Hearing on Pooling Accounting

Prepared Testimony of Mr. Edmund Jenkins
Financial Accounting Standards Board

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

Mr. Chairman, members of the Committee, I am Edmund Jenkins, chairman of the Financial Accounting Standards Board. With me is Kim Petrone, one of the project managers on the subject of today's hearing. I am pleased to be here today. I plan to discuss the due process of the Financial Accounting Standards Board and our proposed standard to improve the accounting for business combinations. I have brief prepared remarks, and I would respectfully request that my full statement and supporting materials be entered into the public record.

Let me begin by telling you a little about the FASB. We are an independent organization that is funded entirely by the private sector. Our mission is to set accounting and reporting standards to protect the consumers of financial information--most notably, investors and creditors. Those consumers rely heavily on credible, transparent, and comparable financial information for effective participation in the capital markets.

To quote a recent letter from the Association for Investment Management and Research, an organization of over 40,000 investment professionals:

The 'lifeblood' of United States capital markets is financial information that is: (1) comparable from firm to firm; (2) relevant to investment and financing decisions; (3) a reliable and faithful depiction of economic reality; and (4) neutral, favoring neither supplier nor user of capital; neither buyer nor seller of securities.

The notion of neutrality is a fundamental element of our standard-setting process. The FASB's Rules of Procedure explicitly require that the Board be objective in its decision making to ensure the neutrality of information resulting from its standards.

Neutrality is an essential criterion by which to judge financial reporting standards, because information that is not neutral loses credibility and value. For example, surely, we would all agree there would be little value to Congress or the federal government of purposely altered and manipulated information about the rate of inflation or about unemployment.

Similarly, to create or to tolerate financial reporting standards that bias or distort financial information to favor a particular transaction, industry, or special interest group undermines the proper functioning of the capital markets and impairs investors' capital allocation decisions.

It is important to remember that our standards affect all public and private nongovernmental organizations, not just companies in one or two industries. Our decision-making process is thorough. We operate under Rules of Procedure that require an extensive due process modeled on the Federal Administrative Procedure Act.

That process is open to public observation and provides numerous opportunities for all interested parties to actively participate in and express their views with respect to any and all of our projects and proposals. The issues that the FASB addresses are necessarily difficult ones for which reasonable people can and do hold differing views. We listen to all concerns raised and weigh them carefully before making any final decisions. We do not expect that everyone will agree with our conclusions, but we do expect that they will respect the fact that we have allowed all interested parties to participate in the process, that we have carefully considered their views, and that in many cases, as you know, we have made significant changes to our proposals in response to the concerns raised.

The subject of this hearing is our proposal to improve the accounting for business combinations. The current accounting in this area was established in 1970. That accounting requires that mergers and acquisitions be reported using either of two very different methods--the purchase method or the pooling-of-interests method. Those two methods produce dramatically different financial reporting results for essentially the same or similar economic transactions.

Under the purchase method, the acquiring company records the net assets of the acquired company at the price paid. The excess of the price paid over the fair value of the acquired company's net assets is recorded as an asset called goodwill, which is subsequently charged against earnings over time.

The purchase method is consistent with the accounting for all other acquired assets--all purchases, whether a piece of machinery or a building, are recorded at the price paid and are generally charged against earnings over their useful economic life.

An alternative to the purchase method, the pooling method, is only available if 12 specific criteria are met; a key criterion is that the consideration exchanged must take the form of stock rather than cash or debt.

In contrast to the purchase method, under the pooling method, the book values of the combining companies are simply added together. There is no recognition of the full price paid. There is, therefore, no change in the recorded amount of the acquired company's net assets to reflect their fair value, no resulting goodwill, and thus no additional earnings charge to reflect the true cost of the transaction.

As you are aware, a key requirement of our proposal is that all business combinations would be accounted for under one method, the purchase method, and that the pooling-of-interests method should be eliminated.

The rationale for that proposed decision includes the following points:

First, the pooling method ignores the values exchanged in a business combination, while the purchase method reflects them.

Second, under the pooling method, financial statement users cannot tell how much was invested in the transaction, nor can they track the subsequent performance of that investment.

Third, having two disparate methods of accounting for essentially the same economic transaction makes it difficult for investors to compare companies that have used different methods to account for their business combinations.

Fourth, because future cash flows are the same whether the pooling or purchase method is used, the boost in earnings under the pooling method reflects artificial accounting differences rather than real economic differences.

And, fifth, because all business combinations are acquisitions, they should be accounted for as such, based on the value of what is given up in the exchange, regardless of whether it is cash, other assets, debt, or equity shares.

As the pace of mergers and acquisitions has significantly increased over recent years, the availability of two different accounting methods that produce dramatically different levels of information to the market has become more and more problematic. Beginning in the early 1990s, the Financial Accounting Standards Advisory Council, a group composed of over 30 senior-level individuals from business, public accounting, professional organizations, and the academic and analyst communities, consistently ranked a project on improving the accounting for business combinations as a high priority for the Board. At the Council's July 1996 meeting, members requested that the Board add a project on business combinations to its agenda.

In the fall of 1996, after further public discussion and debate, the Board decided to accept the recommendation of the Council. Among the more significant reasons that led the Board to reach that decision were the following:

First, there are perceived flaws and deficiencies in the existing accounting for mergers and acquisitions. The most significant perceived flaw is that two economically similar business combinations can be accounted for using different accounting methods that produce dramatically different financial results.

Second, many constituents believe that having two accounting methods that produce dramatically different results affects competition in markets for mergers and acquisitions. Companies that cannot meet all of the conditions for applying the pooling method believe they face an unlevel playing field when competing for target companies against those that can apply that method. Some believe those companies are willing to pay more for a target than companies that cannot use the pooling method.

Third, there has been a continuous need to interpret the existing accounting literature for mergers and acquisitions. The volume of those inquiries, many of which focus on the criteria for use of the pooling method, indicate the literature might be in need of significant repair.

Fourth, because of the rapidly accelerating movement of capital flows globally, there is a need for financial reporting to be comparable internationally. In most parts of the world, the pooling method is either prohibited or used only on an exception basis.

And, fifth, the Board observed that the legitimacy of the pooling method has been regularly and continually challenged by constituents since the term "pooling-of-interests" was first coined in the 1940s.

Since 1996, the Board has held over 40 public meetings about the project on business combinations, issued 2 preliminary documents and an Exposure Draft for public comment, and carefully analyzed and discussed, at public meetings, over 400 comment letters received from a broad range of companies, investors, and other constituents. Among those letters, a significant number were from the high technology and financial services industries, including letters from several of the individuals that appeared today on your first panel.

The Board recently held four days of public hearings to discuss the proposal with interested constituents. Those hearings were held in San Francisco and New York City. Over 40 individuals testified. A majority of those testifying were representatives of companies or organizations from the high technology and financial services industries, including, again, several of those individuals that appeared today on your first panel.

The Board has not yet made any final decisions with respect to the requirements contained in the proposal. The next significant stage in the Board's due process will be to begin its redeliberations of all of the issues contained in the proposal, including the Board's proposed decision to eliminate the pooling method. That process will include numerous public meetings held over the next several months. At those meetings, the Board will carefully consider the comment letters, public hearing testimony, what we learned from this hearing, and all other relevant information received from constituents--including information obtained from the members of our Task Force on Business Combinations and the members of our Financial Accounting Standards Advisory Council. No final decisions will be made until that process is completed.

The Board presently estimates that that process may be completed, and a final standard on business combinations issued, by the end of the year 2000. Any new standard that the Board may issue will be applied prospectively; it will have no impact on the reporting of business combinations that occur prior to the issuance of any final standard.

In closing, I want to be clear that the FASB understands and supports the oversight role of this Committee. We will carefully consider what we learn from this hearing. Let me assure you, Mr. Chairman and members of the Committee that our open due process and our independent and objective decision making will be carefully and fully carried out. To do otherwise would jeopardize the very foundation upon which the FASB was created, and for which it has proven invaluable to the US capital markets and to investors--the consumers of financial information.

Thank you Mr. Chairman. I very much appreciate this opportunity and would be pleased to respond to any questions.

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