New accounting rules may artificially inflate corporate earnings.

Recently, several multi-billion dollar companies announced big increases in this year's earnings. 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 Jan. 1, 2002, 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 - compared with a company like Ford Motors. 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 acquisitions. Let's look at the "old" rule and the "new" rule to see the impact on companies' financial statements.

The "Old" Rule

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 is 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 dollars. However, the fair market value of the assets of company B is $2.5 million dollars; 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.

The "New" Rule

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. If the "Transitional 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 "Transitional Impairment Test" is completed, companies are then required to begin the second phase of the process. Corporations are required to perform a "Goodwill Impairment Test" on an annual basis. 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 compare 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.

Exceptions To The Rule

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 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.

The Results Of The Accounting Change

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

(1) The change will generate a boost to earnings per share (EPS) that could 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. Since our economy reported dismal earnings last year, an uninformed investor may get caught up in the excitement and could lose money as he/she chases what was thought of as a strong earnings growth. Perfect examples of these types of companies are Internet and telecommunication companies whose earnings disappeared last year and will likely post significant earnings growth this year.

(2) The one-time charge-offs that may be forthcoming during the next two quarters will further depress already weak earnings in financial records of some companies. As mentioned above, companies are required to annually evaluate goodwill in light of expected value and deduct goodwill if it is impaired. Companies have a year after adoption of the new rule to perform the impairment test and deduct impaired goodwill, but the rule provides incentives to absorb the repercussions during the first fiscal quarter after adoption.

For example, if the deductions are made in the company's first fiscal quarter, no restatement is required and the charges are treated as an extraordinary item; deductions made after the first quarter of the fiscal year will require restatement of the preceding year's financial statements, and charges made after the first year will be treated as operating expenses and will reduce net income in the year of deduction.

(3) Corporate executives are ecstatic over the change because it allows them to accomplish mergers without telling shareholders to expect big write-offs. Now, in the wake of the telecommunication fiascoes, it could trigger some surprising confessions about deals recently done. In addition, the corporate executive will have to absorb more questions because it is one more item to have audited. The new accounting rule could also mean more scrutiny for the accounting watchdogs, the IRS. The goodwill rule requires companies to make subjective decisions about whether their assets have declined in value, which could prove to be another added headache for corporate executives since this probably was not considered in the past.

The impact of the new accounting rule will likely cause chaos for investors, CEOs and other financial statement users. A financial expert quoted in USA Today stated, "... a 10% boost to earnings would likely result in a 5% increase in the stock price." To an investor who is not aware of the new change placed on accounting for goodwill, this could mean disaster! Investors should do more research pertaining to a corporation's financial statements before acting on high increases in company earnings!