The Accounting Onion

A Sampling of What Lurks at the Bottom of the Goodwill Garbage Heap

I have already reported stumbling upon a fascinating interview of Clarence Sampson, SEC Chief Accountant for more than a decade starting in the mid-1970s. Of his many tales of peculiar interactions with special interests, this one struck me right in one of my biggest pet peeves:

"In the process of recording ... [a business combination transaction] ... they discovered, by golly, that in a $300,000,000 acquisition, $100,000,000 of assets they thought they had didn't exist. And so the company tromped in with their auditors and said, the rules say the difference between what we got and what we paid is goodwill. I simply wasn't able to accept the fact that there should be $100,000,000 goodwill on their books, which didn't exist, and we told them to write it off."

I have explained in a previous post many months ago why I think the process of measuring goodwill and periodically testing it for impairment is a shameful waste of time and money. I would be hard pressed to think of a better example than Clarence's story to back that up. But, I also want to explain why Clarence's story is more than merely an interesting anomaly.

Goodwill (I despise the term, but will use it here for the sake of clarity and with the understanding that it's meaning as a term of art bears no relation whatsoever to what regular folks think it means) arises from two sources. One source is genuine assets that have been acquired, but for various and sundry good reasons those assets are never separately recognized under GAAP. Even the management that bought those assets probably can't adequately explain to you what those assets actually are in anything but very general and vague terms. Yet, in a business combination, we recognize them all together (and mixing them in with liabilities of a similar ilk as part of the process) as 'goodwill.'

The second source of goodwill are 'mistakes.' In other words, paying a price to acquire a company greater than its value. Although the amounts of money in Clarence's story are extreme, the fact of the matter is that mistakes happen all the time. There are business school academics who spend virtually their entire careers trying to explain why it is so often the case that an acquiror's stock price goes down after they have proudly announced their plans to acquire another company. During my part-time career as litigation consultant, I can recall at least four cases where acquirors have claimed that assets they purportedly purchased either didn't exist, or those assets were worth less than they were represented to be worth by acquirees. In all of those cases I was involved in, how did a mistake get accounted for? Capitalized as goodwill, of course! No Clarence Sampson or auditor suggested they do otherwise.

I suppose that one could justify initial capitalization of mistakes as goodwill, because they are impossible to detect at the time a transaction takes place; if they could have been detected, then the purchase price presumably would have been adjusted. But, don't business combination accounting rules give one a full year to adjust the values of assets acquired and liabilities assumed? Sometimes they do, but the rules don't mention that mistakes aren't supposed to go to goodwill; so that's where they go.

But, won't impairment testing eventually catch the mistakes and chase them out of goodwill? Not usually. If it ever should happen that a mistake pops out as an impairment charge, it's usually years after the mistake has become known to management. The goodwill impairment tests allow companies to aggregate subsidiaries into 'reporting units,' which are usually large enough to allow any mistakes to be offset by goodwill from other acquisitions that have accumulated a successful enough track record over time to protect their own goodwill, plus the goodwill generated by any recent mistakes.

At least the big mistakes will get caught by the Chief Accountant, right? Ironically, I doubt whether the current chief accountant or his predecessor would have the gumption Clarence did to stand up to a registrant and its auditor like that. Unlike Clarence, who spent decades coming up through the ranks of the SEC, these guys spent their distinguished careers chest bumping their fellow Big Four partners. When an erstwhile comrade-in-arms "tromps" into the SEC as his client's Doberman Pincer, will he be welcome with the secret Big Four handshake? But to be fair, today's SEC staff may not have the technical ammunition Clarence did; the FASB's sausage factory has created a new line of business combinations rules; their literal application has come to be the generally accepted method for leveling the M&A playing field…

… as opposed to Clarence Sampson's application of common sense principles:

"And that's the kind of thing that the Commission can say - look that's just too far; you can't look at the written words and try to apply them to a situation where it just doesn't make sense. And as a matter of fact there's some language, and I'll bet you can tell me where it is, which says if it doesn't make sense, you can't do it."

Those "written words" (principles-based rules?) Clarence couldn't specifically recall are still in the cupboard (see Exchange Act Rule 12b-20, and AICPA Ethics Rule 203-1), but they haven't been taken off the shelf in a real long time.

Anyway, I hope you enjoyed Clarence's story as much as I did.

SAB 112: Let the New Earnings Game Begin

In a recent post on business combinations accounting that is related to SAB 112, I criticized the FASB for creating yet another loophole in business combinations accounting that make M&A transactions more attractive than they really should be. To recap, I described how JP Morgan wrote down toxic loans acquired from WaMu so that, going forward, JP Morgan had a built-in stream of future earnings at very high interest rates.

First, a Mea Culpa

I was feeling pretty satisfied with myself until reader Michael interrupted my reverie with several interesting and valid comments. With great reluctance, I began to re-think parts of my screed.

First of all, he found a couple of inaccuracies in my telling, which should be corrected:

"Tom, I think I'm with you on your conclusion (i.e. mark all financial assets to fair value (replacement cost?)) but the area of GAAP causing the inconsistent measurement is not FAS 141(R). FAS 141(R) was first effective for transactions that closed on or after 1/1/09 for calendar year companies. JPMorgan was subject to FAS 141 (no R) for this transaction and disclosed as such. However, you may be aware that even under FAS 141, certain loans were required to be accounted for at fair value, notwithstanding the SAB [Topic 2A-(5)]...those loans that were purchased at a significant discount are subject to the guidance in SOP 03-3, which requires a fair value measurement [at the acquisition date] for such loans. Given the purely awful composition of WaMu's portfolio, it is not surprising that half their loans fell into that guidance. I think most of the focus should be on the criminal allowance put up by WaMu pre-transaction...$2 billion on $240 billion in loans at 3/31/08, $8 billion on $240 at 6/30/08. Yikes." [italics and bolding supplied]

That's a really interesting last sentence, especially coming from an auditor, and I'm betting that even the PCAOB will not want to go near that one. As important as that may be, it's a digression from the mea culpa I now proffer to all who read that post: I overlooked the fact that SOP 03-3 would be applicable, because I mistakenly thought the acquisition of WaMu was accounted for under FAS 141(R).

Michael's comment and my mea culpa notwithstanding, the fact remains that henceforth, FAS 141(R) has taken over for SOP 03-3 in the earnings management toolbox when it comes to making sure that a business combination transaction will be accretive to future earnings. (Note: that doesn't mean that SOP 03-3 has become obsolete. Loan acquisitions that are not part of a business combination are also within its scope.)

Michael also responded to my suggestion that the offending provision of FAS 141(R) should be suspended until loans are fair valued.  He pointed out that should that day ever come, the invitation for earnings management of which I spoke doesn't completely go away:

" … [L]et's assume that all financial instruments were remeasured each period at fair value. While there will be timing differences with loans that are measured at fair value at acquisition, net income over the life of the same loans will be the same...if JPMorgan had to continue to remark the loans, they'd still recognize that accretion into earnings if the loans ultimately perform. I understand your generally well founded skepticism, but I think this is one of the less offensive areas of FAS 141R.

Michael is right (again). I could live with an outcome whereby unbiased fair value measurements will provide a stream of accounting earnings to an acquiree. But, I am indeed more than a little skeptical that two versions of fair value will emerge from FAS 141(R)—if they haven't already from other games that executives will play with earnings. The WaMu's will still have strong incentives to overstate market value, and even Michael implies that auditors are not likely to stand in their way. The JP Morgans of the world have incentives to understate the same fair values.

Enter SAB 112

That's where SAB 112 comes into the discussion. Among other ministerial changes, it deleted Topic 2A-(5) of the SAB codification, which I described in the earlier post and became unnecessary after FAS 141(R) instituted the fair value requirement for acquired loans. The crux of this post is this: if the SEC thought that manipulation of loan loss reserves during a business combination merited an anti-abuse rule, then more than ministerial adaptations were called for.  How can the SEC be so naïve as to think that fair value will fix the problem of loan value manipulation? Instead of merely deleting Topic 2A-(5), they should have re-written it to put the brakes on what will surely become a new recipe for chicken salad. It would have been really simple for the SEC to make the following rule:

Irrespective of pre- and post-acquisition bases of measurement, the new carrying amount of every asset recognized may be no less at the date of acquisition than the carrying amount recognized by the acquiree; similarly, the fair value of liabilities assumed may be no greater than amounts recognized by acquirees.

I know that my suggestion may sound unprinicpled and draconian to some (and I would be prepared to allow for some exceptions), but the reality is that no set of business combination accounting rules will be perfectly 'efficient.' For any accounting rule, it is inevitable that some value-creating transactions will be discouraged, and some value-destroying transactions will occur because the accounting result is too sweet to resist. The key for regulators is to strike an appropriate balance based on broadly acceptable objectives for financial reporting.

In regard to business combinations, there have been no such objectives ever before.  It is clear that the rules have been completely out of whack since the inception of GAAP in the 1930s. As for the last few decades, the evidence is crystal clear that our economy has been administered a nearly lethal dose of value-destroying business combinations to juice executive compensation while killing share prices and wreaking havoc among rank and file employees. That's why I believe it is time to trying something more radical: an acquiror should not be able to create a stream of reported earnings by writedowns to assets or increases to liabilities. Therefore, post acquisition writedowns of assets and write-ups of liabilities would be charged against the post-combination earnings of the acquiror.

Let's see if the 'new SEC' is up to the task. We'll know they're doing it right if the EU and IASB have conniptions over it.

FAS 141(R): Turning Toxic Loans into Star Performers*

From a MoneyNews.com story published this Wednesday headlined "Banks Stand to Reap Billions from Purchased Bad Loans," came an account of a jaw-dropping transaction. It was spawned by FAS 141(R), the latest and greatest standard on accounting for business combinations:

"When JPMorgan bought WaMu out of receivership last September, it used the purchase accounting rule [FAS 141(R)] to record impaired loans at fair value, marking down 118.2 billion of assets by 25 percent.

Now, JPMorgan says its first-quarter gains from the WaMu loans resulted in $1.26 billion in interest income and left the bank within an accretable-yield balance that could result in additional income of $29.1 billion."

Business combination accounting has forever been fertile ground for earnings and balance sheet management for one simple reason: the opportunity to tweak the amounts reported for the assets acquired and liabilities assumed, with the ultimate objective of brightening post-acquisition earnings reports. But, as tiresome as that old game might be, the kind of maneuver that JPMorgan's management has engineered is a novel twist on an old loophole that had once been closed pretty tightly by the SEC.

The Closed Loophole that Would Be Re-Opened by the FASB

Once the "pooling of interests" method of business combination accounting of APB 16 was abolished with the advent of FAS 141 (not to be confused with FAS 141(R)), the most basic surviving principle of business combination accounting became thus: the acquisition of a business should always be reflected on the financial statements of the acquiror by assigning a new carrying amount to each of the acquired company's assets and liabilities. This new carrying amount would be updated, based on current assumptions and estimates regarding the future role of the acquired assets and liabilities in the combined entity. The implementation of this principle had long been known as the "purchase accounting" method for business combinations.

With certain important exceptions, SFAS 141 mandated that new carrying amounts for assets acquired in a business combinations would be based on their fair values. The exception that is germane to the JPMorgan story pertains to loans (i.e., trade receivables, interest-bearing loans and marketable debt securities classified as held-to-maturity). The measurement bases for these items were carried forward from APB 16's version of the purchase accounting method: a gross amount reduced by an appropriate allowance for uncollectible accounts. This exception to loan measurement was important, because it also meant that a 1986 SEC staff position would still be applicable to purchase accounting.

At that time, the SEC saw fit to put a stop to unwarranted increases in the allowance for loan losses as part of the business combination transaction. Increases to loan loss allowances would mathematically transfer future loan losses to goodwill, where they would be deferred indefinitely, with the effect of reporting inflated earnings in future periods as the loans were eventually settled for more than their understated carrying amounts. Staff Accounting Bulletin 61 (Topic 2-A(5)) states that the SEC would not permit any adjustments of the acquiree's estimate of loan loss reserves, unless the acquiror's plans for ultimate recovery of the loans were demonstrably different from the plans that had served as the basis for the acquiree's estimates of the loss reserves.

FASB Amnesia?

FAS 141(R) did away with the "purchase method" and established the "acquisition method" of accounting for business combinations. It apparently did so out of a belief that measurements of assets and liabilities that are based on the most current information available are usually, if not always, preferable to valuations based on less-current information. The JPMorgan case glaringly points to a significant flaw in that belief: inconsistent application of fair value could be more harmful than consistent application of a less desirable attribute. As to the case at hand:

• WaMu, as is quite common, accounted for its loans based on a held-to-maturity model. That is, except for recognizing declines in creditworthiness, the loan carrying amount is based on the original contractual terms; interest is accrued by multiplying the net carrying amount by the yield to maturity as of the date the loan was originated/acquired.

• Even though the market value of these loans had declined significantly as they turned toxic, WaMu apparently was not required to record losses to bring the loans down to their fair values.

• JPMorgan, when acquiring WaMu, was required by FAS 141(R) to mark the loans to market. Subsequent accounting by JPMorgan will continue the WaMu the held-to-maturity model.

It would be a pretty safe bet that JPMorgan was very 'conservative' in their estimates of fair value for the loans; that's because the lower the fair value, the higher the yield to maturity, and the higher the amount of reported future earnings. Of course, there are some limits to JPMorgan's estimate of fair value: auditor pushback, SEC review, increased risk of goodwill impairment charges, and capital adequacy regulations. But, at least in this case, it is possible to become rich without being greedy.

Where is the SEC!?

Maybe there has been more coverage of this issue, but I haven't seen it; kudos to its author, Julie Crawshaw of Newsmax. If we are concerned that bank executives are being overcompensated, especially on the taxpayers' dime, here is a prime example of where insufficient oversight has spawned a new source of moral hazard.

For starters, the SEC should put a stop to this obvious and blatant abuse, immediately. They should issue another SAB, carving out the offending provision of FAS 141(R) and restoring the long-established and functioning status quo. Every company that benefitted from the ill-conceived accounting rule should be forced to retroactively restate their earnings – especially any financial institution on the government dole.

Perhaps the lack of permanent leadership in the Commission's Office of the Chief Accountant is contributing to a lack of attention to this obvious problem, but it is in no way an excuse. Also, this is a problem created by the FASB. Let's be charitable and call it an unintended consequence, but whatever the cause, the FASB should move to fix it forthwith. I'm suggesting that the SEC should act first, solely because they have the demonstrated capability of being able to move the fastest. That's because a SAB doesn't have to be exposed for comment before it can be issued.

But, lacking any actions by either the FASB or SEC to put the cat back in the bag, auditors (perhaps via the PCAOB), and boards should be put on notice of a new potential scheme to inflate executive compensation in the absence of actual value creation for stakeholders. If a single dime of executive compensation comes out of accreted excess earnings from these business combination games, I hope that private securities lawyers will round up the proxies and the lawsuits, settling for nothing less than "a pound of flesh."

A larger lesson is important to briefly discuss in order to understand how this kind of loophole can occur: in accounting for financial assets, the only workable system is comprehensive mark-to-market, all of the time. The current situation is a consequence (intended or otherwise) of the piecemeal approach pursued by the FASB (and IASB) towards fair value accounting.

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*Note:  I made a technical correction to this post, that you can view here.

High Time to Abandon the Accounting for Contingent Liabilities

What the FASB calls "contingent liabilities" in FAS 5, the IASB terms "provisions" in IAS 37. I prefer the IASB's language, because of its pejorative ring to my American ears: it more clearly connotes the virtually unchecked discretion issuers have abused to obfuscate liabilities and trends in earnings.

In a previous post, I described how the IASB has been working on giving issuers even more discretion to manage their provisions.At the same time, the FASB has been fighting the good fight, but getting its butt kicked in the process. Their latest defeat was the issuance of FSP FAS 141(R)-1, to back off of their requirement to measure at fair value contingent liabilities assumed in a business combination.

Part of the FASB's problem is that they still haven't fully come to grips with measuring the fair value of any liability, much less a contingent liability. It seems reasonable enough to aim for consistent measurement of all assets acquired and liabilities assumed; but, how does one measure the fair value of a matter under litigation? Even if it were legal to pay a third party to assume the consequences of a matter in litigation, a 'moral hazard' is likely an unwanted by-product. Specifically, the transferor's incentives to act in ways that could lessen the ultimate consequences of the obligation could diminish significantly. The bottom line: score one for the issuers who fought the offending provisions in FAS 141(R) and made the FASB retreat.

But, as the FASB has retreated in one area, it is retrenching in another with the issuance of Proposed FSP No. FAS 157-f, Measuring Liabilities under FASB Statement No. 157. The FSP, among other things, addresses fair value measurement of a liability when contractual restrictions may prevent it from being transferred. The proposed FSP provides that if a quoted price in an active market for the identical liability is available, that price must be used to measure fair value. In all other circumstances, fair value would be measured by selecting the one approach, of four allowable approaches, that maximizes the use of relevant observable inputs and minimizes the use of unobservable inputs. The four allowable approaches are as follows:

• The quoted price of the identical liability when traded as an asset in an active market;

• The quoted price of the identical liability, or the identical liability when traded as an asset in markets that are not active;

• The quoted price for similar liabilities, or similar liabilities when traded as assets in markets that are active;

• Another valuation technique that is consistent with the principles of SFAS 157.

So, as best as I can tell, the issue of measuring contingent liabilities is still not resolved. Since FAS 157 defines the fair value of a liability as the price that would be paid to transfer a liability in an orderly transaction between market participants at the measurement date (para. 5), it seems that the FSP is providing no help for contingent liabilities. The first three approaches permitted by the proposed FSP are clearly inapplicable, and there is nothing new in the fourth approach that would permit the evaluation of a contingent liability from the perspective of the asset holder.

A Solution: Assume There is No Problem

As I mentioned earlier, both the FASB and the IASB have been working on the contingent liability problem in their own separate ways. The FASB has been getting lambasted for their proposals to enhance disclosures and fair value measurement, while the IASB is going on its merry way to see how they can make a new and improved version of chicken salad for issuers. They have been mulling over an approach that would recognize all 'present obligations' (whatever that means), regardless of likelihood of payment, if they can be measured 'reliably' (whatever that means).  Since likelihood of payment is being taken out of the equation, whatever 'present obligation' means is the crux of the matter. And, as it turns out, a hypothetical case scenario that the IASB discussed during its deliberations is a convenient vehicle for me to express how I think contingent liabilities ought to be handled.

Here's the case:

A vendor sells hamburgers in a jurisdiction where the law stipulates that the vendor must pay compensation of C100,000 to each customer who receives a contaminated hamburger. Past experience indicates that one in every one million hamburgers is contaminated. On the last day of the reporting period, the vendor sold one hamburger.

And, here are some questions, along with my responses:

Question #1: Does the vendor have a present obligation at the balance sheet date?

My response: No.

Businesses have many responsibilities under various laws: reasonably ensuring that no physical harm will come to their customers as a result of their actions, truth in advertising, not polluting, and so on and so forth. Although investors would care to know about these exposures and their potential affect on future cash flows it is simply not practical to convey this information through recognition of contingent liabilities on the balance sheet.  It has been vividly demonstrated over the past 35 years that FAS 5 has been in existence that it is a pipe dream to think that reliable estimates can be expected from issuers when doing so conflicts with the interests of executives. (Note as well, that the ability to precisely state an amount for the contingency does not affect my response to this question.)

Question #2: Does the answer change if the probability of contamination is more likely than not instead of one in a million?

My response: No.

This gets at the key issue as to whether the probability of an outcome should determine whether a contingent liability is recognized. I agree with the IASB in so far that the probability of an outcome should not affect recognition. Whatever their reasoning, however, mine is that FAS 5 and IAS 37, which depend on probability estimates, have failed. Moreover, from my point of view, which is different from theirs, it is undesirable to let preparers continue to abuse the opportunities to exercise "judgment" in FAS 5 to manage earnings. The only solution is to restrict liability recognition to legally certain obligations.

Question #3: Should the answer change if the customer who purchased the hamburger claimed it was contaminated?

My response: No, unless it is established with virtual certainty that the vendor has a legal obligation.

I admit that judgment would be required to determine whether a legal obligation exists, but it is significantly less consequential than estimating probabilities and expected outcomes of contingent liabilities.

Question #4: Reverting to the original scenario, should the answer change if the vendor warranted the safety of their hamburgers, and stood ready to pay C100,000 to anyone with a valid claim?

My response: Yes.

The vendor clearly has a present obligation to stand ready to compensate customers who have been served contaminated hamburgers. That obligation is strongly analogous to an insurer's obligation, and should be accounted for the same way. Amazingly, neither GAAP nor IFRS currently require recognition of liabilities arising from a product warranty unless the warranty is separately priced.

Question #5: Reverting to the original scenario, should the answer change if there was a "constructive obligation" to compensate customers who were served with contaminated hamburgers?

My response: No.

Basically, a constructive obligation is defined in both GAAP and IFRS as a non-legal obligation inferred from business conditions indicating that if a payment would not be made, then the impairment of future business prospects would be greater than the payment saved. While there is some justification to be made on economic grounds, the practical problems of inviting preparers to exercise "judgment" once again trump.

 

In summary, after years of thinking about ways to improve the accounting for contingent liabilities, I am now throwing in the towel on what I have come to see as a futile exercise. By limiting liability recognition to present legal obligations, standard setters can kill two birds with one stone: first, financial statements will become more reliable and auditable; second, some of the difficult issues in measuring the fair value of liabilities that have not yet been satisfactorily addressed would become moot.

Compromising Accounting Principles: A History Lesson (and a Mea Culpa)

(I apologize to anyone who has read an earlier version of this post. Due to a problem with my blogging software, it was not sent out to subscribers. Therefore, I am re-posting it.)

First, the Mea Culpa

Over the year that I have been writing my blog, I have been fortunate to receive kind words every now and then from readers.  Writing alone, being provocative at times, and hitting the "publish" button perhaps too soon to meet a self-imposed deadline often combine to give me an uneasy feeling that I could be sitting way out on a high limb.  It was inevitable that at times I have been accused of being wrong, but never unfair -- until now.

I recently received from two readers similarly critical missives concerning some not-so-nice things I wrote about Jim Leisenring, former FASB and current IASB member. One of the commenters, identifying himself as "Guest," wrote:

"That's a pretty unfair attack on Leisenring with no appropriate context regarding the background of FAS 133. The alternative to FAS 133 was virtually no recognition of derivatives in financial statements. Is it perfect? No. Were compromises made? Absolutely. But it was better than what was there before. And it certainly doesn't indicate a pattern of Jim "capitulating to the majority." If you've ever met Jim [actually, I have], then you know he's not real concerned with what the majority thinks." (comment in brackets is mine)

After thinking about these comments for a few days and discussing it with my genious wife, I have decided that I owe an apology. When I gratuitously remarked that I was not surprised by Jim Leisenring's decision to "capitulate" on IFRS 3(R) because of his past participation in FAS 133, I crossed a line.

The Point I Was Really Trying to Make

Now that I hope I have cleared that up to the satisfaction of all, I want to address the related issue raised by Guest, which should have been the real point of my criticism.  I do not believe that compromising one's principles in crafting accounting standards in the name of incremental progress can be expected to produce a net benefit for investors.

Merely being "better than it was before" (to quote Guest) may still be far from good enough, and there is plenty of U.S. GAAP history to back that up. The table below is a partial list of standards where compromises clearly must have occurred, and serious consequences ensued:

Statement	What Gained	What Lost and Consequences
FAS 87 - pensions	Balance sheet recognition of some pension liabilities.	Timely recognition of gains and losses in pension plans. Plans were mismanaged because of FAS 87.  The toll in shareholder value destruction and lost pension benefits has been enormous.
FAS 13 - leases	On-balance sheet treatment of some leases	Most leases can still be classified as "operating." Managements have misspent vast sums over the past 30 years on financial advisers and auditors because FAS 13 invites unnecessarily complex and inefficient lease contracts.
FAS 133 - derivatives and hedge accounting	Fair valuation of derivatives	Complex and unprincipled hedge accounting rules distort values of other assets and liabilities, or permit deferral of gains and losses from holding derivatives. Managements engage in costly and inefficient accounting hedges that may not result in appropriate hedges of economic risks. The value destruction caused by Fannie Mae's misapplication of FAS 133 may be enough by itself to regard FAS 133 as having failed.
FAS 115 - marketable securities	Current values for some investments whose market value is readily determinable	Securities classified as available-for-sale or held-to maturity categories are mismanaged because ofFAS 115. The held-to-maturity category unreasonably deprives investors of current value information.
FAS 123 - stock options	Grant date present value of options granted to employees	Because of FAS 123's option for footnote disclosure without income statement recognition, excess stock options were granted to employees.
FAS 114 - loan impairment	Consistent measurement of impaired loans	Measurements are still based on historic interest rates, and the criteria for timing of loan loss recognition provide inappropriate discretion to manage earnings. As a result, investors have been deprived of accurate and timely information; management makes inefficient decisions on delinquent loans out of a desire to manage reported earnings.
FAS 141, 142 - business combinations	Elimination of pooling of interests and amortization of goodwill	Costly goodwill impairment test on a number that provides minimal information to investors. As a result, excess financial statement preparation, auditing and consulting costs are incurred.
FAS 95 - statement of cash flows	Converting inconsistent funds flow statements to more consistent cash flow statements.	The direct method of presentation is rarely used, depriving investors of information regarding actual operating receipts and disbursements.  Subsequent attempts to revise this glaring flaw in FAS 95 have failed.

What would have happened in each of these cases if those who those who gave up the fight in the name of incremental progress refused to yield the high ground?  For example, how would derivatives and non-derivative marketable securities be accounted for today if compromises had not been made ten and fifteen years ago? Fair value is still the only plausible answer. The lost momentum of compromise with closure reigns forever and a day.  In the case of FAS 133, it's been 10 years and counting.  As for lease accounting, it's been 30 years and even getting a second wind no less; the FASB has recently announced that it is limiting the scope of the project to revise lease accounting rules, which has already dragged on for far too long.  I may be able to add to my list of compromises with negative examples, and I cannot think of a single compromise that ended up as a standard making those who compromised eventually look like heroes instead of patsies.

My point is that the absence of patience and fortitude can leave its stain on accounting standards for generations.  The IASB's process leading to IFRS 3(R) tells me that the lessons of history demonstrating the futility of compromise go unheeded by the putative heirs to U.S. GAAP.

I have read from numerous sources that adoption of IFRS in the U.S. is regarded to be "inevitable." I don't know about that, but I am convinced that uneconomic mergers doing immeasurable harm to both shareholders and work forces will occur because of IFRS3(R)'s loosey-goosey business combination standards. Even more important, if the non-U.S. members of the IASB come to understand that we in the U.S. are effectively committed to allowing sausage-factory-style accounting standard setting in our capital markets, we will be doomed to a steady diet of sausage.

That's why Jim Leisenring should not have voted for IFRS 3(R). 

The Revisions to IFRS 3: Bad Enough to Abandon Faith in IFRS?

In my previous post, I described how an SEC honcho, while speaking to the choir at an event sponsored by FEI, espoused his version of faith-based accounting; though he could not provide a single, solid reason to explain why the U.S. should adopt IFRS, he has seen the light and has become a true believer.   In contrast, reason-based accounting permits recitation of a vast litany of blasphemies against IFRS to make one a serious, if not committed, agnostic.  Today, I write of one of these latest abominations: the latest revision to IFRS 3 on the accounting for business combinations.

Goodwill and NCI:  IASB Fakes Right and Goes Left

Perhaps the most significant development in the accounting for business combinations is that FAS 141(R) now requires the same basis of measurement for assets acquired and liabilities assumed, regardless of the percentage of a company acquired (so long as control is achieved).  Therefore, if control is attained without purchasing 100% of the existing equity interests in the acquiree, non-controlling interests (NCI) must be measured at full fair value. 

As you may be aware from reading my post "What Good Comes from Goodwill Accounting?", I am not a big fan of recognizing 'goodwill' under any circumstance, so I will grant that the justification for the FASB's approach is not airtight.  Nevertheless, it was common knowledge that the FASB was given to understand that, by sticking its neck out to make these controversial changes to FAS 141(R), the IASB would follow suit. 

Instead, the IASB renegged on its promise in the worst way imaginable: they voted to allow entities a free choicebetween the partial and full fair value alternatives to goodwill and NCI measurement.  What's more, issuers can make their choice on a transaction-by-transaction basis -- kind of like going to church one week and synagouge the next.  Not even the most devoted acolyte can spin this any other way except as a significant step backwards from establishing the IASB as a credible agent of quality financial reporting and investor protection. 

And, it's not just me who is outraged.  Read the strongly-worded dissents* of Mary Barth and John Smith, two of the three Americans on the IASB.  As to the third American, Jim Leisenring, I guess I shouldn't be surprised that he capitulated to the majority.  Leisenring was the most prominent voice in support of FAS 133 (on hedge accounting) when he was on the FASB; a standard whose middle name is inconsistency.  Be that as it may, one can only imagine where the IASB will take the interests of U.S. investors when our membership, and hence our influence, on IFRS inevitably wanes. 

Mind These GAAPs, Too 

If the unprincipled and unconstrained choice of accounting treatments for goodwill and NCI aren't enough for you to abandon any faith in a high-quality convergence, consider two more of the numerous departures from U.S. GAAP; these may be even worse.

First, the devilish game of managing the timing of contingent liabilities still thrives in IFRS.  FAS 141(R) now requires that any non-contractual, contingent liability assumed in a business combination must be recognized at fair value, if the probability of occurrence is more likely than not.  IFRS allows any contingent liability to be recognized, regardless of likelihood, if it can be reliably measured. 

As I discussed in a previous post on IASB machinations of contingent liability accounting, the ubiquitous criterion of "reliable measurement" is one of those areas of "judgement" in IFRS that help management make their numbers with little chance of being challenged by auditors.  Here is how this game will be played in a business combination under IFRS 3(R):  if management thinks that goodwill won't be impaired any time soon, they will recognize contingent liabilities to the max.  The effect is to create an earnings bank of liability writedowns when unlikely events become, as anticipated, resolved without the incurrence of an actual liability.  And speaking of inconsistency, IFRS 3(R) provides that all intangible assets are to be recognized, even if their fair values cannot be measured reliably.  Where is the "principle" for that one? 

Second, FAS 141(R) requires extensive disclosures that are designed to aid analysts in determining the past and future effect of a business combination on earnings and financial position.  For example, FAS 141(R) requires the following disclosures:

• The amount of revenue and earnings of the acquiree since the date of acquisition. 
• Revenue and earnings of the combined entity for the current period as though the acquisition had been consummated as of the beginning of the period
• Revenue and earnings of the combined entity for the previous period, as if the acquisition had been consummated as of the beginning of the previous period. 

Inexplicably, IFRS does not require the third item, above.  Therefore, inferences as to earnings trends of the combined entity from historical financial statements are defeated.

The recent activities of the IASB, the high priests of IFRS, confirm that they are most definitely not the august body to which the future of U.S. financial accounting standards should be entrusted.  To those who persist in practicing faith-based accounting, put IFRS's accounting for business combinations in your pipe and smoke it.

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*Unlike statements of the FASB, IFRS publications are not freely available.  Just thought you might want to know why I didn't provide a link.

FAS 52: Another Goodwill Charade, and IFRS Convergence To Boot

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In a recent post, I argued that goodwill arising from a business combination was just a random number; therefore, any attempt to measure impairment amounted to nothing more than a costly charade.  By coincidence, I recently had an inquiry from a client about the accounting for goodwill at foreign subsidiaries per FAS 52.  Thinking about it for my client also reminded me of yet another sordid tale of accounting convergence for its own sake. 

The General Problem of Goodwill Arising from Foreign Subs under FAS 52

By way of background, FAS 52 requires that assets of a foreign subsidiary with carrying amounts based on historic costs (e.g., plant and equipment) be translated into the reporting currency (e.g., dollars) at the exchange rate existing on the balance sheet date (e.g., the 'current rate).  As I have noted in an earlier post, multiplying historic costs by current exchange rates is the equivalent of multiplying apples and rocks -- with the inevitable result being a random number. 

What about goodwill arising from the acquisition of a foreign subsidiary?  As I am about to show, the choices arising out of a slavish application of the general approach of FAS 52 is so absurd that the FASB buried its own decision deep in an Appendix.  Be that as it may, the specific question is whether goodwill should be measured in dollars, or measured in the currency that is used to measure all of the other assets and liabilities of the subsidiary and translated into dollars.  The implications are the following:

1. If the foreign currency is the answer, then goodwill will be translated to dollars at each balance sheet using the current exchange rate.  Exchange rate movements will affect the carrying amount of goodwill expressed in dollars, which will in turn affect consolidated shareholders' equity through other comprehensive income (the so-called 'translation adjustment'). 
2. If goodwill is measured in dollars from the outset it will remain at a constant dollar amount over time, unless it becomes impaired per the FAS 142 charade.   

From an investor's viewpoint, which treatment of goodwill is preferable? Measuring in a foreign currency and translating with current exchange rates (the first choice, above) adds another information-less element to goodwill measurement, confounding even further any potential to glean something relevant out of the translation adjustment.  Therefore, measurement in dollars (the second choice) would be the lesser of two evils. 

Which answer did the FASB pick?  Hint: look for the answer that creates a consistent set of rules, irrespective of whether the rules themselves make any sense.  Yep, FAS 52, para. 101 requires goodwill measurement in the foreign currency.  The only conceivable reason must be that it is consistent with the treatment of other historic-cost-based assets of the foreign subsidiary.   

Unintended Consequences

That brings me to the question my client asked, which goes something like this:

The functional currency of Company A is the U.S. dollar.  Company A acquires 100% of the outstanding shares of Company B, for which the dollar is also its functional currency.  However, Company B has two foreign subsidiaries, C and D, whose functional currencies are their respective local currencies.  Given the requirement of paragraph 101 of FAS 52, must a portion of the goodwill recognized from A's purchase of B be attributed to C and D? 

It would seem that the fact pattern described above is not uncommon.  Yet, I could not find even a glimmer of insight in the official GAAP literature that would acknowledge that the problem even exists. So this is how my own thinking goes:

• Given that the only purpose of paragraph 101 would appear to be consistent with the accounting for other assets, one would think that a reasonable allocation of goodwill would be intended.  Take the extreme example where the U.S. operations of the acquired company might be insignificant: failure to allocate goodwill among the subsidiaries would result in a significant inconsistency, and perhaps even, an opportunity for manipulation.
• FAS 142, charade that it is, does require a rigorous apportionment of goodwill among reporting units for the purposes of determining whether goodwill is impaired.  A reasonable approach to allocating goodwill to foreign subsidiaries might be similar to the reporting unit approach of FAS 142.   

However, to my surprise, the few inquiries I have made of practitioners with experience in the area are unanimous in the view that, in practice, goodwill would not allocated below the intermediate parent -- in this case, Company B.  Why might practitioners take that view?  Because no rule prevents them from doing otherwise; and because it benefits them to reduce the volatility caused by translating goodwill from a foreign currency to the reporting currency.  In fairness, and as I have noted above, even though what appears to be broad practice may result in inconsistencies, it is arguably better accounting -- or rather less bad -- than results from a rote extrapolation of the extant rules (which is the most I can say of my own reasoning).

The International Convergence Connection

As I have pointed out elsewhere (interest cost capitalization), some changes to IFRS are made for the sake of convergence, with well-reasoned standards thrown on the junk heap for the sake of convergence with U.S. GAAP and the prospect of IASB financial reporting hegemony. The goodwill provisions of IAS 21, the IFRS counterpart to FAS 52, is another case in point.  At one time, IAS 21 allowed either of the approaches we have discussed for goodwill measurement.  But as part of an omnibus project to eliminate alternatives in numerous standards (brought on by the 2005 adoption of IFRS by the EU), the IASB eliminated the option to measure goodwill in the reporting currency, making it the same as FAS 52.  Again, the only conceivable motivation appears to be convergence for convergence's sake. 

I imagine that the progenitors of the original IAS 21 were thinking that at least part of goodwill arises from synergies between a parent that 'thinks' in its reporting currency and a subsidiary that 'thinks' in a foreign currency.  Thus, the source of the goodwill is not strictly foreign or domestic; so, who is to say in which currency goodwill should be measured?  Evidently a race for convergence trumps reason and reasonableness. 

What Good Comes from Goodwill Accounting?

In an earlier post, I described how SFAS 141R resulted in some incremental improvements to the accounting for business combinations.  However, warts remain, and the purposes of this post is describe the ugliest and most painful of them all: the accounting for so-called 'goodwill.'

Here's a simple example to contemplate:

• Company P determines that Company S has a value of $1,100, and negotiates an acquisition for 100% of its outstanding shares for $1,000.
• S has the following assets:
  • Plant and equipment with a fair value of $200.
  • An assembled workforce with a fair value of $100.
• S has no liabilities eligible for accounting recognition.
• Company S will be run independently from Company P; thus, any synergies created by the acquisition are negligible. 

The root of the problem is literally that debits (the assets acquired) do not equal credits (the purchase price).  Business combination accounting is a collision of fantasy and reality: the fantasy is that accounting can fully reflect the economic impact of past events on an enterprise, and the reality is that it cannot be so. A balance sheet produced by even the most principled of accounting systems imaginable cannot possibly comprehend the entire set of economic assets and liabilities.  One example on the asset side would be that S has been put together in such a way as to rapidly and inexpensively expand or contract capacity as market conditions change.  In other words, S holds 'real options', and the shareholders of S would want P to pay for them. On the liability side, not all obligations are legal, amounts are highly uncertain, and the probability of payment may be low. 

The FASB's solution to the debit and credit problem is to plug the shortfall in debits and to weave a fantasy around it.  The plug is euphoniously dubbed 'goodwill' -- to be classified on the balance sheet as an asset and tested for impairment at least once each year. In the above example, the amount reported as goodwill would be $800 (=$1,000 - $200). 

Whipped Cream on the Balance Sheet   

As described above, the amount reported as goodwill is, at its best, a conglomeration of assets offset by liabilities.  Nowhere else in accounting would there be permitted such a hodgepodge, and by no other means other than a narrowly defined 'business combination' may it -- whatever it is -- be recognized.  But even granting that offsetting assets with unrelated liabilities may be permissible, of what use to investors is the assignment of a number to something that, by definition, is beyond description?  (Ironically, even though the value of S's assembled workforce may be measurable and significant, separate recognition of this asset is streng verboten and kept a dark secret from investors.) 

As I have reported in my earlier post, Walter Schuetze (former SEC Chief Accountant and FASB member) derisively characterizes reported goodwill as "the lump left over." Actually, I think he was being generous.  FAS 141R contains some significant exceptions to fair valuation of assets acquired and liabilities assumed.  Thus, the unknown difference between recorded amounts and their fair values are  shoveled into the goodwill muddle.  As if that weren't enough, the math of the goodwill calculation blithely compares apples with oranges: prices paid with values received.  "Lump", "goodwill" or whatever name you can think of implies that the number is associated with actual attributes, but what we are dealing with here is nothing more than just a number--an arbitrary number.

So, dear readers, I hope you are not disillusioned to realize that 'goodwill' is invariably anything but.  If it must be recognized at all, let's drop the obvious pretension and call it what it is: in this example, "excess of purchase price over recognized amounts of identified assets acquired and liabilities assumed."  However, dropping the pretension is not as easy as it seems.  If a muddle is to be reported as an asset, it must be subject to an impairment test; and without a dressy name that belies the muddle that is 'goodwill', there can be no pretense for the charade of an impairment test that is FAS 142. 

The Goodwill Impairment Mess

Recognition of goodwill may seem but a curious anomaly until you get to the impairment test specified in FAS 142.  It's a real money pit:  goodwill has to be assigned to "reporting units" (a new concept rife with opportunities for manipulation); the fair value of each reporting unit has to be assessed at least once a year (another opportunity for manipulation); and the real mayhem begins if, heaven forbid, you are required to estimate the "implied fair value of goodwill" (another new concept rife with opportunities for manipulation).  The only good that comes out of goodwill impairment testing are the jobs created for valuation consultants, accountants and attorneys. 

A Proposed Solution

In olden days, the British permitted a charge to contributed capital for the amount that would otherwise have been recognized as goodwill.  While imperfect, it may well be the only reasonable solution to the problem; for as I have shown above, there can be no perfect solution.  If you can't describe what something is, than what possible good can come from purporting to measure it?

By the way, even though business combinations rules have been somewhat converged by the issuance of FAS 141R and a revised IFRS 3, goodwill impairment remains one of the most significant differences between IFRS and U.S. GAAP. The two approaches are fundamentally at odds, but it should be said that IFRS's impairment rules are much less worse.  But that's not the most important point I want to make.  Whatever the merits of the two approaches, by eliminating goodwill and the inevitably screwball impairment tests, standard setters would not only be improving financial reporting, they could also say that they have resolved one of the thorniest convergence issues.   

Peeling the Onion on the New Business Combination Standards: FAS 141R and FAS 160

This post examines the onion skin, if you will, of the new business combination standards. I'm going to explain the differences between the so-called 'purchase' method of accounting and the new 'acquisition' method. As is my habit, let's begin with a simple example.

Assume that ParentCo acquires 70% of the outstanding shares of SubCo for $1,000. Additional facts are as follows:

• ParentCo estimates that the fair value of 100% of SubCo is $1,405:
  • You should note that the fair value of SubCo may not ordinarily be calculated by extrapolating the purchase price paid to the remaining shares outstanding (i.e., $1,000/70% = $1,429 is not ordinarily the fair value). The reason is that a portion of the purchase price contains a payment for the ability to exercise control.
  • In this case, the control premium would be $55, calculated as follows:

($1000 - .7($1405))/(1-.7) = $55

• It may be difficult to estimate the control premium, because it may have to be derived from an estimate of the full fair value of the acquired company, as above.
• The book value of SubCo's assets and liabilities approximate their fair value, except for one asset with a remaining useful life of 10 years. For that asset, the fair value exceeds the book value by $100.

The table below displays the following: (1) respective balance sheets of ParentCo and Subco at the date of acquisition, (2) consolidated results under the purchase and acquisition methods, and (3) the goodwill calculations under each method.

The purchase method had a lot of warts, but it took the FASB decades to replace it. In essence, it was nothing more than a slavish application of the historic cost principle to mute the future effect of an acquisition on operating expenses. The idea was that if you purchased 70 percent of the outstanding shares of another company, then revaluation of assets would take place only to the extent of the shares purchased. Among other things, this meant that the basis of the assets of a subsidiary acquired in business combination transaction would be the sum of the fair value of the portion acquired and the historic cost of the portion not acquired. This is illustrated above by the calculation of consolidated assets: $2,000 + $800 + .7($900 - 800) = $2,870. The mix of fair value and historic cost to measure one asset reminds me of something my father would say when someone (mainly me) was less than fully committed to a principle: "you can't be half pregnant."

The acquisition method represents a full commitment to fair value, yet ironically, the FASB still doesn't require fair value for all assets and liabilities assumed (more on that in another post). In other words, if the transaction results in the acquisition of control of an entity, assets acquired and liabilities assumed will be initially measured at 100% of their fair value--even if less than 100% of the outstanding shares are purchased. That's why consolidated assets are $30 higher in the illustration under the acquisition method.

The example also illustrates two other important differences between the methods:

• The consolidated amount attributed in consolidation to the non-selling shareholders was� termed 'minority interests' under the purchase method. It was reported on the balance sheet between liabilities and shareholders' equity'; and following the same reasoning allowing half-pregnant measures of consolidated assets and liabilities, was measured based on the historic costs of the subsidiary. 'Noncontrolling interests' (NCI), has replaced minority interests, and are now measured on the same basis as the 'controlling interests', and firmly categorized as part of shareholders equity.
  • Well, maybe not so firm. See my post on the FASB's recently issued Preliminary Views document entitled Financial Instruments with Characteristics of Equity, which proposes to move NCI to liabilities. In fact, one intrepid FASB member objected to the issuance of FAS 141R until the FASB could actually enunciate clear principles for distinguishing between liabilities and equity. Until then, it's just another rule that's subject to change.
• "Goodwill" is higher under the acquisition method, because as can be seen by comparing the calculations, it now includes amounts attributable to NCI.
  • What hasn't changed, though, is that goodwill is still a euphonious sobriquet for a random number masquerading on the balance sheet as an asset measurement. (I'll write more about this in a post soon to come.) Under the purchase method, it's the difference between the purchase price and amounts for the other assets and liabilities recorded. Under the acquisition method, it's fair value of SubCo (equivalently, purchase price plus amount recognized for noncontrolling interests) minus the amounts for the other assets and liabilities recorded. SFAS 141R may describe goodwill in more dignified terms, but the way I just did is more accurate. At least I'm not as blunt as Walter Schuetze, former SEC Chief Accountant, who is fond of calling goodwill "the lump left over." I smile to myself every time I think of that.

Since only balance sheet differences are illustrated above, I have only told part of the story so far. The table below extends the illustration to the end of the first year subsequent to the acquisition of SubCo.

The foregoing illustrates that there is an additional step on the income statement. It may be hard for some people to get used to, but net income is no longer the bottom line. In fact, the bottom line doesn't change in this case, because $3 of additional depreciation expense is recorded, but it is taken out of the earnings attributed to NCI. If you are familiar with the SEC's required presentation of 'net income applicable to common stock (SAB Topic 6.B.1), you will know that the idea is not new.

Well, that's all for now. If you want to look at my spreadsheet, you can get it by clicking here. I'll have a lot more to say about goodwill and accounting for business combinations in the near future, and it won't be pretty.

Note: The original version of this post contained an error in the calculation of the control premium. Thanks to Wallace Enman of Moody's for pointing out the error, and for helping me to get it right. Thanks also to Barb Foerster of Western Union for finding another technical error that I have now corrected.

If You Think GAAP is Opague, Try SEC Staff Interpretations!

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The securities laws give the SEC broad power to create regulations to implement the pertinent statutes.  The political appointees of the Commission, in turn, allow their staff to publish "interpretations" of the regulations.  These have accumulated to a mountain of technical detail dispersed over obscure documents that only an expert can hope to find, much less divine the need for. 

One wonders whether the system (such as it is) exists to protect investors, or to secure employment for Commission staff after they leave the SEC?  Companies who must comply with the SEC's disclosure rules pay a premium to SEC alumni who came to know the arcana first hand; and have street cred with the SEC staff by dint of their own contributions to the mountain when they themselves were SEC staff members.

A Recent Example to Illustrate the Point

By way of background:

• SFAS 159 permits a company to account for financial assets at fair value, including investments that otherwise would be accounted for under the equity method (per APB 18).
• Regulation S-X (the principle SEC regulation governing the form and content of financial statements in reports to the SEC), Rule 3-09 requires a company to provide separate financial statements of individual investees accounted for under the equity method, if the investee meets any one of the three quantitative tests of significance set forth in Rule 1-02(w) at the 20% level.
• Rule 4-08(g) requires supplementary disclosures regarding the assets, liabilities (i.e., a highly condensed balance sheet), revenues and expenses (i.e., a highly condensed income statement) of all such investments in the aggregate if the Rule 1-02(w) significance test is met at the 10% level. 
• APB 18 has similar disclosure requirements as Rule 4-08(g), but it lacks a specific significance test.  Moreover, the free election of SFAS 159 would obviate the APB disclosure requirements, since the investment would no longer be within the scope of APB 18.   

The two questions recently addressed by the SEC staff were: (1) whether the Reg. S-X disclosure rules still apply for investments elected to be accounted for at fair value under SFAS 159 that would otherwise be accounted for using the equity method; and (2) how significance should be determined (i.e., how Rule 1-02(w) should be applied) when the fair value option is elected. 

The staff's answer to the first question is “yes.” If an investment is eligible to be accounted for under the equity method as set forth in APB 18, then Rules 3-09 and 4-08(g) apply by "analogy."  In other words the rule clearly states that the disclosure rules don't apply to investments measured at fair value, but the staff is telling you to apply them anyway.  The Staff’s position on significance is that the ‘income test’ (one of three tests of significance) should be based on the change in the fair value reflected in the investor’s income statement—instead of the investor’s equity in the earnings of the investee as if the equity method had been applied. Again, the rule, as written, doesn't give you a clue as to what you're supposed to do--just do what the staff is telling you to do.

These SEC discloure rules, as written, were good rules, because they balanced abusive off-balance sheet accounting practices afforded by APB 18 (you can view my post on the equity method of accounting here).  Also, the questions the staff adressed are important, given recent developments in GAAP.  But, my point is this: if a disclosure rule should be updated, why doesn't the SEC simply vote to modify the rule for all to know and plainly see? In fact, the only place you will find the Staff's position is in an obscure AICPA publication -- you can't even find it on the SEC's website. 

Coincidentally, a recent GAO report to be released tomorrow -- you can read what Gretchen Morgenson has to say about it here -- has found significant problems with the SEC's antiquated methods of policing insider trading violations.  I find it ironic that the SEC's approach to updating many of its own rules also benefits a class of 'insiders' -- current and future SEC alumni.   

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