Hearing on Pooling Accounting

Prepared Testimony of Mr. Harvey Golub
Chairman and CEO
American Express

10:00 a.m., Thursday, March 2, 2000 - Dirksen 628

Mr. Chairman and members of the committee, I am Harvey Golub, Chairman and CEO of the American Express Company. It is a pleasure for me to be with you today, and I want to thank you for providing this forum to discuss the public policy implications of the FASB proposal to eliminate the use of pooling as a method of accounting for business combinations.

This is a relatively arcane subject, normally of interest only to technicians and academicians. However, it also has important policy ramifications, and it is to those ramifications that I will address my remarks.

Let me begin by stating that we have no corporate axe to grind on this issue. American Express has not used pooling since 1990. Acquisitions we made over that time utilized purchase accounting, and we have recorded approximately $1.4 billion of goodwill on our balance sheet as a result. So this is not a matter of narrow self interest to my company.

Furthermore, I fully support independence in the standards setting process. I believe this issue does not warrant legislative intervention. But I believe this issue does have a potential impact on public policy. FASB, by its own admission, does not consider these broad public policy ramifications in the revision of its standards. Therefore, I greatly appreciate the role this Committee plays in ensuring open and honest dialogue on matters such as these and their impact on U.S. businesses.

While most accounting issues have limited scope and impact outside of the business community, merger and acquisition accounting is different. With this topic, as well as a few others, the accounting treatment does have a material impact on a public company's reported financial statements, and, as such, the decisions made by investors. The FASB proposal to eliminate pooling could affect not just the reporting of the transaction itself, but the ability and desire of businesses to initiate them. That is why this accounting issue has a broader impact.

Here's the context: Our economy is one of the fastest growing, most resilient in the world, creating vast wealth that produces the highest standard of living in the world, and has served as an economic model for the world - and has been in this position for decades. There are many reasons for our success - too numerous to discuss in detail.

However, two of these reasons bear on this discussion - first is the mobility of capital and second is the honesty and transparency of our financial reporting - both hallmarks of the American economic system.

  • With regard to the mobility of capital.

    The growth and vibrancy of U.S. businesses require fluid capital markets, where companies and individuals have the freedom to put their capital to what they believe is its best use - and to succeed in their endeavors or fail - depending on their wisdom and wit.

    Under this system:
    * Successful companies come together to gain productivity and efficiencies,
    * Under-performing companies either change, are acquired by stronger ones or go out of business,
    * The capabilities and expertise of one company are bought to enhance the growth and productivity of the other.

    The ability to move capital freely and conduct these types of transactions are basic requirements for a successful economy.

  • With regard to the second factor of public policy related to the FASB proposal - honesty and transparency in our financial reporting - it is to ensure that the books and records of public companies are accurate and consistent.

    Reported numbers must be reliable and the financial results of a company transparent.

    Maintaining these two elements are bedrock requirements of our dynamic economic system and must be protected and maintained.

    * * * * * * * * *

    Yet, the FASB proposal undercuts both of these objectives, I believe for a number of reasons. The best way to demonstrate this is to address each of the reasons the FASB has given for changing the existing accounting standard.

  • First the FASB states that pooling provides less information, and less relevant information, than purchase accounting.

    While the proposed change may provide investors with additional data, I believe it actually provides less useful information.

    With pooling, the financial results of the combining companies are added together using existing balance sheet values.

    Under purchase accounting the balance sheet of the acquired company - and only the acquired company - is "marked to market" as of one specific day, and then has historical cost applied thereafter. This treatment produces financial statements that are a hybrid of historical costs, market values at a single point in time, and assigned asset values.

    Therefore, although the investor may end up with different information under the purchase accounting method, I believe the investor actually receives less useful information given the complexities of the balance sheet and income statement that result from this method.

    The argument for more information is based on a supposed desire to make the results of individual business decisions easier to evaluate. For the reasons I indicated, and will illustrate in a moment, it is impossible to do that. Moreover, executives make decisions every day. Most are not reported and evaluated in the financial statements in any event. Instead investors must rely on the comprehensive results of a company over time to determine if its strategies and its management team are successful.

    It is unrealistic to believe that each and every business decision can be analyzed and assessed from reported numbers. A company can never disclose enough information and analysis to make this true. And since the goal is unattainable, we should not be raising false expectations about the merits of purchase accounting.

  • The second and third reasons given by the FASB relate to valuing a business combination. The FASB believes that pooling ignores the values exchanged in a business combination, and that there should be no difference in accounting treatment regardless of whether that exchange of value involves stock or cash. In my view, the value of the combination is reflected where it matters most - in the marketplace - and how you pay for a combination, be it by issuing stock or paying cash, should be accounted for differently.

    In a merger of companies involving an exchange of stock, the parties to the transaction are the shareholders - not the individual or combined companies. Therefore, under pooling, the dollar value of the transaction itself is not reflected on the company's books, which are maintained at historical cost. The dollar value of the transaction is instead "recognized" by the shareholders based on the market value of their investment as determined by the valuation of the outstanding stock. This valuation process has been successfully managed by our capital markets and there is no reason to believe this will change in the future.

    A cash transaction is different. In that instance one company is acquiring another. The shareholders of the acquiring company are not direct participants, although their approval may be needed. Purchase accounting, although seriously flawed, might be acceptable in a cash transaction depending on the size of companies involved and the intent of the transaction. If there is no intent to truly merge the companies, and the acquiring company is essentially just buying assets, rather than a related business, then this is more like acquiring a new building - the price you pay is the amount you record on your books.

  • The fourth justification given by the FASB is that investors cannot tell how much was invested in the transaction, nor can they track the performance of that investment if the pooling method is used.

    Under either method, the amount being invested is clearly evident from the very first press release announcing the combination. The headlines invariably focus on the dollars involved - either the amount of cash being paid or the value of the shares being issued.

    In terms of investment performance, I would argue that this information is not obtainable under either method. The purpose of business combination is to bring together products, facilities, and employees. If implemented effectively, after the first several months of operations the former "pieces" of the combination become indistinguishable. The reported results under either pooling or purchase accounting do not, and cannot, provide information on the performance of the acquired company. Only the performance of the combined entity can be evaluated.

  • FASB's fifth reason for the elimination of pooling is that having two accounting methods makes it difficult to compare companies. A corollary argument suggests that since the U.S. is the only developed country that allows the use of pooling, we should change our standards to conform to the rest of the world.

    First, under GAAP, there are any number of circumstances where businesses, even those in the same industry, use different methods of accounting for the same transaction. There are different methods of inventory accounting, depreciation, and treatment of capitalized versus expensed costs. Accounting policies are disclosed, and investors make comparative adjustments. The system works well.

    I am aware of no groundswell of support within the investor community, nor major problems identified to support FASB's change. Furthermore, we should be very careful when modifying our standards to conform with the standards of other countries, most of which have lower growth, higher unemployment and less fluid capital markets than we do. I suggest that this is an area where this country should lead instead of follow.

    Finally, if it is consistency that is required, then by all means, lets be consistent - use pooling for all transactions and eliminate purchase accounting entirely.

  • The final reason the FASB gives for eliminating pooling is that it generates a boost in earnings as a result of artificial accounting differences rather than real economic differences.

    There is no boost with pooling. Pooling reflects far better the economic effects of a merger with stock. On the other hand, there is an artificial decline with purchase accounting. This is a significant distinction. The FASB is saying that, because pooling does not create and then amortize the artificial asset of goodwill, it presents a distorting result. To me, the whole concept of goodwill as expressed in purchase accounting is flawed.

    The difference between a company's book value and market value is generally formed over many years based on the positive actions management takes on a company's behalf. At American Express, for example, our market value has increased based on the value of our brand, our growing merchant network, and the capabilities of our employees.

    As the value of these assets cannot be adequately measured, they don't get recorded on our books. But these assets are considered by the market in valuing our stock price, thereby making our market value greater than our book value. Under the proposed standard of purchase accounting, these assets would be given the label "goodwill" and written off over an arbitrary life of 20 years.

    The most basic flaw with the proposal is the FASB presumes that goodwill must be written off. The assumption is that it will lose value even though we continue to take the same type of positive actions that created it in the first place. Reported earnings are reduced by this writeoff, even though there is no negative economic event to justify it.

    Companies can and do tie themselves up in accounting "pretzels" to specifically structure transactions to avoid this amortization. It is this artificial reduction of income that is the most serious issue with the extension of purchase accounting. Moreover, I would strongly urge FASB to postpone any action on these standards until it comes to grip with the more fundamental question of how to treat all intangible assets, including goodwill.

    * * * * * * * * *

    While I believe the FASB proposal is not in the best interest of either businesses or investors, I know that words will not convince everyone. That is why I like to use examples.

    For 1999, American Express reported net income of $2.5 billion and generated a Return on Equity of 25%. I will admit to being biased, but those represent pretty good numbers. I believe we have a strong business and manage it well.

    Now, imagine that a company exists that is the exact clone of American Express - same earnings, ROE, market cap, book equity and share price.

    If these two companies combine under pooling, consolidated earnings would equal $5 billion ($2.5 + $2.5) and ROE would be the same - 25% - exactly what you would expect and exactly what exists in the real world.

    Under purchase accounting it is a completely different result. Because of the difference between American Express' book equity and market value, a $60 billion asset called "goodwill" would be created overnight. We would then have to immediately begin writing this new asset off - at a cost of $3 billion per year.

    So if we combined under purchase accounting, because of the goodwill amortization, reported earnings would drop to $2 billion instead of $5 billion, and our ROE would be only 3% - not 25%. Assuming 500 million shares of stock outstanding for each company, EPS would be $5 prior to the merger and, with pooling, $5 after. With purchase accounting, EPS goes from $5 to $2. This makes no economic sense.

    The underlying business performance of the two companies has not changed. It is still a strong business, and hopefully still well managed. Yet you certainly couldn't tell this by looking at the bottom line reported numbers under purchase accounting.

    Those financial results are enough to make any CEO question the decision to initiate a combination. And it is this potential harm to the economy and our capital markets that requires the purchase accounting proposal be rejected.

    * * * * * * * *

    Mr. Chairman, I hope that my testimony contributes to the debate surrounding FASB's proposed standards. It has been a pleasure for me to be with you and I would be happy to answer any questions you might have.

    Thank you.

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