Two new accounting rule changes may drastically affect the way companies report their earnings. The changes took effect Jan. 1.
The accounting rules governing business combinations, good will and intangible assets recently changed when the Financial Accounting Standards Board (FASB) finalized Statements of Financial Accounting Standards No. 141, Business Combinations, and No. 142, Good will and Other Intangible Assets.
Companies that will be most affected by these changes are ones with significant amounts of good will reported on their balance sheets. A company typically records an asset as good will when it purchases another company at a price that is greater than the fair value of the net assets acquired. Good will represents a premium paid due to the additional value the buyer expects to receive as a result of purchasing the business, such as synergies or expanded distribution of its products.
Under the old accounting rules, good will was amortized over its expected useful life (not to exceed 40 years), thus creating a noncash charge reducing earnings of a company.
Under the new rules, good will will no longer be amortized, thus eliminating the expense recognition. Instead of periodic amortization, it will be evaluated at least annually to determine if its value has been impaired. If the good will is determined to be impaired, it will be reduced to its estimated fair value, requiring a potentially significant charge to the company’s reported earnings.
Accordingly, in periods where market values are low, many companies will be reporting large charges to earnings related to reductions of goodwill values. This may be particularly true when the acquisitions were in dot-com-type companies whose values have declined.
Another change resulting from these pronouncements is the accounting method used for a business combination. In the past, there were two methods of combining the financial statements of merging entities: the purchase method and pooling of interests. Under the new guidance, pooling of interests has
Although often difficult to obtain due to strict requirements, pooling of interests was often viewed as a more favorable accounting treatment for merging companies. Pooling of interests resulted in a simple combination of balance sheets, with no recognition of good will. Therefore, under pooling of interests, there was never a periodic charge to earnings created as a result of the merger.
Under the purchase method, the assets and liabilities of the acquired entity are recorded at the fair value on the acquirer’s financial statements. The difference between the price paid for the company and the fair value of the net assets acquired is reported as good will.
After the initial favorable reaction to not having to amortize good will passed, companies began to quickly focus their energies and allocate resources to adopt the new rules. Most companies have already begun to implement the
Although these new rules will have no impact on a company’s cash flow, reported earnings per share will be less predictable. Given the recent volatility in the markets, impairment charges may be difficult to avoid for some companies.
Mike McDonald is a partner in the assurance and business advisory practice of Arthur Andersen, Lancaster. Arthur Andersen employs 85,000 people in 84 countries.