exposure Draft and to decide what
modifications or clarifications, if any, to the Exposure Draft are
appropriate. The Board will not make any final decisions about the
Exposure Draft, including whether or not to retain the pooling method,
or consider whether to issue a final standard, until it has completed
its full due process and is satisfied that all substantive issues
raised by all parties have been carefully considered.
Question 4 Congressman Crowley writes: ``Your Exposure Draft
specifically states that international harmonization is one of the
reasons for your decision to eliminate pooling. Let's assume for a
minute that that is a valid goal. Given the fact that countries like
the U.K., France, Japan and Germany permit pooling, at least in some
form, how could eliminating pooling here increase international
harmonization? Assuming that various foreign and international
accounting rules are moving away from allowing pooling accounting, why
should the U.S. be following a trend in Europe or elsewhere rather than
encouraging the adoption of U.S. rules?''
Response: Because of the rapidly accelerating movement of capital
flows globally, the Board believes there is a need for financial
reporting to be comparable internationally. In response to that need,
part of the Board's mission includes promoting international
comparability of financial reporting, and accounting for business
combinations is one of the more significant areas of difference in
accounting standards.
For example, in most parts of the world, the pooling method is
either prohibited or used only on a rare exception basis. A recently
issued exposure draft from the Canadian Accounting Standards Board
would prohibit use of the pooling method, the International Accounting
Standards Committee has established a Steering Committee on accounting
for business combinations that will consider whether the pooling method
should be prohibited, and in the United Kingdom, the technical director
of the Accounting Standards Board has stated:
If the US bans pooling, the International Accounting
Standards Committee (IASC) will come under pressure to ban it
and then the UK will have to ask itself whether it wants to be
the only country that allows it.
The part of the Board's mission that includes promoting
international comparability is secondary to the Board's central mission
of establishing standards that result in credible, transparent, and
comparable financial information for the efficient functioning of the
US capital markets. The Board, and many of its constituents, believes
that the proposed elimination of the pooling method is consistent with
the both the Board's central mission and the Board's secondary mission.
I hope that my effort to provide thorough answers to the questions
posed by Congressman Crowley has been helpful. I would be pleased to
meet with the Congressman in person to further discuss any of his
concerns.
Sincerely,
Edmund Jenkins
Chairman
______
Biotechnology Industry Organization
Washington, D.C.
May 4, 2000
Brian McCullough
House Committee on Commerce
316 FHOB
Washington, DC 20515
Dear Brian: Per my conversation with Jim Conzelman, enclosed for
the Finance and Hazardous Materials Subcommittee's hearing record are
six copies of the testimony BIO presented at the Financial Accounting
Standards Board's (``FASB'') hearing on February 11, 2000 in New York
City.
The biotechnology industry is totally opposed to the FASB proposal
to repeal the ``pooling'' method of accounting. In our industry, more
so than in any other industry, appropriate business combinations are
often the only source of capital for struggling companies. The use of
the pooling method of accounting facilitates these arrangements. If
pooling is repealed, there will be a dramatic downturn in combinations
in our industry. This will result in many companies simply going out of
business.
Thank you for including our testimony in the Committee hearing
record. Please feel free to call if you wish to discuss this matter in
greater detail.
Sincerely,
Philip J. Ufholz
BIO Tax/Finance Counsel
Prepared Statement of Richard Pops Before the Financial Accounting
Standards Board On Exposure Draft
business combinations and intangible assets
Grand Hyatt Hotel, New York, New York
february 11, 2000
Good afternoon, my name is Richard Pops. I am the Chief Executive
Officer of Alkermes, Inc., a biotechnology research and development
company located in Cambridge, Massachusetts. I wish to thank you for
allowing me the opportunity to testify today on behalf of the
Biotechnology Industry Organization (BIO), the national trade
association that represents over 850 biotechnology companies worldwide.
My testimony will focus on the Financial Accounting Standards
Board's (hereafter, ``the Board'') proposal that would repeal the
``pooling'' method of accounting which allows companies that merge to
record their assets in the ongoing entity by simply combining their
assets and liabilities. This testimony will supplement my comments that
were submitted to the Board on December 3, 1999.
If pooling is eliminated, all mergers will be treated as purchases
of one company by another. The result of this mandatory application of
``purchase accounting'' will be that biotechnology companies will be
required to recognize and value at the time of the transaction a
variety of intangible assets, including goodwill. This asset would have
to be amortized, according to Generally Accepted Accounting Principles
(GAAP), over the course of twenty years. This has at least two
important implications for biotechnology companies. Both relate to the
critical issue facing entrepreneurs seeking to build and grow
successful biotechnology companies: the ability to raise large sums of
capital over a period of several years prior to first profitability.
First, elimination of pooling accounting means a potential delay in
profitability for businesses that merge to build critical mass.
Biotechnology companies are unique in that they typically operate for
years (average approximately 14.5 years by BIO's estimate) in a loss
position. Raising enough money to survive is incredibly challenging.
The pooling method of accounting allows a profitable or potentially
profitable biotech company to acquire a non-profitable company without
incurring an adverse charge to its earnings. In most cases, a merger or
acquisition is the only viable option for the loss company. The
alternative, due to a lack of cash flow and resultant inability to
continue vital research and development efforts, is frequently
financial failure. This is generally not the case in other high
technology industries where profitable companies acquire or merge with
other profitable companies in order to create synergy and improve
efficiency. With biotech companies, it is a case of survival. For
investors supporting these companies, the timing of profitability is a
critical consideration in their investment decision. A delay in
profitability due to non-cash amortization charges can add years to the
time that a biotechnology company operates at a loss. This extends the
time that its securities are unattractive to many investors and,
therefore, increases the already difficult task of fundraising.
Second, it means that, once profitable, biotechnology companies
that merged to build critical mass may report significantly depressed
earnings per share over the course of many financial reporting periods.
This has the potential to severely damage the company's overall value.
This has a profound effect much earlier in the company's life as
investors make the investment decision prior to profitability. If the
eventual valuation of the company is lower once it is profitable, the
present value of its equity is lower today. This affects the company's
ability to raise capital.
It is important to recognize that for biotechnology companies,
tangible book value is low in comparison to total company value.
Biotechnology mergers often occur between companies of similar size,
and result in large amortization charges in purchase accounting. The
effect of the elimination of pooling accounting is magnified for small
biotechnology companies, where the non-cash amortization charges can
dwarf total profitability of the combined business in the early
quarters of profitability.
Biotechnology companies are part of a new generation of companies
that presents a financial profile profoundly different from traditional
``bricks and mortar'' enterprises. The issue of pooling should be
addressed in the context of a larger examination of how GAAP can best
handle the financial disclosure for these types of companies. For the
same reason that the Board recently decided to defer consideration of
new rules governing in process research and development, because the
issue was too closely intertwined with the treatment of research and
development costs generally, the Board should defer consideration of
the pooling issue.
Repeal of the pooling method will reduce the likelihood that some
desirable combinations will occur. This would be an unfortunate outcome
for the biotechnology industry, where mergers of complementary
technologies are often necessary to enable the development of
innovative new drugs and diagnostic products for the benefit of
patients and families around the world.
The problems of comparability, relevance, reliability, and
neutrality that the Board says drives its proposed change are recreated
in purchase accounting by the need to confront the many problems
inherent in the treatment of intangible assets, in general, and
goodwill in particular. With so much of the value of biotechnology
companies lying in these intangibles, the financial presentation under
the mandated use of purchase accounting will be significantly more
problematic than under pooling.
One of the foundations of financial accounting is comparability
across time as well as between companies. Users of financial statements
should be able to look across periods and evaluate a company's
performance over time, to see and be able to evaluate trends and
significant new developments in its financial situation. The strength
of accounting for business acquisitions by pooling is that it allows
for just such a comparison. The merger of two entities by their owners,
the shareholders, is undertaken with the expectation that the new,
combined entity will allow for greater value to be generated going
forward. By preserving the historical values of assets carried on the
books of the predecessor companies, such a comparison can be made
easily. The assets, income flow, and other financial elements of the
two companies are simply combined and not altered, and so any change in
the future, good or bad, is readily apparent.
Purchase accounting departs from this model of combination and thus
undermines the users of financial statements' ability to compare
performance over time easily. Under purchase accounting, the historical
valuation of assets of one of the predecessor companies is preserved,
while the assets of the other company are revalued according to the
fair market value at the time of the business combination. Thus, going
forward there is an amalgam of valuation of assets, some at historical
cost and some at this new, fair market valuation.
The Board's proposed rule does not adequately take into account the
true worth of a biotechnology company's intangible assets and would
slow their growth, which is more important than detailed accounting.
Investors do not care about accountants' estimates of a company's
various hard-to-measure intangible assets. What they really want to
know is, does this merger contribute to the bottom line.
I do not pretend that there are any easy answers to the problem of
dealing with intangible assets and their role in biotechnology
companies. The rapid changes in the biotechnology industry have created
new situations where traditional accounting principles no longer can be
relied upon to provide accurate, transparent, public disclosure. The
worth of biotechnology companies is increasingly related to intangible
assets that traditional accounting fails to measure. It is a difficult
problem, and I applaud the Board for continuing to grapple with it.
However, in the face of this recognized difficulty, the elimination of
pooling alone means not that problems with accounting reliability,
comparability and neutrality will be eliminated, but instead will be
exacerbated.
The magnitude of this proposed rule change requires a careful
weighing of the possible costs of change against the conviction that
the public will enjoy significant benefits.
The risk of adverse impact to the biotechnology industry due to the
elimination of pooling is significant enough to require an equally
significant showing of the benefits to be realized. In fact, none of
the benefits claimed on behalf of the proposed rule change meet such a
standard either separately or collectively.
______
National Association of Manufacturers
May 3, 2000
The Honorable Michael Oxley
Chairman, Subcommittee on Finance and Hazardous Materials
House Commerce Committee
2233 Rayburn House Office Building
Washington, DC 20515
Dear Mr. Chairman: I am writing on behalf of the National
Association of Manufacturers (NAM) regarding the subcommittee hearing
on business combinations scheduled for Thursday, May 4. The NAM--``18
million people who make things in America''--is the nation's largest
and oldest multi-industry trade association. The NAM represents 14,000
members (including 10,000 small and mid-sized companies) and 350 member
associations serving manufacturers and employees in every industrial
sector and all 50 states. As many of our members are current or
frequent participants in mergers and acquisitions (M&As), we have a
vested interest in this issue and have, in fact, testified before the
Financial Accounting Standards Board (FASB) and the Senate Banking
Committee in February and March of this year, respectively.
While the NAM fully supports the independence of the FASB and
strongly believes that setting of accounting standards should be left
to the private sector, we are also very concerned about some of the
changes the FASB has suggested in its proposal on Business Combinations
and Intangible Assets. Most notably, the FASB has proposed to eliminate
the pooling-of-interests method of accounting and to halve the maximum
amortization period for goodwill (currently 40 years, would be 20 years
under the proposal). The NAM opposes both of these changes for the
reasons set forth in our enclosed statement for the record.
Our primary purpose for writing to you today is to clarify the
scope of those who would be harmed by these proposals, should the
project move forward unmodified. In much of what has been written and
said about this issue, it has been characterized as a ``high tech''
issue. (The NAM insists that modern manufacturing and ``high tech'' are
increasingly synonymous but, for the sake of this discussion, will
accept the distinction.) And the FASB has correctly asserted that
accounting rules should be equally applicable to all sectors of the
economy and not favor one sector over another. However, while it is
certainly true that much of the incredible growth of the high tech
sector has been achieved through mergers relying on pooling, pooling
has also played, and continues to play, a very significant role for
more traditional manufacturers. It is important to note that the NAM's
very active involvement in this issue is not due solely--or even most
significantly--to the interests of our many high tech members. We are
consistently hearing, primarily from more traditional manufacturers,
that this merger or that merger would not have occurred had it not been
for the applicability of pooling. This is not to say that all mergers
are inherently good, but that is up to the market to decide--not the
FASB.
The FASB has made it quite clear that it is not its mission to take
into account economic consequences when promulgating new accounting
standards. But there is no ``abuse'' being addressed in this case that
would require drastic or expedited action, and the potential risks far
outweigh the potential benefits. Consequently, we are heartened that
this subcommittee has seen fit to fill the gap by considering the
potential economic consequences of the FASB's Business Combinations and
Intangible Assets proposal. Please feel free to call me or the NAM's
director of corporate finance and tax, Kimberly Pinter (202-637-3071)
if you have further questions.
Sincerely,
Michael E. Baroody, Senior Vice President
Policy, Communications and Public Affairs,
National Association of Manufacturers
Enclosure
Prepared Statement of Kimberly J. Pinter, Director, Corporate Finance
and Tax, National Association of Manufacturers on Behalf of the
National Association of Manufacturers
i. introduction
The National Association of Manufacturers (NAM) appreciates this
opportunity to present its views on the Financial Accounting Standards
Board's (FASB) Business Combinations and Intangible Assets proposal.
The NAM is the nation's largest and oldest multi-industry trade
association, representing 14,000 members in every industrial sector and
in all 50 states. A significant number of our members are frequent or
current participants in merger and acquisition (M&A) activity and have
a vested interest in the outcome of this project.
ii. pooling
The centerpiece of this project is the proposed disallowance of the
pooling-of-interests method of accounting. The NAM finds this proposal
objectionable based on a number of different factors.
First of all, the NAM disagrees with the FASB's underlying premise
that all business combinations are substantively the same. My personal
observation as a non-accountant is that it seems very odd that the term
``M&A'' would be standard jargon if ``M's'' and ``A's'' were really
exactly the same thing.
Substantively, a transaction in which a shareholder remains a
shareholder fundamentally differs from one in which the shareholder
cashes out. The pooling method respects this continuity. The criteria
for using the pooling method are already quite strict and reflect the
primary factors of such continuity. The FASB contends that by
eliminating pooling they will be aiding comparability of financial
statements--making like things look alike. It is the NAM's position
that not all transactions are alike, and that while like things should
look alike, dissimilar things should look different.
Additionally, there are substantive problems with the purchase
method that should be addressed, particularly before the elimination of
pooling, should its elimination ultimately be determined to be an
appropriate goal. These problems center around the valuation of
intangibles.
The NAM's first concern in this area is the proposed halving of the
maximum allowable period over which to amortize goodwill charges. The
FASB has taken the position that goodwill is a diminishing asset. The
NAM disagrees with this premise. In the case of a successful merger,
goodwill should actually increase. Goodwill results because the value
of a company is greater than the sum of its parts. Following from that,
every merger participant is hopeful that a successful merger will yield
more than the sum of its parts.
Furthermore, even if we were to accept the idea of goodwill as a
wasting asset, it has been conceded that goodwill cannot be reliably
measured nor its actual useful life determined. Therefore, the
arbitrary limit of 40 years was set some time ago. Companies and
markets have acclimated to this standard. Now, with no more accurate or
useful way to account for goodwill, the FASB is proposing to replace
one arbitrary limit with another--in a way that would significantly and
adversely affect our members' financial statements.
The problems inherent in the valuation of goodwill are not unique
to goodwill. Technological advance has fueled a whole host of new
intangibles, many of which are equally difficult to characterize and
value. They are, if you will, a by-product of the ``new economy.'' But
let me explain for a moment what I mean by the ``new economy.'' It is
not a place or a specific industry segment. It is a pervasive concept
affecting all industries to varying degrees. The NAM has done several
reports, in fact, on ``Technology on the Factory Floor.'' Traditional
manufacturers are huge consumers and producers of technology, whether
it's to improve methods of cutting steel using laser-like streams of
super-cooled chemicals; to locate oil, gas, or other natural resources;
to automate an assembly line; or even to provide all of their employees
with home computers. Such a dramatic evolution in the way our companies
do business seems to warrant at least an examination of whether
traditional accounting principles are still accurate and appropriate.
I have personally discussed the proposed elimination of pooling
with many of our member companies, and I have been truly surprised by
the number of times I have heard that this merger or that merger would
not have happened had it not been for the applicability of pooling. And
I have heard these comments across the board from all kinds of
manufacturers. Even those that don't use pooling are very concerned
about its possible unavailability for future transactions.
Manufacturing is the largest contributor to economic growth, and
the recent surge in M&A activity has coincided with a surge in
productivity growth. By mentioning these facts, I don't mean to suggest
that pooling should be retained because it somehow ``encourages''
business combinations; rather, it appears that the existence of only
the purchase method to account for a diverse array of transactions
would discourage such activity--and that result could well have a
negative effect on the economy.
iii. process
Finally, the NAM is concerned that the FASB is not hearing from all
parties who may be critical of the project. Too often we have found
that companies are very reluctant to too visibly criticize the merits
of a FASB proposal due to concern that such activity might invite
increased SEC scrutiny. Regardless of whether such concerns are
founded, as they say, perception is reality, and it does have a
chilling effect on full participation in the process. That said, the
NAM appreciates the FASB's extensive efforts to thoroughly evaluate
these issues with significant outside input and participation, and we
do fully support the FASB's independence and private-sector setting of
accounting standards.
______
American Business Conference
May 3, 2000
The Honorable Michael G. Oxley
United States House of Representatives
Washington, DC 20510
Dear Congressman Oxley: I write in regard to the upcoming hearings
in the Subcommittee on Finance and Hazardous Materials on the efforts
of the Financial Accounting Standards Board (FASB) to change
substantially accounting rules for business combinations.
The American Business Conference (ABC), a coalition of CEOs of
fast-growing, midsize companies, is very concerned about FASB's
proposal. We hope that the Subcommittee's hearing will illuminate the
many important issues put into play by the FASB initiative--issues we
regard as far from settled. As background, I have enclosed with this
letter a memorandum I wrote on FASB's business combinations project. I
hope it may prove of use to you and your colleagues.
In the view of ABC members, the single greatest service your
hearing can perform is to underscore the comprehensive nature of FASB's
business combinations project. The project is not, as some have
suggested, merely an effort to eliminate pooling-of-interests with a
few extra details thrown in. FASB's project seeks to change all
business combinations--accounting--the pooling-of-interests method,
used in about 5 percent of merger and acquisition deals, and the
purchase method, used in the vast majority of merger and acquisition
transactions.
Because the FASB business combinations project is a comprehensive
agenda for change, it carries critical implications for every business
enterprise in the country, regardless of industry and regardless of
which method of accounting--pooling or purchase--they have used in the
past or may plan to employ in the future. Interest in and concern about
various aspects of FASB's proposal accordingly can be found in all
segments of the American business community, among accounting firms,
and among investors.
This is the essential point for understanding the controversy
swirling around FASB's project. The fact is, as a reading of comment
letters to the FASB demonstrates, there is no meaningful consensus in
the private sector in support of the business combinations project.
For example, defenders of FASB's plan to abolish pooling-of-
interests accounting point to the Association for Investment Management
and Research (AIMR), for support of their position. And it is certainly
true that AIMR, the leading association of investment professionals, on
balance advocates the elimination of pooling. However, the AIMR
``disagrees strongly'' with another crucial aspect of FASB's proposal,
namely the display under the purchase method of goodwill amortization
charges net of tax and after operating earnings.\1\ (The enclosed
memorandum discusses the latter issue in greater detail.)
---------------------------------------------------------------------------
\1\ Letter of the Association for Investment Management and
Research, to Mr. Timothy Lucas, Director of Research and Technical
Activities, Financial Accounting Standards Board, December 7, 1999
(Letter of Comment No.: 56A).
---------------------------------------------------------------------------
A review of the positions of the major accounting firms also
displays misgivings about the FASB proposal. PricewaterhouseCoopers, as
an instance, disagrees with FASB's position regarding the elimination
of pooling and with some of the Board's proposed changes to purchase
accounting, including the display of goodwill amortization. For its
part, KPMG does not support the total elimination of pooling or the
separate treatment of goodwill amortization from other intangible
assets under purchase accounting.\2\
---------------------------------------------------------------------------
\2\ Letter of PricewaterhouseCoopers LLP to Mr. Timothy Lucas,
Director of Research and Technical Activities, Financial Accounting
Standards Board, December 7, 1999, (Letter of Comment No: 1A) and
Letter of KPMG to Timothy Lucas, December 7, 1999, (Letter of Comment
No: 35A). Most of the other accounting firms submitting comment letters
to FASB cite similar problems in the exposure draft. These misgivings
are mirrored in letters from leading investment banks, commercial
banks, and money management firms.
---------------------------------------------------------------------------
The comment letters to the FASB from corporations constitute a
litany of dissent. Thus Ford Motor Company, although it does not use
the pooling-of-interests method, is nonetheless ``not in favor of its
elimination.'' As for FASB's proposed reform of purchase accounting,
Ford does not agree with the Board on goodwill recoverability,
disclosure requirements for acquisitions, the new twenty-year period
for goodwill amortization, or the separate line-item disclosure of
goodwill amortization. Ford's dissent is more or less typical of the
response of other corporations, big and small, ``old'' economy and
``new'' economy.\3\
---------------------------------------------------------------------------
\3\ Letter of Ford Motor Company to Timothy Lucas, Director of
Research and Technical Activities, Financial Accounting Standards
Board, December 3, 1999 (Letter of Comment No.: 92).
---------------------------------------------------------------------------
Although the Board's rulemaking process. is not complete, FASB
members thus far have shown little inclination to rethink their
proposal. In spite of the considerable criticism that the Exposure
Draft has attracted, the Board seems determined to move forward on the
elimination of pooling accounting and the alteration of purchase
accounting. Undoubtedly the Board will have to ``tweak'' aspects of its
proposal, but it seems unlikely that those marginal changes will speak
to the broader objections of the private sector.
If I am correct about the Board's attitude, the result will be
unfortunate. It will be unfortunate first because FASB will force on
the business, accounting, and investment communities a ``reform'' of
business combinations accounting that I believe is deeply flawed and
that will almost surely have to be revisited, sooner rather than later.
It will be unfortunate, too, because a decision by the Board to
press ahead with a rule that has met with so much resistance during the
comment period threatens the Board's long-term capacity to exert
leadership on a host of other cutting-edge accounting issues. The Board
very well may have its way in this matter, but at what price? ABC
strongly supports the FASB and respects the Board's independence. We
believe, however, that FASB's ability to maintain that independence is
directly proportionate to its constituents' faith in the Board's
capacity to respond to constructive criticism. Fairly or not, many of
our colleagues in the business community harbor serious doubts on this
point.
We at ABC believe that a responsible, intellectually tenable
compromise is possible in regard to business combinations accounting.
We also believe the FASB process itself is sufficiently flexible to
allow for that compromise to happen, provided that all the interested
parties are willing to take the time to do the job correctly. I do not
pretend to know the exact lineaments of a workable compromise but I
suspect it would, as a first step, entail a satisfactory, mutually
agreeable recasting of purchase accounting, particularly as it pertains
to intangible assets including goodwill.
In closing, let me state a view that I suspect you share: Congress
ideally ought not to have a legislative role in the setting of
accounting standards. What Congress can do, and indeed, what I hope it
will do through the Finance. Subcommittee's hearing, is to exert its
traditional oversight function in such a way as to inform citizens of
the issues at stake while encouraging intelligent compromise within the
private standard-setting process. To that end, ABC stands ready to
assist you and your colleagues on the Subcommittee.
Sincerely,
Barry K. Rogstad
President
cc: The Honorable Edolphus Towns
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