September 1999

Salomon Smith Barney Survey Says Losing Poolings Of Interest Will Be OK

FASB has decided that the pooling-of-interests method of accounting for business combinations should no longer be permitted and is in the process of developing a proposed standard that would eliminate the pooling option. It is not likely that the new standard will be effective in less than a year or so. In the meantime, it would not be unsurprising if there were a rush to complete business combinations using the pooling approach to avoid having to record goodwill.

Salomon Smith Barney's Financial Strategy Group recently released the results of a study on the extent to which the market distinguishes between business combinations accounted for as poolings versus those accounted for as purchases, where goodwill is recorded as an asset and amortized against future earnings. The study sought to answer whether in a purchase transaction, the price earnings multiple is adjusted to negate the goodwill charge because it has no effect on cash flow.

Specifically, the Salomon Smith Barney's objective was to find answers to the following questions:

* Does the choice of purchase or pooling affect firm valuations?

Salomon Smith Barney's conclusion: The evidence from stock market valuations and from stock market reactions to transaction announcements strongly demonstrates that purchase accounting does not adversely affect firm valuations.

* How do differences in goodwill and its amortization affect cash flow and price/earnings multiples?

Salomon Smith Barney's conclusion: Balance sheet goodwill has no adverse impact on cash flow multiples. Price/earnings multiples expand sufficiently to offset income statement amortization, leaving stock prices unaffected.

* Does the rate of amortization affect valuations?

Salomon Smith Barney's conclusion: The evidence suggests that differences in the rate of goodwill amortization have no adverse impact on stock prices. This point is particularly relevant in light of the possibility that the maximum life of goodwill may be reduced from 40 years to 10 or 20 years.

* How has the market reacted to the purchase and pooling acquisition announcements?

Salomon Smith Barney's conclusion: The market reacts more favorably to the announcement of purchase acquisitions than to the announcement of pooled mergers. Half of this difference is attributable to the form of consideration.

* Will a curtailing of pooling treatment curb M&A transaction activity?

Salomon Smith Barney's conclusion: The market's ability to "see through" goodwill amortization suggests that when pooling ends, interest may increase in transactions that are cash accretive, yet EPS dilutive.

Based upon the findings, Salomon Smith Barney made a number of recommendations, some of which are quite startling:

* Equity analysts and portfolio managers ought to base their view of a firm's fair value upon cash earnings, not GAAP earnings.

* Corporate development executives should ignore goodwill and its amortization when evaluating an acquisition's prudence.

* CFOs should capitalize on the market's willingness to see past goodwill amortization by consistently breaking out amortization from depreciation on the income statement.

If the study presents a true picture of an omniscient marketplace, the need to agonize over accounting earnings seems to be questionable. Cash flow is all that matters. It can't possibly be that simple. *

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