Seldom has a proposed change in accounting rules generated such a vociferous response from corporate America. The US Financial Accounting Standards Board (FASB), in its efforts to bring clarity and consistency to accounting for business combinations, has infuriated chief executive officers, chief financial officers, and venture capitalists with its proposal to eliminate pooling accounting. Silicon Valley executives decry this devil that will destroy the so-called new economy. Senior executives from powerful corporations are invoking the national interest to preserve the M&A engine that, by their reckoning, has brought the United States unprecedented prosperity. And the debate is being watched closely by companies around the world that abide by US accounting standards or are considering M&A deals in the United States. Are opponents of the rule change correct? Could accounting kill the new economy?

We think not. On the contrary, the proposed change is a positive one. In fact, pooling accounting encourages the destruction of a great deal of value, so putting a stop to the practice is an excellent move. It will no doubt present companies with challenges, but, far from making mergers and acquisitions grind to a halt, it will help companies that respond positively to end up with stronger M&A decisions, better-managed intangible assets, and improved investor relations.

What does FASB want?

Although the number of deals that are pooled has remained small, at about 5 percent of the total, this treatment has been adopted for an increasing proportion of large deals; in fact, it accounted for 36 percent of the total value of mergers and acquisitions in 1999. Many significant US deals—such as those between Exxon and Mobil, Citicorp and Travelers, and Bell Atlantic and GTE—were pooled.

FASB is proposing three basic changes. First, pooling accounting will be eliminated. Second, the maximum period over which goodwill can be amortized will be shortened. Finally, the acquiring company will be forced to provide more financial information about its acquisitions, including some rationale for the purchase price. It is obvious why companies object to points two and three: shorter amortization periods mean higher charges against income, and companies always want to have, if nothing else, at least the option of providing less rather than more information. The issue of pooling itself is a little more complicated.

A business combination can be accounted for in either of two ways. In purchase accounting, the buyer writes up the target’s balance sheet to reflect the current value of the assets acquired and then amortizes the premium over book value—loosely, goodwill—against income. In pooling accounting, which is designed for "mergers of equals," where no one company can be designated the acquirer, the buyer simply carries over the target’s historical book value. Since no goodwill is recognized on the balance sheet, there is no amortization charge to future earnings.

That, of course, is the key. Companies try like mad to qualify their deals for pooling treatment because the amortization of goodwill required by purchase accounting pulls down their net income. And since, for better or worse, most CEOs care above all about their companies’ quarterly net-income reports to Wall Street, the idea of having to amortize, say, $10 billion of goodwill is anathema. This has always been true, but it is doubly true today. First, the market is deluged with new dot-com companies desperate to show a profit or at least a time line to profit. Many of them have done deals involving expensive intangible assets, so amortizing goodwill can delay profitability by years. Second, intangible assets are now much more prized than they were in the past, so goodwill write-ups are much higher than they used to be.

Do the objections have any merit?

The most serious opposition to FASB’s recommendations comes from Silicon Valley and financial institutions. In these industries, mergers and acquisitions are rampant and valuations are dominated by intangibles. Although many of the players understand that cash flow—unaffected by goodwill write-downs—is what ultimately drives value, they believe that investors care about earnings per share (EPS), which is affected by goodwill. As a result, they fear that FASB’s proposal, if implemented, will generate a negative reaction from capital markets and stifle M&A activity. Why do anything that might put the vibrant bull market at risk?

But this argument is flawed. There is simply no evidence that goodwill amortization has any impact on the market’s perception of value.

First, substantial evidence suggests that analysts, investors, and, ultimately, capital markets see through accounting treatment. The form of accounting for business combinations has no impact on shareholder value: price-to-earnings ratios tend to rise to offset the impact of amortization. Many deals have been well received by the market even though purchase accounting forced a significant dilution of earnings.

Second, new-economy analysts are already demonstrating flexibility in looking past the (often nonexistent) earnings of emerging businesses to more relevant indicators of future cash flows, such as the quality of the business model and management team, the pedigree of the backers and the business partners, and the volume of customers.

Why, then, is so much attention paid to earnings? Because changes in quarterly earnings are often taken as a proxy for a company’s current and projected cash flows. It is true that in the absence of special circumstances, changes in quarterly earnings really are such a proxy: a positive change will bump the stock price, as it should, and a negative change will weaken it. But in a merger or acquisition, the situation is quite different, and the market recognizes perfectly well that the standard quarter-to-quarter earnings analysis doesn’t tell the whole story.

FASB’s changes will have a positive effect

We therefore believe that FASB’s proposals, far from having a negative effect, will actually have a positive one.

In the first place, M&A activity won’t collapse, because the market understands the difference between reported earnings and cash flows.

Second, companies will stop squandering their money and making poor financing and operating decisions to fit the 12 rules by which deals qualify for pooling. At present, they spend a great deal of hard cash to make themselves eligible for this treatment. What is worse, pooling can drive bad financing decisions: it requires acquisitions to be completed almost entirely with stock, so if the target company’s shareholders prefer cash, an acquirer intent on pooling must overpay in stock or, worse, forgo the whole transaction. If the target has too little debt in its capital structure, pooling’s all-stock requirement may drive the acquiring company toward an inefficient capital structure.

Worst of all are the bad operating decisions pooling can impose. Under pooling, significant divestitures are explicitly prohibited for as long as two years after a transaction, limiting the new company’s strategic options and delaying the restructuring moves critical to the capture of synergies. Moreover, neither company may repurchase a substantial amount of its own stock for 24 months before an acquisition, and the combined entity can’t do so for up to 24 months after it—thus limiting a tax-efficient way of returning cash to shareholders. There are other financial issues as well, but the short story is that companies incur many costs, both direct and indirect, to qualify for pooling. Indeed, companies have been known to offer a higher purchase price on the understanding that their targets would help them to do so.

Third, FASB’s proposals are sound because putting goodwill on the balance sheet will put pressure on management to justify deals to investors by focusing on cash flows, growth, and synergies. What are these intangible assets that cost $10 billion? How and when will they generate an income stream? It isn’t bad to require a company to answer such questions, even if it doesn’t care to.

What, then, should companies do? They should stop trying to prevent the change and start thinking about how to win once it is in place. That means two things.

Redesigning the M&A decision process

Too many managers and investors pay too little attention to the economic fundamentals of acquisitions and spend too much time worrying about the accounting impact. Internal M&A processes frequently use EPS accretion or dilution as a screening metric, implicitly biasing results toward pooling deals. When earnings are diluted by premiums paid in excess of the clear synergy value or the future growth prospects of the acquired business, that is a problem. Dilution caused by accounting treatment is irrelevant, and the market knows this.

More generally, FASB’s change represents an important opportunity for companies to rethink fundamentally the way they evaluate deals. Many experienced acquirers have reasonably strong processes in place, but all could improve.

Improving investor communications

Habitual poolers never have to give the market a strong justification of their deals, and that may be the source of the greatest danger posed by FASB’s proposal. Afraid of the implications of goodwill, such companies may restrict their deal activity, which would be disastrous. Alternatively, they may continue to merge but explain mergers poorly and get hammered in the market.

CEOs and CFOs must seize the opportunity to develop a robust dialogue with investors about the long-term creation of value and the free cash flows that drive it. In a mature business that is generating positive earnings and cash flows, the discussion should focus on growth in free cash flows and the spread between the return on capital and the cost of capital. In an emerging business that has yet to generate profits or free cash flows, what matters are leading indicators of future cash flows, such as alliances, leadership pedigrees, and the acquisition of customers.

If companies are willing to meet the challenge, FASB’s much-feared recommendations will make them sharper, more sophisticated, and more transparent, ensuring the continued creation of value from synergistic, strategically rational transaction activity.