Roundtable Meeting and Discussion of "Accounting for Goodwill"

The Financial Accounting Standards Board (FASB) has long favored eliminating the pooling-of-interests accounting treatment (pooling accounting) in favor of purchase accounting treatment. The issue driving the debate on pooling vs. purchase accounting is so-called goodwill, defined to be the difference between the market capitalization of a corporation, the value of all its outstanding shares, and the assets of the corporation, including the value of the corporation's buildings, equipment and other valued property. In other words, goodwill is the added value ascribed to a company by its shareholders, above its hard asset value, to reflect that a company has more value than just its assets.

In a pooling accounting treatment of a merger or acquisition, the constituent companies are added together financially: total merged sales, profits, assets, etc. are simply the sum of those of the two companies. And on the day of the acquisition, the goodwill value of the companies is, in effect, also added together. Unlike the other financial parameters, goodwill value-for each of the companies before the merger, and for the combined company after the merger-is set by the shareholders, not by the direct action of the company or according to any accounting rules.

In purchase accounting treatment of an acquisition, the goodwill value of the acquired company is treated like a tangible asset, which loses value over time and is amortized (written off) against earnings. Current SEC practice allows without comment the use of a five-year goodwill amortization period; however, the SEC routinely challenges very short periods ("No, you will not dump this goodwill problem and get it behind you.") and very long periods ("No, you will not spread out the charge over a time frame long enough to make it inconsequential on a quarterly basis.")

Purchase accounting, the FASB-favored method, treats the goodwill of an acquired company identically to the depreciation of a piece of manufacturing equipment that wears out in five years. To equate the goodwill of a company-the intangible value of its employees, technology and success-to the wearing out of a piece of manufacturing equipment is ludicrously wrong. We would not have taken the effort to be here in Washington today if this proposed accounting foible weren't also very harmful to Silicon Valley, for reasons I will explain.

This testimony, makes six major points in bold type, with bullet points to support each of them.

Pooling-of-interests accounting is accurate and preferred by investors. We should maintain its use, even if that requires congressional intervention. FASB's attempt to eliminate pooling accounting will cause significant harm to high-technology companies with no tangible benefit to anyone. Purchase accounting treats people and intellectual property like machines by depreciating them-just when the information economy is proving that the opposite trend is the course for the 21st century.

• FASB should subordinate its zeal for accounting perfection to the basic principal of the Hippocratic Oath: "First, do no harm."

• One would think that FASB would isolate the mechanisms that drive the incredible success of Silicon Valley and promote their broader use as a best practice. Yet, in the last five years, FASB has twice proposed-for the sake of some sort of accounting purity-accounting changes that would gravely harm Silicon Valley.

• FASB's latest threat is the elimination of pooling accounting, an unnecessary impediment to the implementation of mergers and acquisitions at the very time when M&A is clearly becoming the quickest and most efficient way to build the companies and technologies America needs for the emerging information economy.

• FASB's prior attack on Silicon Valley was an attempt to destroy the proven accounting treatment for the stock options that drive the success and economic democratization of Silicon Valley. Where but in Silicon Valley are company shares so widely held that an accounting change relating to stock options could cause an uproar (rallies, acrimony, threatened congressional intervention) big enough to force FASB to withdraw its proposal?

• We would all like an accounting system that is not subject to the ebb and flow of politics, but FASB has proven to be a strident bureaucracy that is willing to harm real economies and real people for intangible, theoretical accounting objectives. Congressional intervention is warranted in the pooling vs purchase debate.

• That some corporations agree with FASB on eliminating pooling does not justify forcing all companies to swallow FASB's bad medicine all of the time. The leaders of Silicon Valley have stated very clearly, and nearly unanimously, that our economy will be damaged by FASB's newest bad idea. That alone should be enough to convince FASB to retreat from forcing this harmful accounting change on us; i.e., "to do no harm."

• What is the benefit of hobbling one of the technology sector's most useful financial tools, mergers and acquisitions? What severe disease in the economy does FASB intend to cure with this medicine laden with side effects? Common sense says that the risk/reward tradeoff of this ill-conceived accounting change clearly favors doing nothing-or, better yet-widening the use of pooling accounting to achieve accounting consistency and market compatibility, as I will explain.

• FASB describes at great length an image of open hearings on the pooling issue, but the recent hearing in San Francisco made it clear that FASB had already made up its mind to eliminate pooling-our "inputs" were ignored in a meaningless pro forma exercise.

FASB's logic on the issue of eliminating pooling is massively flawed as shown by my common English translation of quotes from FASB Chairman Edmund L. Jenkins' Senate testimony, dated June 14, 2000.

• Quote: "However, the full value of the consideration exchange cannot be ignored in transactions in which cash is a consideration. The entire cash outlay must be accounted for and, as a result, something else must be recorded if goodwill is not-either another asset was acquired or the acquirer overpaid (and thus a loss was incurred). Thus, ignoring goodwill only in transactions effected by stock would produce discontinuities in how the purchase method is applied."

  Translation: Goodwill must be an asset, because companies sometimes pay cash for it, and we must have some asset on the balance sheet to offset the cash loss.

  What tangible difference is there between transaction A, in which a company buys a second company with stock, and transaction B, in which a company sells stock and uses the cash proceeds to buy another company for the same price? At the end of the transaction, the situations are identical. Yet, the two methods of accounting produce starkly different results-because the purchase method of accounting is inaccurate, not vice-versa, as shown below.

• Consider the hypothetical acquisition of Amazon.com by a hypothetical, identical second company, Bamazon.com. Suppose also that both identical companies have assets of $1 billion, sales of $2 billion, profits of $100 million and a market capitalization of $10 billion. If Bamazon.com buys Amazon.com with stock, the combined company, as defined by pooling accounting, faithfully replicates its two constituent parts, with twice the sales, profits, market capitalization, and assets. On the other hand, if Bamazon.com sells stock and buys Amazon.com for the same price with the cash raised, the combined company is now forced to report losses of $8 billion over the goodwill amortization period.

• Quotes: "The board acknowledged that measuring goodwill subsequent to its acquisition is more difficult than measuring many other assets … The board conceded that there is some merit to the view that goodwill may not be a wasting asset… Alternatively the amount recorded for goodwill may reflect an undeterminable overpayment for the target company … In addition, testing goodwill for impairment is fraught with difficulties … For all of these reasons the board concluded that impairment testing could not be relied on as a sole means of measuring goodwill subsequent to its acquisition."

  Translation: We do not know how to measure goodwill; in many cases we do not even know if it is increasing or decreasing.

• Quote: "Instead, amortization is the only viable alternative…"

  Translation: Because we do not know how to measure goodwill, let's just make a simple, inaccurate assumption that it always deteriorates and write it off linearly.

• Quote: "Thus the board concluded that goodwill should be treated as a wasting asset and acknowledge that its amortization can at least in part be seen as compensating for a less than fully effective impairment test."

  Translation: Even though we admit there are cases in which goodwill increases in value, we have decided to mandate the write-off of goodwill anyway, because we cannot measure it.

• Quotes: "The board agreed that the amount of goodwill amortized each period may be somewhat arbitrary … Another reason [why the board also disagreed with taking those charges to OCI] is that virtually all companies report OCI on the income statement of changes in equity, which is a statement that attracts less investor attention than the income statement and thus would make goodwill charges less transparent."

  Translation: Even though the goodwill amortization charges we propose would be highly arbitrary, we will force them out of the "other income" line (OCI) and into the highly scrutinized operating earnings line so that investors can understand them better.

• Translation (summing up FASB's rationale): There's this asset called goodwill, which must exist because people sometimes pay cash for it. We don't know exactly what it is composed of, how to measure it, or even if it goes up or down in value over time. Given that lack of knowledge, let's just demand that corporations account for goodwill as if it always goes down in value linearly over an arbitrarily chosen time frame and mandate that goodwill write-offs get mixed directly into the highly sensitive income statement of companies-all to make things clearer for the investor.

  This is the illogic that purports to justify doing great harm to our overwhelmingly successful venture capital industry and its portfolio of companies, many of whom have as their only value intellectual property. This is the illogic that purports to justify damaging the current M&A process, which is the most efficient way to transform our information technology sector. Congress should not allow an important part of our economic future to be injured by poorly conceived theoretical accounting arguments, as "justified" by accounting gibberish.

Even if FASB is allowed to force this ill-conceived accounting change on business, the market will ignore the edict, leading to ad hoc accounting rules.

• The stock market looks at high-tech mergers as if they were done on a pooling basis-period. Ask any analyst on Wall Street. Five years ago, technology acquisitions were made only if they could qualify for pooling accounting, or if the acquiring firm was prepared to endure the painful write-offs associated with purchase accounting. In the last few years, high-tech CEOs have started to effect whatever acquisitions they deem right for their companies-regardless of the burdens of purchase accounting. The analyst community has responded by inventing a new earnings metric called EBG, earnings before goodwill. EBG is equal to the legally mandated earnings per share (EPS), minus charges for goodwill amortization. The analysts obviously feel that the EBG figure more accurately reflects the performance of a company than does EPS.

• When EBG was invented a few years ago, it was used only to forecast and report the earnings of companies with a huge disparity between EPS and EBG due to massive goodwill write-offs. Today, EBG is much more universally used for technology companies. For example, my company, Cypress Semiconductor, reports EPS and EBG figures which differ by only $0.02 of goodwill write-off per quarter, out of a total amount of approximately $0.40-yet, all of the analysts that follow our company report and forecast our earnings as EBG, not EPS, for the sake of only two cents per quarter of goodwill distortion.

• That investors prefer pooling to purchase accounting is obvious because it is the only treatment consistent with the way their free market functions. The great majority of goodwill value in the stock market is controlled directly by investors without government intervention. In the free market, investors agree to pay a market price for the shares of a company, thereby setting both the market capitalization and the goodwill value of that company. Investors own goodwill; they neither need nor want government intervention into their free markets.

• Only in cases of purchase accounting does FASB meddle-or try to meddle-in goodwill valuation. When FASB meddles, goodwill degrades from being the well-defined value investors award a company above its asset value (presumably for its intellectual property and market position)-and starts being a strange, government-mandated asset, depreciated in an often-inaccurate way. It is no wonder that investors look past the distorted purchase accounting treatments to the normal valuation method they use to value every other company in their portfolio, pooling accounting.

• FASB's claim that pooling accounting hides the cost of acquisitions and is not transparent to investors defies common sense. When a CEO says, "We have just purchased a company with no revenue and no profit for $200 million in stock, amounting to a 5% dilution," it is obvious to investors that the outstanding shares in the corporation have increased by 5% and, all things being the same, the earnings per share of the corporation will decrease by 5%, due to the acquisition. What is so difficult to understand? If investors believe that the acquired intellectual property will benefit the company in the long haul, they may choose to increase the share price of the company, thereby increasing its goodwill, to reflect their approval-even if the acquisition brings "mere" intellectual property. On the other hand, as often happens, the investors may drop the share price of the acquiring company, because they do not feel that the share count dilution is warranted by the promise of the acquisition. Pooling accounting is simple, investor-obvious, and market-based-all good reasons not only to leave it in place, but even increase its use.

• FASB says it wants "investor transparency" in financial statements, but its actions are inconsistent with that claim. Today, to get its way on eliminating pooling, FASB is touting the inaccurate, but simple straight-line amortization of goodwill-for the supposed benefit of easily confused shareholders. Yet, five years ago, when FASB was trying to double-count stock options against earnings-both through dilution and as a write-off-they touted the use of the Black-Scholes model for stock-option valuation-one of the least understandable and most opaque formulas in finance-to aid in "investor transparency." FASB's priority is to have its way, not to simplify financial statements for shareholders.

• A technical perspective on M&A: As voice, data, and video converge, how will that service come to American homes? Will it be through the phone (by wire or fiber optics), or through cable connections, or via satellite? No one yet knows how the solution will work out. The Silicon Valley market mechanism, the most efficient way to solve this problem quickly, is working full speed. Telephone companies obviously have a connection to virtually every home in America, but they do not have the bandwidth to bring video or high-speed data into the home. Venture capitalists are busily funding dozens of start-up companies to solve the problem of putting video and high-speed data on telephone lines. The cable companies are also wired to a significant fraction of America, obviously with the ability to bring in video, but how they will take the complicated, computer-controlled voice and data traffic of the telephone system and put it on cable is not yet known. There are numerous start-ups also working on that problem. Many American homes and most American companies are wired for Ethernet/Internet communication. Data flows naturally over this system, but the Internet jumbles voice and video signals. Many Silicon Valley companies are working on solutions for VoIP (Voice over Internet Protocol), or how to put voice bits into lines intended for data bits and keep them unscrambled. In the aggregate, the market-driven purpose of all of these start-up companies is to solve a myriad of difficult technical problems quickly and efficiently, and to sell those solutions to large players (including Lucent, Cisco and AT&T) in the form of acquisitions to enable the corporate restructuring needed to achieve the convergence of voice, data and video. I am not discussing accounting gimmicks here-the corporate structure of the Information Age will undoubtedly be determined by mergers and acquisitions.

• These venture-funded, start-up communication companies were created to be sold for their goodwill value-their technology and brainpower-as they have few tangible assets. Why would we want to adopt hostile accounting rules to hobble the thousands of mergers and acquisitions that will be needed to enable communications convergence? Why not let the free market determine the winners and losers by setting share price-and therefore the goodwill value of information companies-outside of the dictates of a central authority?

• By eliminating pooling, FASB will, with one fell swoop, reduce the value of hundreds of Silicon Valley companies that have already been funded by venture capitalists. Overnight, an excellent start-up company that would have appeared to an acquirer as an excellent $200-million investment will turn into a $200-million burden to be written off. The Fourth Amendment protects our property from government confiscation. One way to take property from citizens is to force them to use their property in a way that they do not want. ("You thought you bought a home site, but what you really bought was an environmental reserve.") FASB's pooling edict would destroy intellectual property value to some extent in many Silicon Valley start-up companies and therefore harm the investments of their venture capitalists. What benefit can FASB demonstrate to offset that harm?

Pooling of interests is the proper way to account for mergers and acquisitions.

• Pooling is accurate: the dilution impact of a pooling transaction is simple and obvious to the investor.

• If pooling accounting were allowed for cash transactions, investors could also easily comprehend the impact on the balance sheet of cash expenditures and the impact on the income statement of reduced interest income. To allow pooling accounting treatment for cash transactions would also eliminate the accounting discrepancies between stock and cash purchases.

• Market analysts use pooling-of-interests accounting to evaluate companies. When they are forced by a FASB mandate to use another accounting treatment, they look past it and recalculate pooling-equivalent earnings to use in their evaluations.

• Investors use pooling accounting for their evaluations because it reflects transactions properly; that is, because it reflects the value of merged companies with a method identical to that used to value companies that have not undergone mergers, and because it keeps the control of goodwill valuation in the marketplace, where it belongs.

• Pooling accounting values "intellectual property" companies-those companies that will dominate the economy as this century progresses-with an appropriate value set by the free market. Purchase accounting values the people and ideas in our most advanced companies as if they were machines that wear out over five years. As we move into the Information Age, FASB is demanding that we use accounting principles more appropriate to the Industrial Age of the 19th century.

Free markets work; let's use them on goodwill, and on FASB.

• The Politburo, Keiretsu and Chaebol have failed. Meanwhile, the "irrational exuberance," "dot.com mania," and alleged lack of "investor transparency" characterizing the chaos of our free markets have served us well. Central planning of goodwill value makes no more sense than central planning of economies.

• As a Silicon Valley CEO, I watched a little start-up, Cisco Systems, spring up across San Jose's Tasman Street from my company. In less than a decade, Cisco became the world's most valuable company by acquiring profitless, goodwill-laden, development-stage companies with no other assets but their important ideas. Is Cisco a great company-one of the Silicon Valley companies that will help America to be pre-eminent in the Information Age-or is Cisco a hollow corporation that should be reporting billions in losses each quarter, spared only by the pooling accounting "loophole?" The obvious answer to this question reflects more on FASB than on Cisco.

• When our standards-setting accountants refuse to look at the reality outside the GAAP-box they choose to live in, we cannot allow their myopia to harm the economy that supports us all. It's time for the Senate to issue a wake-up call to FASB.

• America's current economy is stronger than any economy in history. The free market has served us well in setting the value, and therefore goodwill value, of public companies. Why should we trade the genius of the free market for a set of admittedly inaccurate accounting procedures? Where is the benefit? What is FASB trying to fix? What will FASB do about the important segments of our economy that will be undoubtedly harmed by its edict?

• The current attack on pooling is the second time in five years that FASB-inspired by its zeal for the purity of accounting principles-has proposed and doggedly pursued an ill-conceived and unwise accounting change that would harm Silicon Valley. Congress should intervene to solve the pooling problem now, and, in the long term, consider allowing for an official competitor to FASB so that business can have choices on critical accounting issues instead of FASB's monopolistic dictates.

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