Hearing on Pooling Accounting


Prepared Testimony of Mr. Martin Regalia
Chief Economist
U.S. Chamber of Commerce

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

My name is Dr. Martin A. Regalia, and I am Vice President and Chief Economist of the U.S. Chamber of Commerce. Mr. Chairman, we appreciate the opportunity to testify on the Financial Accounting Standards Board's (FASB) exposure draft entitled "Proposed Statement of Financial Accounting Standards - Business Combinations and Intangible Assets," and we commend you for holding these hearings.

We oppose the decision of FASB to prohibit the use of the "pooling-of-interest method of accounting" for all business combinations and to force the use of the "purchase method" with the subsequent amortization of goodwill over, at most, a twenty-year period. Our opposition is based both on technical and accounting grounds, as well as economic policy concerns. We believe that changing long-standing practices and adoption of new standards will not further the goals of providing more accurate, transparent or reliable financial statements. In addition, such changes likely will hinder the growth of specific sectors of the economy which depend disproportionately on intangible assets.

Pooling-of-Interests vs. Purchase Accounting

When firms combine, there are two alternative methods for computing and reporting for financial statement purposes the combined entity: the pooling-of-interest method and the purchase accounting method. Each combination is evaluated according to a 12-factor test. Those combinations that meet all 12 factors must use the pooling-of-interest method, whereas those failing any of the 12 factors must use the purchase accounting method.

Under the pooling method, the balance sheets of each partner in the merger are simply added together. The new entity reports the combined historical book value. Under purchase accounting, one firm must be designated the acquirer and the other the acquiree. The acquired firm's identifiable assets are valued at current fair market value, and the difference between the fair market value of those assets and the purchase price is recorded as an intangible asset - goodwill. The financial statement of the combined entity is reported as the combination of the acquiring firm's historical book value and the acquired firm's fair market value plus the goodwill. Thereafter, over the years, the goodwill must be "written-off" or charged against reported income. As a result, under purchase accounting, there is a subsequent drag on reported earnings. The magnitude of this drag will depend upon the proportion of intangible assets in the acquired firm and the length of the amortization period - currently 40 years, but shortened to 20 under FASB's proposal.

Technical Issues

FASB's decision to eliminate the pooling-of-interest method and to shorten the allowable amortization period of goodwill to 20 years is based on two assertions: first, that all business combinations are equivalent to a purchase where one firm acquires another and gains control; and second, that all goodwill and other intangible assets degenerate over time. We disagree on both counts.

Clearly, many of today's combinations do not meet FASB's assertion that one firm gains control. For example, when the new entity has a combined board of directors, management and staff, no clear-cut control is established. In such cases, the exposure draft states that one firm will be designated the acquirer based on the "evidence available" without stating what that evidence is or how it should be weighted in the decision process. We do not believe that disallowing a long-standing accounting method that addresses such an ambiguity without prejudice against either partner and substituting a methodology that may ultimately rely on an arbitrary decision, is an improvement. When a market activity does not fit an accounting model, arbitrarily forcing it rarely achieves the desired result.

We also disagree with FASB's assertion that purchase accounting, with its creation and amortization of goodwill, will result in more accurate or more reliable financial statements. While some intangible assets are definable, measurable, and have discernable lives, many do not. It is hard to see how the purchase accounting convention - which lumps intangible assets that are unidentifiable or identifiable but not measurable into an amorphous category called goodwill that is immediately assumed to depreciate in value - provides more accuracy. The excess of the purchase price over the fair market value of the identifiable assets, i.e. the goodwill, is the result of a complex interaction. In past times, it was interpreted as the premium paid for the value of the "ongoing" concern - the brand name and the customer and community relationships. While these factors are still part of goodwill today, intangible assets in the new economy are much broader and more pervasive. Education, management style, and entrepreneurial spirit can easily represent the bulk of assets in today's information technology-driven firms. Whereas, goodwill in the old economy may have been a depreciating asset, goodwill in the new economy may not be. The synergies achieved by modern combinations create intangible assets that are designed to appreciate in value. That is why the free market values them so highly.

While purchase accounting may have been useful for acquisitions of firms with a large percentage of physical assets, it is inadequate for combinations of firms composed primarily of intangible assets, especially when those intangible assets are largely unidentifiable, unmeasurable and of indeterminate lives. It is hard to see how combining the historical book values of an arbitrarily designated acquiring firm with the estimated market value of the acquired firm and some dubious measure of goodwill yields a more reliable financial statement than a combination of book values, especially if the combined entity engages in successive combinations. Moreover, resorting to the approach of forcing a "write-off" of an intangible asset merely because accountants cannot understand or quantify it, is unacceptable.

A better course of action might be that taken by Securities and Exchange Commission Chairman Arthur Levitt who has commissioned a group of experts to examine the issues surrounding the accounting of intangible assets and goodwill. We urge FASB to await the findings of this distinguished group of advisors before implementing accounting rule changes.

General Policy Considerations

In addition to the previously discussed technical objections, we believe that the proposed action by FASB has broad economic ramifications as well. We understand that FASB should, indeed must, be concerned primarily with the "relevance and reliability" of financial information and not the economic consequences. However, the Exposure Draft states two reasons for undertaking this project, neither of which are relevance and reliability concerns. One concern was the increasing amount of staff time at both the SEC and FASB being devoted to mergers and acquisitions using the pooling-of-interest method. The other concern was a desire to achieve international convergence of accounting standards given the increase in international capital flows. We believe proposals to change accounting standards undertaken for staffing and/or international policy considerations ought to also include domestic economic considerations in the evaluation process.

The fact that SEC staff are being asked to devote more time to business combinations using the pooling method is as much an indication of the increased importance of the high technology sector in today's new economy, as it is an indication of excessive use of a "loophole." Today's high technology firms are composed primarily of intangible assets. They are in many cases relatively cash poor and, as such, are not in a position to buy other firms. They do, however, wish to create synergistic value through business combinations, and the financial markets have voted their approval. While we share FASB's belief that accounting standards must remain credible and reliable, the current method is well established and widely understood and in our view, clearly meets that standard. Staffing constraints should not be sufficient cause for changing a useful and workable approach.

We find FASB's other rationale equally uncompelling. There is no plan currently in place to achieve convergence of accounting standards for business combinations. Some countries allow the pooling method, some do not, and others allow it in fairly restrictive circumstances. If we want to adjust our standards on the basis of achieving convergence of international policy, then we should have assurances from the other countries of a similar commitment in advance, and the decision process to adopt such changes should include domestic economic consequences.

The technology and financial services sectors have played a crucial role in our current position as a world leader. One reason for the success of these sectors has been their ability to grow. We do not believe that this opportunity for economic growth should be curtailed because of staffing constraints or the desire to adjust our standards to conform to our international competitors, especially when there is no consensus abroad. We should not change our standards without more compelling reasons.

The U.S. Chamber urges FASB to reconsider its position and withdraw its exposure draft on this issue until Chairman Levitt's group has reported and all concerned parties have had the opportunity to digest its findings. The issues at stake are of great concern to our members and to all who want to encourage the continued economic growth we are currently enjoying.

In conclusion, I would like to add that we are not asking Congress to adopt accounting standards or to establish an official oversight role, but rather to encourage FASB to rethink this rush to judgment. The current accounting framework has worked well. There are no egregious or exigent market failures driving this proposal for change. There are legitimate concerns over the proper accounting for intangibles and a commission has been delegated to examine this issue. Clearly, we have time to wait and evaluate. Prudence dictates that we do so. Thank you.




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