The FASB May Add Spark to Lackluster M&A Market

Overview
Unprecedented levels of merger and acquisition activity in the last decade have highlighted the divergence between the purchase and pooling-of-interests methods of accounting for business combinations. Although the current M&A markets have taken away much of the fuel, the Financial Accounting Standards Board (the "FASB") stoked the fire in June 2001 by issuing two new accounting statements: Financial Accounting Standards No. 141, Business Combinations ("SFAS 141") and No. 142, Goodwill and Other Intangible Assets ("SFAS 142," collectively referred to herein as the "Statements").

The Statements are the culmination of FASB's five-year effort to revamp the long-standing purchase accounting rules defined by Accounting Principles Board ("APB") Opinion No. 16, Business Combinations and No. 17, Intangible Assets, as well as certain of their amendments and interpretations. Although the Statements mandate changes in several areas, some of the more significant modifications include the following:

• Pooling and goodwill amortization will be eliminated.Identifiable intangibles will continue to be amortized over their estimated useful lives.Goodwill will remain on the balance sheet and tested periodically for impairment.Certain intangibles that are determined to have "indefinite" lives will be treated like goodwill, residing on the balance sheet and reviewed periodically for impairment.
• The Statements do not require earnings restatements; however, affected companies must make appropriate adjustments for prior purchase acquisitions to be in compliance with the new rules going forward.

Although there has been much discussion since the FASB's initial Exposure Draft regarding the impact of the Statements on the financial statements of public companies, most companies have yet to adopt the new rules. In anticipation of the market evidence that will be prevalent as adoption becomes more widespread, speculation has increased regarding the impact of the Statements on financial markets, with particular focus on M&A activity.

Impact on the Financial Markets: Theory vs. Reality
Theoretically, accounting conventions neither create nor destroy value. As the underlying cash flow of a business will be unaffected, certain academicians would suggest that the impact on the financial markets should be nominal under the Statements. In reality, however, the financial community considers such measures as growth in earnings per share ("EPS"), return on equity, price-to-earnings ("P/E") ratios and dilution when pricing securities and evaluating deals. Although the ultimate impact remains to be seen, these and other factors suggest that the financial markets will experience change in both stock price and deal volume.

Stock Price Impacts
Based on recent studies, the elimination of goodwill amortization is expected to increase net earnings by 10% to 20%, on average. However, due to a variety of factors, P/E ratios may not immediately and fully adjust downward to reflect the accounting change. Table 1 provides examples of the potential changes in both P/E ratios and market capitalizations of selected companies after the removal of goodwill amortization. The discrepancy may create a period of stock price instability and the potential to earn arbitrage profits until market equilibrium returns. The magnitude of the impact, however, is generally expected to be industry driven. For example, the technology sector (i.e., computer hardware, software, life sciences and new media companies) is expected to experience little impact as these companies generally record earnings without goodwill amortization as part of current practices. This is in contrast to those industries that are typically priced on a P/E basis, such as energy and financial services, where the effect is expected to be more acute.

In addition to the expected impact on P/E ratios, stock prices may increase for companies that had negative earnings under the old rules and positive earnings under the Statements. As the pricing behavior of securities analysts does not always track cash flow but instead looks to net earnings, earnings growth and P/E multiples, a negative-to-positive earnings change due to the elimination of goodwill amortization may support increased stock prices.

Potentially mitigating any positive stock price impact due to the expected EPS appreciation is the fact that write-offs of goodwill may become more frequent under the Statements. A study by Professor Hopkins of Indiana University indicated that one-time earnings charges (such as those related to write-offs of in-process research and development) are generally ignored by securities analysts; however, buy-side analysts placed lower valuations on companies that were burdened with recurring goodwill amortization charges using the purchase method than on companies that did not amortize goodwill under pooling. Companies that record an initial goodwill impairment charge upon adoption of the new rules would not likely be penalized by the investment community due to the one-time nature of the expense, and the fact that the charge would be considered as a change in accounting method and not perceived as a potentially negative indication of the company's underlying operations. In addition, the number of companies expected to record such initial impairment charges may further lessen their importance to securities analysts and the investment community.

Although the investment community may largely ignore initial goodwill impairment charges, stock prices may receive a negative response under the Statements if companies take repetitive impairment charges. Similar to goodwill amortization expense under the old rules, recurring goodwill impairment charges may be perceived as a long-term drag on EPS and, more importantly, a warning signal for the company's underlying operations. Moreover, impairment charges may lead to increased earnings volatility, which in turn might negatively impact stock prices.

Deal Volume Uplift
Similar to the impact on stock prices, many factors suggest that M&A activity will increase under the Statements. Transactions that may not have been executed in the past due to anticipated earnings dilution may represent qualified deals in the absence of goodwill amortization. It is generally believed that many transactions that qualified for pooling treatment would not have occurred if purchase accounting were required. As an example, James Barksdale, former CEO of Netscape Communications Corp., stated on numerous occasions that America Online Inc.'s acquisition of the company in 1999 would not have taken place under the purchase method. As the elimination of goodwill amortization under the new rules mitigates many of these concerns, fewer deals are expected to be discarded due to potential earnings dilution.

Hostile takeovers should also contribute to the expected growth in deal volume under the Statements, albeit to a lesser degree. Companies that were historically unattractive acquisition candidates due to size and potential goodwill value (i.e., excess of fair market value over book value) may become attractive to hostile bidders. Moreover, defensive stock buy-back programs that were historically used as a means to "bust a pooling" no longer serve as an effective deterrent to a hostile bidder. Last, cross-border transactions are expected to increase as the Statements put domestic and international buyers on a more closely related accounting basis.

The effect on deal volume is also expected to be somewhat industry centric. Industries with high price to book value ratios (that is, companies with potentially large amounts of goodwill and intangible asset value) will become more attractive as goodwill amortization is eliminated. As illustrated in Table 2, healthcare, consumer staples and information technology represent relatively attractive industries based on this measure.

Summary
The FASB has put forth a credible solution to a historically problematic area, all while negotiating the unique and somewhat divergent interests of numerous constituents, including company managements, auditors, securities analysts, valuation specialists and M&A professionals. Although the ultimate impact is yet to be seen, several elements point to positive implications for the financial markets, at least in the near term. Stock prices may experience a net benefit due to EPS appreciation, and the M&A markets may get an uplift from the existence of more accretive deals. Interpretation and perception of securities analysts and the financial community more generally is the wild card, however. Overall, the FASB may have granted a reprieve to what was otherwise shaping up to be a potentially dismal year of M&A activity.

By Karen Miles and Mark Asbra,
Houlihan Lokey Howard & Zukin

For more information about the authors and their company, please visit Houlihan Lokey Howard & Zukin's website: www.hlhz.com

This article originally appeared in the ACG Network, a publication of the Association for Corporate Growth, www.acg.org and is reprinted with their permission. The Association For Corporate Growth is the premier association of middle-market corporate growth executives and M&A professionals.
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