January 2002

Untangling FASB's convoluted logic

Robert Waxman's article in October ("Goodwill Convergence"), regarding the FASB's largely misguided recent pronouncements on accounting for business combinations and nonamortization of goodwill, inspired me to share some thoughts.

The publicity surrounding these statements brings to mind the adage "watch what we do, not what we say." These statements are billed as eliminating pooling of interests accounting, a laudable goal. However, the effect of the statements is to significantly expand the use of pooling accounting. True, the minority of acquisitions previously accounted for as poolings will now be recorded at full value on the balance sheet. However, eliminating the amortization of goodwill means that the income statement effect of the majority of acquisitions previously treated as purchases will now be determined under the old pooling rules: The appropriate portion of the "excess" purchases price will not be charged to income. (I realize this will not be the case for the portion of the "excess" allocated to specific assets, but that will often be only a, small portion of the purchase price.)

The arguments used to support the nonamortization of goodwill recirculate theories that were popular in the past and have been rightly discredited. One argument is that amortization is too difficult. Because we don't know the exact life, do nothing, and the impairment test will take care of any problem. These same arguments were advanced several generations ago as reasons not to depreciate fixed assets: Properly maintained, they will last indefinitely. Furthermore, why should there be an income charge if the assets are not declining in value? These are familiar arguments and I won't discuss them here.

Let's be realistic: Obviously, companies make acquisitions in order to enhance their profits. Because companies include those profits in their income statements, they should also include all the costs of generating those profits. Under the impairment approach, any write-down will be taken in the wrong period (i.e., when the acquired company or product is no longer profitable). The company is likely to stress the "one-time" nature of the charge and encourage users of the financial statements to ignore it when evaluating the company's performance. Too many analysts will happily oblige, and the company's press release or financial statements are unlikely to disclose that this "one-time charge" is really the delayed correction of overstated profits for previous years.

A similar argument is that there are too many uncertainties regarding the determination of an asset's useful life and thus it shouldn't be done. Similar arguments were advanced when FASB proposed accrual accounting for OPEBS. Fortunately, in that case, the board did not accept those arguments.

In the interest of brevity, a final point: In the past, FASB and its supporters have implied that its processes and pronouncements are superior to those of other standards-setting bodies, such as the late International Accounting Standards Committee (IASC), on whose board I served from 1990 to 1994 as the AICPA representative. I acknowledge imperfections in the IASC's procedures. However, when it addressed these issues, it came up with a superior standard. Let's hope that the new International Accounting Standards Board (IASB) does not feel compelled to follow FASB down the wrong path.

Ronald J. Murray, CPA (Retired) Stamford, Conn.

The writer is a former member of the Emerging Issues Task Force (EITF) and Advisory Task Force on the Consolidation Project of the FASB, the International Accounting Standards Committee (IASC), and the AICPA Accounting Standards Executive Committee

. The Author Responds

Because of space limitations, Mr. Murray mentions only a few of the concerns CPAs have with SFASs 141 and 142. His letter, together with another article in the October issue ("Users' Comments on SFAS 141 and 142 on Business Combinations and Goodwill," by Eric E. Lewis, Jeffrey W. Lippitt, and Nicholas J. Mastracchio, Jr.), illustrate some of the weaknesses, questionable conclusions, and implementation difficulties of these two statements.

Negative goodwill (after it is allocated to certain assets) is a realized gain on the date of a business combination, a gain which is classified as extraordinary. FASB believes negative goodwill is an unrecognizable obligation that does not meet the definition of a liability, and therefore recording it as income is a "practical answer." However, many CPAs believe that a gain should not be recorded in a business combination because substantial and uncertain obligations are associated with such an acquisition, and thus it is not realized income. The net effect of this accounting is to record the income today and the anticipated losses of the acquired company (one reason the entity may have been bought below net fair value) over near-term subsequent periods.

The board believes that negative goodwill categorically meets the definition of an extraordinary item-that is, it is both unusual and infrequent, while many accountants believe that negative goodwill does not meet both criteria. SFAS 141 provides an exception to the extraordinary treatment when a business combination involves contingent consideration that, if paid, would be recorded as an additional element of the cost of the acquired entity (e.g., an earnings contingency). In this case, an amount equal to the lesser of the maximum amount of the contingent consideration, or the remaining excess, is recorded as if it were a liability. In effect, this accounting records contingent consideration as a liability before it is issuable. The significance is that all (or part) of the "gain" is deferred and the carrying amount of the assets acquired will not be reduced on a pro rata basis, resulting in more deprecation and amortization expense.

SFAS 141 tells us that internally generated goodwill maintains the value of recorded goodwill and therefore indirectly supports the impairment model. Many CPAs, however, are not convinced that internally generated goodwill transmutes goodwill into a nonwasting asset. More to the point, the statement tells us that the quality of financial reporting is enhanced by not amortizing goodwill (i.e., the financial statements are more useful and relevant), and that the board believed that amortization of goodwill was in many cases ignored by users of financial statements anyway. But if that were the case, why did the board need to "fix" the accounting?

Ronald Murray's letter touches on fixed assets, which, together with the arguments for not amortizing goodwill in SFAS 142, revisits some old discussions on depreciation: Why should a specific appreciating asset (e.g., real estate) that is properly maintained be amortized as long as its fair value is in excess of its initial carrying value? Many accountants believe that determining the fair value of tangible property like real estate is easier than determining the "implied fair value of goodwill."

The potential need for a legal opinion to definitively establish if an intangible asset is a contractual or legal right or obligation creates an implementation problem. For example, consider the question of whether a trade secret or trade dress is, at the acquisition date, in fact supported by a legal right or contract. If there is no discernable contract or legal right, the entity must establish that the intangible can be sold, transferred, licensed, rented, or exchanged. If this separability criterion is not met, the intangible will be subsumed in goodwill. Nevertheless, if the trade secret or trade dress meets the separability test, each intangible must then be fairly valued and its life objectively determined. These are not easy tasks, and probably relatively few valuation experts have the skills to do this work.

Even though CPAs have always had to deal with subjective tests, their load is increasing. We know that subjective tests result in different answers depending on the observer and when the observation is made-the Heisenberg uncertainty principle as applied to accounting. For example:

• Intangible assets should be tested for impairment whenever events or circumstances indicate there will be a write-down (SFAS 144), such as-
• a significant decrease in the market price,
• a significant adverse change in the way the asset is used, or
• a significant adverse change in legal factors or in the business climate.
• Goodwill should be tested for impairment whenever events or circumstances indicate that there is a more than 50% chance of reducing its fair value. Examples include-
• a significant adverse change in legal factors or the business climate, n an adverse action or assessment by a regulator, n unanticipated competition, n a loss of key personnel, or
• a more than 50% chance that a reporting unit or a significant part of a reporting unit will be sold or disposed of. Next question: In each of the above tests, how do (or should) CPAs define "significant" (how much) and "adverse" (how bad and for how long)? In addition, when does competition become unanticipated, and how does the CPA know when the 51% threshold has been reached?

Carving up the entity into reporting units will be difficult, but determining fair values will be even more so. Deriving and auditing the fair values of reporting units-and then the fair values of each asset (both tangible and intangible) and each liability in those reporting units-will be quite a challenge and a substantial implementation issue. Furthermore, although these fair value allocations are strictly memo accounts, the board effectively requires the "push down" of the hypothetical purchase price to reporting units (even where there is a significant minority interest). Even more interesting, in certain situations, the board requires the determination of the hypothetical purchase price be allocated to the net assets of the reporting units of the acquirer.

In general, I wish that more CPAs would respond when FASB and the AICPA ask for comments on their proposals. When we don't speak up, we get more complicated accounting pronouncements, more audit challenges, and more rules that we may not understand, want, or deserve.

Robert N. Waxman, CPA Corporate Finance Advisory New York City

Editor's note: As readers work with these two statements, we encourage them to e-mail questions, views, and comments to cpaj@nysscpa.org

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