Guest Article – Crafting Deals After Pooling Is Scrapped: The days of pooling-of-interest accounting may be numbered, but there are ways of making deal structures work for value-creating acquisitions.

The Financial Accounting Standards Board (FASB) has voted to explicitly eliminate pooling-of-interest accounting by January 1, 2001. If the proposal is adopted in its current form, companies will be required to use purchase accounting to record every merger or acquisition. To fully understand what this would mean, a brief review of purchase accounting is warranted. Purchase accounting requires the buyer to record in its financial statements the fair market value of all assets acquired – tangible and intangible – and liabilities assumed. The typical buyer initially estimates the market value of the target’s tangible assets, such as property, plant and equipment, and inventory, as well as liabilities like trade payables. Next, the buyer identifies and estimates the market value of intangible assets, such as patents, trademarks, and brand names. Any “excess or residual” purchase price is considered goodwill that must be recorded as an asset and amortized over its useful life. Acquirers shun purchase accounting not so much because they have to record the balance sheet at fair value but because it forces them to take additional depreciation and amortization charges that dilute reported earnings and can trigger a negative market response. The FASB’s proposal goes further. It reduces the maximum amortization period for goodwill and most identifiable intangibles from 40 to 20 years. Identifiable intangibles must be placed in one of three categories: those with lives of 20 years or less, those with lives of more than 20 years, and those with indefinite lives. While most intangibles are presumed to fall into the first category, those that generate clearly identifiable cash flows and are either exchangeable or carry contractual rights lasting for more than 20 years can qualify as “longer lived” assets which may be written off over more than 20 years. For an intangible to qualify as having an indefinite life, an observable market that clearly demonstrates the asset’s value must exist. In these instances, an indefinite life asset avoids amortization entirely. While not a new requirement, the proposed standard emphasizes the longstanding impairment test applied to intangibles and goodwill. This entails, when triggering events occur, assessing an asset’s future cash flows and comparing this amount with its carrying value to determine whether an impairment write-off is warranted. In certain instances, fair value is used as a proxy for cash flows. Some observers are concerned that when write-offs occur, the market may interpret the event as a sign that the buyer overpaid for the target. On a positive note, the FASB – in a bold move – is accepting an earnings-per-share (EPS) concept that excludes certain components of income and expense by allowing companies to clearly report on their income statement how the new goodwill amortization charges will dilute earnings. The proposal adds two new lines to the income statement – income from continuing operations before goodwill and goodwill net-of-tax, along with the corresponding per-share amounts. Interestingly, the FASB did not evaluate the one-time write-off for in-process research and development (IPR&D), opting to keep the accounting for IPR&D unchanged, although the issue continues to be subject to close scrutiny by the Securities and Exchange Commission (SEC). If adopted, the proposed rule will have a short-term and a long-term impact, particularly as the market adjusts to the new accounting and reporting practices that undoubtedly will emerge. In the shorter term, we would expect to see: A surge of pooling transactions. Dealmakers are expected to accelerate merger plans before pooling expires. More competition from private equity firms. Financial buyers, no longer competitively disadvantaged by their inability to use pooling to extract synergies, will compete with corporate buyers on a level playing field. More focus on intangible assets. Acquirers will try to minimize the persistent annual amortization by qualifying intangibles as having indefinite lives, lives of more than 20 years, or as IPR&D. Longer term, we would expect to see: New deal structures. Companies will craft acquisition strategies that emphasize deal economics, such as growing revenue, market share, and margins rather than qualifying for the coveted pooling-of-interest result. Greater acceptance of quasi-cash-flow performance benchmarks. Companies will capitalize on their ability to segregate goodwill amortization charges from operating earnings by reporting “income from continuing operations before goodwill” and the EPS equivalent. Although the new income statement entries do not segregate the entire amount of additional depreciation and amortization that purchase accounting generates, some observers view the FASB’s proposals as accepting the stock market’s move toward cash-based performance measures. Since some industries are already valued on non-EPS measures, such as EBITDA (e.g., media and cable companies), the market may well consider the new metrics to be a relevant performance measure, and we expect companies will use the separate breakout of goodwill to their benefit when reporting operating results. Moreover, given current trends in how companies communicate and position operating results, regulators may begin scrutinizing acquirers’ purchase price allocation methods to ensure that they acknowledge and appropriately value all identifiable intangibles. More rigorous analyses of potential synergies and cash flows prior to offering high premiums for targets. This will be important because impairment reviews could shed light on how much buyers overpay, especially where embarrassing write-offs occur shortly after a deal closes. Under existing pooling rules, overpayment is not highlighted, since pooling masks the fair value paid. As the proposed standard takes hold, however, there may be a dampening of deal activity and/or less willingness to pay high premiums for targets whose current cash flows do not justify their valuations. Over time, however, we suspect that better tools for quantifying synergies and predicting cash flows will be utilized. Table 1 summarizes the key provisions of the proposed standard and their likely impact. Even pooling-savvy dealmakers will welcome being freed from prohibitive pooling rules that restrict asset rationalization, treasury stock, and other capital restructuring transactions, or impede their ability to structure compensation packages with appropriate equity and cash awards. However, since traditional EPS will continue to be an important performance measure, management will face new challenges in maintaining earnings trends since the reduction in most intangibles’ useful lives will produce a heightened drag on earnings. In the longer term, we believe that the new rules will have a profound impact on the ways deals are done, and we offer the following suggestions on how to re-engineer deals in a post-pooling world. Replicate Pooling In theory, buyers could still replicate a pooling’s softer impact on earnings if they are able to ascribe the entire purchase price premium to indefinite life intangibles. Since this class of intangibles is not amortized, it does not generate a drag on earnings, so the result is similar to pooling. In reality, however, the likelihood that the book value of tangible assets approximates fair value and that the entire amount of an excess purchase price can be attributed to indefinite life intangibles is remote. And even if indefinite life intangibles are recorded, periodic impairment reviews could necessitate a write-off. Nonetheless, indefinite life intangibles demonstrate a very desirable trait. They allow companies to record the target’s balance sheet to fair value without the negative earnings hit that typically accompanies such a step-up. We believe that buyers will try to identify indefinite life intangibles and take advantage of any opportunities to bolster the balance sheet while sparing the income statement. The market has seen similar trends in the past, such as when IPR&D became a means for taking large, one-time write-offs, while sparing a company’s stock price. Focus on Deal Economics Instead of Accounting If pooling ceases, dealmakers will renew their focus on economics rather than accounting rules as they develop strategies to extract deal synergies. Today, many companies are so wedded to pooling that they are willing to table key business initiatives for up to two years after the deal closes, such as purchasing treasury stock and disposing of non-strategic assets (both of which are impaired by the pooling rules). The downside of pooling is apparent. Restrictions on stock repurchases, along with the inability to use non-stock consideration in the deal itself, can lead to a sub-optimal capital structure with a higher cost of capital. Assets that do not fit with management’s plans squander resources because they cannot be sold immediately. By focusing on deal economics, companies can devise appropriate compensation schemes, perhaps through options or other equity-based incentives, to retain and presumably enhance the services of key employees. Acquirers can also mitigate their risk of overpayment by utilizing contingent purchase price considerations. In such a post-pooling world, dealmakers will be free to focus on what is truly important. They can structure each and every transaction to extract maximum benefit for all stakeholders. Creative compensation arrangements and capital structures can be employed. Only key assets and operations need remain. And, equally important, the seller can be held accountable for adequate performance. Who’s the Buyer? Determining the acquirer in a transaction will continue to be based on such factors as which company has the majority shareholder group, issues stock and/or pays consideration, or dominates the board of directors and senior management. In some instances, particularly a merger of equals, the acquirer may not be readily apparent. In these instances, the parties might be able to structure the transaction to designate which one is the acquirer. Why does it matter which one is the acquirer, especially if the transaction value remains unchanged? Because for accounting purposes, one party would probably make a more attractive target, particularly when: * The purchase price premium for one company is substantially lower due to a higher net asset base or fewer intangibles to amortize. * One of the combining companies possesses long-lived intangibles, thus lowering persistent amortization charge. On the other hand, maximizing the amount of goodwill may be desirable because the concomitant amortization is segregated from operating earnings. To illustrate this point, consider American Online’s pending acquisition of Time Warner. Under the proposed standard, Time Warner might represent the more attractive target, since its long operating history and content focus would suggest that more of its intangibles have a useful life of more than 20 years. In addition, since Time Warner has the larger net asset base, the purchase price premium would be lower than if AOL were the target. Bottom line, the combined company would have less of a hit to earnings. Now, consider what would happen if, for the sake of argument, the parties decided that Time Warner should be the acquirer. If AOL were to pay a premerger announcement dividend large enough to effectively make AOL shareholders the minority, and Time Warner used cash and stock to acquire AOL shares, Time Warner could potentially be the acquirer, especially since accounting guidance presumes that the party who pays cash is the acquirer. In other words, determining the acquirer for accounting purposes is not black and white. Purchase Price Allocation and Deal Modeling Allocating purchase price to the target will certainly become a much more defined exercise, even though its cash flows will not be affected. Why? Because as long as potential earnings are the key evaluation criteria, the composition of the target’s intangibles will dictate the size of the annual amortization charge to earnings. The more value ascribed to longer or indefinite life intangibles, the more a suitor will be willing to pay. Thus, far more effort will be focused on classifying intangible assets when determining a target’s value. Under pooling, the amount paid was not noticeable, since assets were not stepped up to fair value. In modeling deal value in the past, purchase transactions typically ascribed most of the excess purchase price to goodwill and amortized it over a long (e.g., 40-year) period. Going forward, though, careful thought and evaluation should go into modeling deal value because the amount ascribed to the particular intangible asset categories could produce dramatically different results. Who Wins and Who Loses? Companies with strong brand names and intangibles that generate long-term cash flows will benefit if they are able to classify these assets as having a long or indefinite life, thus minimizing their annual amortization charges. Conversely, companies with identifiable intangibles whose useful lives do not exceed 20 years will be at a disadvantage, since they will incur relatively higher amortization charges. A potential benefit for all acquirers will be the degree to which the market accepts EPS before goodwill as a key valuation metric, since this could provide every company with the opportunity to maintain or even enhance valuation. Effects on selected industries include: Consumer products and media – These companies appear to benefit the most. If observable markets emerge for intangibles such as trade names, consumer product companies with strong brand names could conceivably forgo amortization by classifying these intangibles as having indefinite lives. In media, the market for broadcast licenses already exists and should facilitate the ability to record long-lived intangibles. Retail – The impact on retail is difficult to predict. Customer retention and longevity in the market are key factors in classifying intangibles. But with consumer fads and their sporadic buying habits, it will be difficult to discern patterns from the noise. Pharmaceuticals and financial services – Given their well-established histories, companies in these sectors have vast identifiable intangibles that might seem to be long-lived. However, their histories and technological advances suggest that value today does not necessarily mean value tomorrow. E-businesses and technology – These sectors, the darlings of today, may find themselves the outcasts of tomorrow. Their expensive market values and limited cash flows could create impairment issues of epic proportions, if expected future cash flows cannot overcome the vast sums paid for these businesses. Deal activity has been hot for these companies. But will it completely dry up, especially where the potential for enormous write-offs shortly after completing a transaction exists? Table 2 summarizes how the new rules will affect various industries. What Should You Do? The FASB has much to do before the proposal can be adopted as an authoritative standard. It is currently reviewing the proposal based on comments it has received through written submissions and public hearings. But it is prudent for acquirers to prepare for the end of pooling through these methods: Focus on deal economics – Employ the most appropriate structures and terms for a given transaction. If the economics do not justify the purchase of a target, investigate other types of alliances to achieve corporate initiatives. Thoroughly understand the proposed standard – When assessing a target, determine whether opportunities may exist to record indefinite or longer-life intangibles, as well as how they will fare when under the impairment review microscope. Move expeditiously – If you think that pooling is your best option, initiate all deals prior to the fourth quarter of 2000. Table 1: Proposed Rules and Their Expected ImpactsThe Proposed Rules Pooling vs. Purchase AccountingEliminate pooling as a deal structuring option after Q4 2000, forcing virtually every business combination involving a U.S. registrant to be treated as an acquisition, with the target recorded at fair market value. GoodwillReduce the maximum period for amortizing goodwill from 40 to 20 years. Intangible AssetsRequire buyers to place the target’s identified intangibles into one of three groups, based on their estimated useful lives: * 20 years or less * More than 20 years * Infinite life Presumption that intangibles have a maximum 20-year life, unless the buyer can demonstrate that an asset: * Can produce clearly identifiable cash flows for more than 20 years; and * Either involves contractual rights that exceed 20 years or is exchangeable. An observable market is required to support indefinite life classification.Detailed documentation of methods used to value intangibles willalso be necessary.ImpairmentTest goodwill for impairment within the first two years after the consummation date where a deal involved a significant premium or goodwill amount, a bidding process, or was financed primarily with equity. Continued emphasis on the periodic testing of intangibles for impairment to ensure that cash flows support the carrying ensure that cash value. Write-offs will occur when the carrying value of an asset exceeds its cash flows. Income StatementNew lines added to the income statement so that companies can clearly separate the dilutive effects of goodwill amortization (including corresponding EPS amounts): * Income before goodwill * Goodwill net of taxes Cont’dTable 1: Proposed Rules and Their Expected Impacts Impact Shorter Term Last-minute surge of pooling deals as prospective buyers and sellers accelerate merger plans to qualify for pooling before it expires. Intensified earnings dilution as goodwill must be amortized over a shorter time period. Heightened focus on intangibles as acquirers scramble to try to classify them as having a longer (more than 20 years) or indefinite life in order to lower (or eliminate) amortization charges to earnings. Possible dampening of deal activity and/or lowering of premiums paid for companies in sectors in which the multiples are high and current cash flows are quite limited, since such companies could be required to take huge impairment write-offs shortly after the deal closes. Continued focus on EPS as a performance measure as the stock market adjusts to new income and EPS measures. Market acceptance of quasi-cash-flow metrics, which encourage companies to position their operating results to their advantage. Cont’dTable 1: Proposed Rules and Their Expected Impacts Impact: Longer Term New deal strategies and structures that focus on deal economics rather than deal accounting. Less focus on EPS and more emphasis on quasi- cash-flow performance benchmarks. Increased regulator scrutiny of the cash flows, contractual/legal rights, and market dynamics used to justify useful asset lives of more than 20 years. As the observable market criteria become better defined and markets evolve, we may witness an emergence of new practices that broaden the narrow exceptions to long-lived intangibles. Potentially fewer instances of overpayment as buyers conduct more rigorous analyses of potential synergies and cash flows, prior to offering high premiums for target companies. The market acknowledges that these new metrics do not represent an adequate definition of cash flow since they do not include all depreciation, amortization, and other non-cash charges.\TBL> Table 2: Impact of Proposed Standard on Major Industries Presence of Longer- Industry Or Indefinite-Life Intangibles Consumer Products Yes, from trade names long-lived intangiblesMedia Yes, due to the scarcity of valuable properties Energy and Mining No, although mitigated to the extent that value is attributed to reserves possessing long livesRetail Possibly, dependent on customer retention and longevity within marketsServices (including No Health Care) Pharmaceuticals No, due to technological change and limited patent lives Telecom and some No Technology Financial Services No, due to technological change and commodity product offering Industrial Products No, as trade names have limited lives E-businesses and No some Technology Cont’dTable 2: Impact of Proposed Standard on Major Industries Similar to Current Practice Impact of Proposed Standard Yes Potential winner, as other sectors may not possess long-lived intangibles Yes Potential winner, as other sectors may not possess long-lived intangibles Yes Unclear, facts- and circumstance-specific Somewhat Unclear, facts- and circumstance-specific Yes, although Disadvantaged, as some amounts previously goodwill life is recorded as goodwill represent identifiable shortened intangibles Somewhat Disadvantaged, as limited product life cycles offset trade names, etc. Yes Disadvantaged, due to large amount of identifiable intangibles with limited lives Somewhat Disadvantaged, as rapid technological change offsets trade names, etc. No Disadvantaged, due to large amount of identifiable intangibles with limited lives Yes, but impairment Significantly disadvantaged, as limited cash flows concerns could be could create substantial impairment issues detrimental<\TBL>