Note: Today's Investor Forum is the second in a two-part series on the changes in accounting rules and how they affect this earnings season and investors.
As we mentioned in yesterday's
column , if you invest in publicly traded companies, you need to keep abreast of the changes in accounting policies. These policies could wreak havoc on a company's final earnings number, so it's important that you understand their nuances.
Fortunately, there are not a whole lot of new rules that you need to read up on in 2001. "In terms of what will affect people, it appears to be a quiet year," says Liz Fender, director of accounting standards at the
American Institute of Certified Public Accountants
But the few issues that do go into effect can swing a company's numbers and potentially affect the stock price, so you need to be aware of them.
Pooling: Goodbye, Already!
It seems the saga, which has been dragging on since at least 1999, is coming to an end. The
Financial Accounting Standards Board
statement on Wednesday reconfirming its plans to eliminate the pooling-of-interests (pooling) method of accounting for business combinations. The board hopes to have a final standard by the end of June.
As a refresher, many CFOs and CEOs love the pooling rules because they permit a virtually costless merger. When two companies merge, pooling allows them to simply combine their balance sheets and income statements. It then uses historical asset values, which often result in an undervalued balance sheet. That can prevent investors from comparing pre- and post-merger operating performance, which is precisely why the FASB wants to do away with the method.
The purchase method of accounting requires the buyer to appraise the fair market value of the acquired company, and to record the difference between that figure and the actual purchase price as goodwill. This represents a truer picture, according to the FASB. Goodwill then is amortized -- or gradually eliminated -- over 20 years. That means the company must expense a piece of that goodwill balance each year. That can be a drag on earnings.
No surprise there has been opposition to the pooling abolition, especially from Silicon Valley. Currently, two small dot-coms can merge without having goodwill on the acquirer's books. That minimizes the expense of merging.
But it seems to be a lot of hoopla for nothing. Only 9.1% of the merger/acquisition deals in 2000 were accounted for under the pooling method, according to
magazine. "I don't personally think that the death of pooling will hurt
merger and acquisition activity," says Robert Garland, national managing partner in the assurance and advisory practice of
Deloitte & Touche
Especially since this issue of having to take a piece of goodwill as an expense each year is being addressed.
The proposed plan actually will prohibit the amortization of goodwill, replacing it with an "impairment" test, which essentially checks to see if something bad has happened to the acquisition, says Norm Strauss, the national director of accounting standards for
Ernst & Young
in New York.
Let's say Company A had to report $20 million as goodwill after the acquisition of Company B. If the new division is still prospering a year later, then the goodwill amount will not be adjusted, because it's still worth the $20 million. But if the division is in the toilet, goodwill may have to be written down to, say, $5 million. Then Company A must take a $15 million hit that year.
A draft outlining this impairment test is expected in mid-February and will be open to comments for 30 days.
"If they go with this alternative approach to goodwill, arguments that
the demise of pooling will kill deal-making become moot, because there will be less of a drag on earnings," says Robert Herz, chairman of the
Security and Exchange Commission
regulations committee and a
"Once these rules are effective, they will apply to all acquisitions before and after that date, so that you won't have mixed goodwill," says the AICPA's Fender.
This could get ugly for some companies, so be prepared.
If your company does a lot of risk management -- i.e. uses interest-rate swaps, foreign currency options or hedges the price of raw materials -- it is involved with
derivatives. And 2001 is the year that these companies get spanked.
Accounting for derivatives is one of the most complicated areas of the profession. And the implementation of the FASB's
Statement No. 133 Accounting for Derivative Instruments and Hedging Activities has made things worse.
Previously, derivatives were not even reported on the balance sheet. You had to dig through the financial statements' footnotes to find the very vague details of these transactions. Starting Jan. 1 (companies with June 30 year-ends had to start July 1, 2000), FASB 133 called for all derivatives to be reported as assets or liabilities on the balance sheets at fair market value. In addition, these numbers will have to be adjusted to their current fair market value each quarter.
So if a derivative is lower at the end of the quarter, the company may have to account for that loss. On the flipside, if the product moves up, it could inflate earnings. As a result, many companies could see big swings in their final numbers, Strauss warns.
As simple this rule may sound, its implementation is a monster. Companies, accountants and auditors are all under pressure to figure out exactly what FASB 133 means to their business and how to comply with it.
While you don't need to understand the intricacies of FASB 133, you do need to be aware of whether or not this rule will affect your company's bottom line in 2001. "It's likely that companies will report what they think the 2001 effect from this new rule will be in the footnotes of their 2000 financial statements," Strauss says. So be sure to read the 2000 statements when they come out in March.
To Be Continued
There are plenty of other issues that will continue to be investigated and deliberated in 2001.
Regulation FD sits at the top of the wait-and-see list. The regulation, implemented in 2000, is supposed to promote the fair disclosure of company information to all investors, from the pros to the do-it-yourselfers. But with information available to everyone simultaneously, analysts are a bit frightened. They will no longer get information early so they'll have to work quickly to get their analysis out first. In addition, they will need to dig deeper to prove their worth. That extra competition could translate into better disclosure for investors.
Expect to hear more about real-time reporting. The desire for online real-time information is huge, says Allan Anderson, senior vice president of technical services at the
. That could mean that at the end of every day, you could read an updated version of a company's financial statements, instead of having to wait until the end of each quarter. In conjunction with that goal is the ability to do a continuous audit. Then auditors can provide continuous assurance to investors.
We might not necessarily see this aspiration come to fruition in 2001, but we're migrating toward it, says Anderson.
So keep these new rules in mind as you follow your company this year. With this extra knowledge, you'll have an edge over your investing peers.
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TSC Investor Forum aims to provide general investment information. It cannot and does not attempt to provide individual advice. All readers are urged to consult with a professional as needed about their individual circumstances.