Recently, several multi-billion dollar companies announced big increases in earnings this year. On the surface, these announcements could cause an investor to perceive a turn in our economic recession is on the horizon. However, this is not the case! These announcements are due to a new accounting rule issued by the Financial Accounting Standards Board (FASB) that artificially inflates corporate earnings. Effective January 1, 20002, companies that have made acquisitions in recent years will no longer have to deduct part of the cost of acquisition against their earnings from goodwill associated with the purchase. Goodwill is the amount that the purchase price exceeds the value of tangible assets (buildings and equipment). This amount varies depending on the type of business that is being acquired.

For example, many acquiring companies have far less assets such as plant and equipment as compared to a company like Ford Motor. Therefore, goodwill could represent a sizable part of the transaction. As a result of the latest accounting rule, companies now have a new way to account for their purchase of a business. Let's look at the "old" rule and then the "new" rule to see the impact on financial statements of these companies.

Within the last couple of years a lot of company mergers took place. These mergers traditionally used a conservative accounting method to account for the takeover. Under this method, the buyer receives a tax break on the amount of the difference that the purchase price exceeds the actual value of the assets of the acquired company. Under this method, for financial purposes any excess paid over the price of the assets are written off against the earnings of the purchased company, over a period of 40 years. (However, for tax purposes the writing off period is only 15 years.) This method results in a very small effect on the profitability of the acquiring company.

For example, Company A buys Company B for $4 million. However, the fair market value of the assets of Company B is $2.5 million; therefore, the excess of $1.5 million (goodwill) is written off against the earnings of Company A over a period of time not to exceed 40 years.

Taking the test

Under the new rule endorsed by the accounting profession, corporations are required to perform a series of tests over a time period. First, the "Transitional Impairment Test" is conducted on goodwill within six months of the purchase. The calculated amounts are measured as of the first year of acquisition. Consequently, if the Transition Impairment Test indicates that goodwill is no longer worth anything, then the loss in value should be deducted as soon as possible prior to year-end. A loss resulting from the application of the test is treated as a change in accounting and recognized as a loss on the financial statements.

After the Transition Impairment Test is completed, companies are then required to bring the second phase of the process. Corporations are required to perform a "Goodwill Impairment Test" on an annual basis, unless circumstances indicate otherwise. Certain circumstances might require the company to test the impairment of goodwill between annual tests.

The Goodwill Impairment Test is a two-step process conducted at the company level. The first step is to identify potential impairments by comparing the fair market value of the acquired company to its carrying amount, including goodwill. If the fair market value of the acquired company is greater than its carrying amount, goodwill is not considered impaired and no write-off is required.

The second step, which is only required if there is an impairment identified in the first step, is to compared the "implied" fair market value of goodwill to the amount on the books. If the amount on the books exceeds the implied fair market value of the goodwill, then a loss is recognized equal to the difference and presented as a separate line item on the financial statements when it is deducted, lowering the reported profit.

A rule would not be a rule without a list of exclusions and the new goodwill rule is no exception. The Impairment Test is not required every year if the company can meet all of three criteria. If met, then the company may presume that the current fair market value of goodwill is in excess of its current carrying amount and no write-off is required. The three criteria are as follows:

  • The assets and liabilities making up the company have not changed significantly since the previous fair market value computation.

  • The previous computation of the company's fair market value exceeds the carrying amount by a substantial enough margin to make it highly unlikely that a current fair market value computation would result in the value of goodwill falling below its current carrying amount; and

No adverse events have occurred that would indicate a likelihood that the current value of the goodwill has fallen below its current fair market value amount since the previous computations.

So, what are the results of this new accounting change? There are a few potential risks that could occur. All business people as well as investors should understand the potential effects of these accounting changes on financial statements and reported profits.

The change will generate a boost to earnings per share (EPS) that could trick or deceive the market into thinking that the company is doing better than anticipated, causing the stock market to move higher. Also, there is a possibility that the market may react as if a company announced a stock split, bidding the shares higher, although there is no change in the fundamental earning power of the company. In reality, the earning power and cash flow remains unchanged despite the new rules. Since the change was effective in January of 2002, the first quarter profits could show significant results. Consequently, the next three quarters should fall back to lower levels.

The one-time charge-offs that may be forthcoming during the next two quarters will further depress the already weak earnings records of some companies.

Corporate executives are ecstatic over the change because it allows them to accomplish mergers without telling shareholders to expect big write-offs.