Did Tyco ( TYC) use merger-related writedowns to shield its income statement from deterioration at CIT, the commercial lender it acquired last year?

Tyco vehemently denies this allegation. But the timing of $1 billion of asset writedowns made after Tyco acquired CIT provides grounds for taking a closer look at the accusation. After the Enron collapse, Tyco has faced a barrage of accounting criticism that has helped drive down its stock by 50% this year. It was down 13 cents to $28.62 Thursday afternoon.

Tyco bought CIT in June 2001 for $9.5 billion in stock and cash, its largest acquisition of the year. After investors recently started dumping Tyco stock because of concerns over accounting and profitability, the company's execs decided to split up the company. Tyco wants to sell CIT for cash, or separate it from the parent company by distributing ownership in it to Tyco shareholders.

In a sale, Tyco isn't expected to get anything close to the price it paid. When the intention to merge was announced in March 2001, investors immediately took the view that Tyco was paying far too much for CIT, causing Tyco's stock to tank. Now, any indications that CIT's numbers aren't clean will make a sale at a good price that much harder.

Perhaps because it was a large and controversial purchase, the accounting for the CIT acquisition already has received a lot of scrutiny. So far, however, most attention has been paid to the changes made to CIT before it became part of Tyco. Bears have speculated that balance sheet and income statement items were manipulated at CIT prior to the merger to dramatically improve the operation's earnings after it was officially part of Tyco, a charge Tyco has repeatedly denied.

But asset writedowns taken after the merger was consummated also should be examined. There's nothing wrong with writedowns. Accounting rules dictate that an acquirer must evaluate the assets and liabilities of the company it's buying and write them up or down to a value they believe represents their actual worth, or "fair value." Once that's been done, liabilities are subtracted from assets to get a net worth number.

The costs stemming from the merger -- called purchase accounting liabilities -- also are factored into the calculation. If the final sum is lower than the price paid, which doesn't change, the difference is called goodwill and added to the balance sheet. None of these adjustments directly affect the income statement.

There is nothing wrong with making adjustments to assets and liabilities after the merger date. But these adjustments must not be based on anything that happened after the merger date.

Instead, a writedown that is caused by postmerger developments must be taken as a charge in the income statement. And Tyco's critics wonder whether it has avoided this sort of charge by including postmerger deterioration at CIT in the acquisition-related adjustments for premerger deterioration. After all, many commercial lenders experienced a substantial increase in bad loans through 2001.

Tyco spokesman Brad McGee rejected this accusation out of hand. "Tyco's income statement has, at no time, benefited from including post-merger-date asset value deterioration in purchase price write-downs for any acquisition," he wrote in an email.

Tyco Timeline
Key moments in the CIT relationship
March 2001 Tyco says it wants to acquire CIT
June 2001 Tyco buys CIT for $9.5 billion. Of that sum, $4.2 billion is allocated to goodwill
Third quarter 2001 Tyco writes down CIT assets by $490 million
Fourth quarter 2001 Tyco writes down CIT assets by another $417 million
January 2002 Accounting jitters cause sharp selloff in Tyco stock
January 2002 Tyco announces plans to split up and sell businesses, including CIT
Source: Detox

The writedowns in question related to $5.5 billion worth of loans and leases that Tyco wanted to divest from CIT. On a conference call earlier this week, Tyco CFO Mark Swartz said writedowns on these assets totaled around $1 billion. These were made up of a $490 million downward adjustment in 2001's third quarter and a further $417 million in the fourth quarter.

The apparently fishy aspect of the writedowns is their size and distance from the merger date. When writedowns are big, investors will ask what has changed so drastically from the merger date. And when they happen months after the merger date, the suspicion will arise that they include postdeal deterioration.

To be sure, accounting rules state that adjustments can be made up to a year from the merger date.

But, by the time of the merger date, investors expect the acquirer to have made reasonable fair-value assessments of assets at the acquired company. This would especially be the case if the acquirer had announced its intention to do the purchase a good period before the official merger date and was doing sufficient due diligence before then, as is common. Tyco first announced its intention to buy CIT in March 2001, more than two months before it actually closed the deal, and was probably doing due diligence even before March.

McGee offered two points in response. "Even though asset valuations are completed prior to the merger, it is not until you actually sell, exit or begin liquidating the assets that the valuation adjustments are taken," he writes in the email. When asked, McGee didn't provide the accounting rule that lays this out. (That is not to say it doesn't exist, however.)

And he says that it is only after the deal that fair-value appraisers can get a good look at the assets. "The actual appraisals themselves don't take place until after the acquisition is closed," he writes. "The primary reason for this is that until we own CIT, we don't run the company, and there still is the risk of the deal not closing. For that reason, we don't get the unfettered opportunity to bring in outside appraisers for this process."

One way Tyco could resolve this issue is to point to any public statements from June 2001 or before that show the company expected writedowns in the $1 billion range. McGee said no such statements were made.

Know any companies that the market may be misvaluing? Detox would like to hear about them. Please send all feedback to peavis@thestreet.com.

In keeping with TSC's editorial policy, Peter Eavis doesn't own or short individual stocks. He also doesn't invest in hedge funds or other private investment partnerships.