December 7, 1999

 

Mr. Timothy Lucas
Director of Research and Technical Activities
Financial Accounting Standards Board
401 Merritt 7, P.O. Box 5116
Norwalk, CT 06856-5116

 

Re:  Proposed Statement of Financial Accounting Standards, Business Combinations and Intangible Assets 

 

Dear Mr. Lucas:

 

The Financial Accounting Policy Committee (FAPC) of the Association for Investment Management and Research (AIMR) ¹ is pleased to comment on the Financial Accounting Standards Board's (FASB) Proposed Statement of Financial Accounting Standards, Business Combinations and Intangible Assets. The FAPC is a standing committee of AIMR, charged with maintaining liaison with and responding to the initiatives of bodies which set financial accounting standards and regulate financial statement disclosures.  The FAPC also maintains contact with professional, academic, and other organizations interested in financial reporting.

 

General Comments

 

The FAPC strongly supports an accounting method for business combinations which produces financial information that enables users to (1) assess properly the transaction's economic benefits (or risks) and (2) analyze its impact on the  future earnings, cash flows, and business operations of the combined entity.  By nature, acquisitions and mergers disrupt an enterprise's historical operations and financial results, leading to changes in revenue, income, and cash flow trends, as well as financial ratios used to evaluate the enterprise's performance. We believe that the purchase accounting method is the preferable approach. The changes to the purchase model that have been proposed by the Board should enhance the existing framework; the FAPC also recommends additional value-added model modifications, which are detailed below.

 

Users of financial statements need to understand the effects of an enterprise's acquisition(s) on the operations and financial position of the acquirer. Given deficiencies in the current purchase model, it is often very difficult for analysts and investors to (1) discern the incremental change to the acquirer's revenues and operating margins that may result from new acquisition(s) and (2) assess the economic benefits or risks/drawbacks of these transactions.

 

We commend the Board's efforts to improve the current purchase method by requiring certain disclosures that will ensure that more relevant, reliable, and decision-useful information will be provided to financial statement users.  However, we believe that additional disclosures should also be required for business combinations in order for users to assess properly the economic benefits, or risks, of a business combination. Such supplemental disclosures should include:

 

1. allocation of the purchase price to the major categories of assets and liabilities acquired
   
2. the valuation of goodwill and other purchased intangibles, as well as the relevant assumptions and methodologies used to value these items
   
3. the impact of changes in accounting principles resulting from the business combination on reported earnings as well as the financial position of the combined enterprise; and
   
4. discrete and disaggregated financial data reflecting the performance of the target company subsequent to the acquisition, or pro forma basis income statement.
   

 

The FAPC notes that the Board has removed from this ED issues requiring responses and conclusions about the accounting treatment of in-process research and development (IPR&D). Rather, the Board has postponed discussion of that matter until it has the opportunity and resources available to resonsider IPR&D in its entirety, as mentioned in paragraph 20 of the ED, and discussed in Status Report 316 of August 31, 1999. The FAPC acknowledges its interest in, and support of, the Board's efforts to resolve the complex questions associated with the rationale for capitalization and amortization of certain identifiable purchased intangibles, in general (as discussed in this current ED), and IPR&D, in particular, in a separate project. We await further information regarding progress in this area.

 

Scope

 

Issue 1 - Excluding Business Combinations Involving Not-for-Profit Enterprises
The proposed Statement would not apply to combinations of not-for-profit enterprises. The Board has decided to address issues specific to those combinations in a separate subproject to be conducted as part of an overall business combinations project.

 

The FAPC concurs with the Board's decision to exclude not-for-profit enterprises from the current proposed Statement with the intent to address business combinations involving such enterprises in a later subproject.  Although we understand that a discrete and defined project is necessary to address properly the issues specific to this project as it relates to publicly traded (for-profit) enterprises, we urge the Board to continue its discussions regarding business combinations of not-for-profit enterprises.

 

Issue 2 - Definition of Business Combinations
The proposed Statement modifies the current definition of a business combination so that all business combinations are acquisitions and, therefore, should be accounted for under the purchase method of accounting. In addition, the Board clarifies that an exchange of a business for a business is a business combination; an exception applies to transfers of net assets or exchanges of shares between enterprises under common control.

 

The FAPC supports strongly the proposed modifications to the definition of a business combination, as well as the requirement that the purchase method for business acquisitions be employed in all cases and pooling-of-interests be eliminated. The FAPC also concurs with the Board's proposal to exclude transfers of net assets or exchanges of shares between enterprises under common control. For these transactions, we support the use of the historical-cost basis of accounting.

 

Method of Accounting for Business Combinations

 

Issue 3 - Purchase Method Accounting for All Business Combinations 
The proposed Statement would eliminate the use of pooling-of-interests to account for business combinations; the purchase method would be used to account for all business combinations.

 

A majority of the FAPC concurs with the Board's conclusion that business combinations structured as stock-for-stock exchanges, which also meet the current criteria of APB Opinion 16, Business Combinations, are in substance acquisitions rather than mergers of equals. The prohibition of the pooling method is consistent with our position that share-for-share transactions should be accounted for as purchases. We believe that it is important to have the fair value of the exchanged shares recognized in the financial statements of the combined enterprise. The purchase method is much more revealing about the (1) economic nature of the transaction that has taken place, (2) the transaction values involved, and (3) the transaction's effect on the continued operations and financial position of the combined entity. Moreover, the purchase method will provide financial statement users with essential information that will better enable them to:

 

1. assess the economic benefits and risks of M&A transactions;  and
   
2. forecast the amount, uncertainty, and timing of the combined enterprise's future cash flows and reported earnings with greater accuracy.

 

Some FAPC members continue to support using the pooling method over the purchase method because the pooling method (1) ensures that financial statements will be comparable over time and (2) eliminates many of the complexities related to the recognition and amortization of purchased intangibles, as well as internally-generated intangibles. However, those members would embrace the Board's proposed elimination of the pooling method if the proposed Statement required the following additional disclosures about the acquired enterprise:

 

1. the results of operations on a pro forma basis for a year after the business combination and
   
2. a balance sheet showing the major categories of operating assets and liabilities, with their respective book values and fair values assigned at the date of the acquisition and detailed in a footnote to the acquirer's financial statements.

 

Issue 4 - Identification of an Acquiring Enterprise in all Business Combinations
The application of the purchase method would require that an acquiring enterprise be identified in all business combinations. In addition to factors relating to voting rights, this proposed Statement would require consideration of the composition of the Board of Directors and the senior management of the combined enterprise.

 

The FAPC agrees that all relevant facts surrounding a business combination should be considered in determining which enterprise is the acquirer. We concur with the guidance provided by Paragraphs 15 and 16 in the ED and the discussion in the basis for conclusions (Paragraphs 160-168) that apply to the means by which the acquirer can only be identified. We support strongly the consideration of other relevant economic factors. These include information related to (1) which enterprise initiated the combination, (2) payment of a premium (when the existence of a premium can be determined), and (3) assessments as to whether the assets, revenues, and/or earnings of one of the combining enterprises significantly exceed those of the other(s).

 

The FAPC believes that, in rare circumstances, it may be difficult or impossible to identify the acquirer. Conceptually, such cases would involve true mergers of equals. However, we believe that it will be extremely difficult to (1) define clearly this type of business combination and (2) distinguish it from business combinations that are purchases under the proposed Standard. If such transactions could be clearly defined, we recommend that the fresh-start method be applied or that a restatement of the net assets of both enterprises to fair value be presented. Our rationale underlying our support for the fresh-start method in exceptional cases reflects our belief that a merger of equals rarely, if ever, represents the summation of the combining enterprises' book values; frequently this type of business combination involves restructuring, integrating, and assimilating the separate managements and operations into an integral unit.

 

Issue 5 - Negative Goodwill
The proposed Statement would require the excess fair value of acquired net assets over cost (negative goodwill or excess) to be allocated on a pro rata basis first to intangible assets for which there is no observable market and, second, to acquired depreciable nonfinancial assets and to any other acquired intangible assets.  If all the assets to which the excess would be allocated are written down to zero and an excess still remains, that amount would be recognized as an extraordinary gain.

 

The FAPC disagrees strongly with the proposed allocation of negative goodwill to intangible assets and depreciable nonfinancial assets. We do not believe that any remaining, unallocated negative goodwill should be recognized as an extraordinary gain, except in rare circumstances. An allocation of negative goodwill to intangibles or other long-term assets obscures the fair values of those assets and makes their stated amounts meaningless. If all the acquired assets and liabilities are measured properly at fair value, the proposed allocation is arbitrary and has no economic basis. In only rare cases, would the negative goodwill represent a residual from a bargain purchase transaction and be recognized as an extraordinary gain.

 

We believe that negative goodwill is most often associated with a contingent liability that exists at the time of the combination; this assumes that all other identified and recognizable assets and liabilities are measured properly at fair value. Based on this premise, negative goodwill should be recognized by the combined enterprise and amortized, or reduced in the same manner in which the liability is reduced. Currently, such contingent liabilities are not recognized because either the probability of occurrence criterion is not met or reliable measurement is not possible ² under SFAS No. 5, Accounting for Contingencies.  We believe this deficiency would be remedied once FASB's  Proposed Statement of Financial Accounting Concepts, Using Cash Flow Information and Present Value in Accounting Measurements, is completed and approved because this Statement considers the probability of expected future non-contractual, as well as contractual cash flows.

 

If, however, the Board decides that an allocation method for negative goodwill is appropriate, then the FAPC recommends that negative goodwill be recognized as a component of shareholders' equity. This amount would then be amortized over the weighted-average estimated useful lives of the assets to which an allocation would have been made. We believe that this alternative method maintains the integrity of the assets' fair value and provides users of financial statements with the necessary information with which to assess properly the benefits and risks of the acquisition.

 

Accounting for Goodwill

 

Issue 6 - Recognition of Goodwill
The proposed Statement would require that the excess of the cost of the acquisition price over the fair value of acquired net assets (goodwill) be (1) recognized as an asset and (2) amortized over its useful economic life, which may not exceed 20 years.

 

The FAPC believes that goodwill, the residual or excess of the purchase price over the fair value of net assets acquired, should be transparent to users of financial statements in evaluating the performance of the acquiring enterprises' management and their ability to employ effectively the capital of the enterprise. We currently believe that goodwill should be recognized and recorded as part of comprehensive income once the amount of goodwill has been determined. ³ We also believe that accounting goodwill, unlike other assets, does not embody a probable future benefit involving the capacity, singly or in combination with other assets, to contribute directly or indirectly to future net cash flows of the acquiring enterprise. ⁴ But instead, certain cash flow expenditures, such as advertising and public relations costs, are often required to maintain the value of goodwill. Moreover, the immediate recognition of goodwill would improve the comparability of financial statements for enterprises because many are not permitted to record self-developed goodwill.

 

We believe that the residual (i.e., goodwill) under this proposed Statement should be lower than that recorded under APB Opinion 16 because an acquirer will be required to identify and reliably measure the intangible assets, or underlying components, of goodwill.

 

Issue 7 - Impairment of Goodwill
The Board considered several approaches that would have permitted some, or all, goodwill to be capitalized and not amortized.  However, the Board found that none of those approaches were operational because of the subjectivity involved in identifying and measuring the discernible elements of goodwill, particularly those with indefinite lives, and the inability to adequately review goodwill for impairment (no identifiable direct cash flows).

 

If goodwill is recorded as an asset, the FAPC supports the discernible-elements approach that identifies and measures the underlying components. We have noted the results of the FASB's limited field test of its discernible-elements model (Paragraph 233 in the Basis for Conclusions) and the Board's concerns with the subjective nature of such an approach. However, we believe that users of financial statements need improved information to evaluate business combinations; management's subjective assessment of the components of the unallocated portion of the purchase price is an extremely relevant disclosure. To mitigate subjectivity, we recommend strongly that the methodology and basis for determining and measuring these elements be transparent, preferably in a schedule format and presented in a note to the financial statements. Management should be encouraged to provide information on all sources of value deemed critical to the determination of the purchase price.

 

The residual consisting of a single element should be amortized over its determined useful life not to exceed 20 years and subject to impairment tests. If at the time of the acquisition the residual consists of several discernible elements, such as assets and liabilities that cannot be recognized separately under current accounting standards (even if they can be measured with sufficient reliability), then these elements should be identified and documented as components of goodwill. We believe that the estimated useful life of each element should be assessed separately and that goodwill, in total, should be amortized over the weighted-average useful life of its underlying components.

 

Accounting for Identifiable Intangible Assets

 

Issue 8 - Distinction between Purchased Intangible Assets and Goodwill
The proposed Statement would require that intangible assets acquired in the business combination, which are identifiable and reliably measured, be recorded at fair value and shown separately from goodwill in the acquirer's financial statements.  That requirement is based on the assumption that intangible assets acquired in a business combination can be measured separately from goodwill with a sufficient degree of reliability to meet the asset recognition criteria.

 

The FAPC supports strongly the Board's proposal to record separately acquired intangible assets from goodwill and its recommended requirement for impairment tests for each intangible asset identified in the acquisition. These intangibles should be subject to the impairment tests outlined under SFAS No. 121, Accounting for the Impairment of Long-Lived Assets and for Long-Lived Assets to Be Disposed Of. Furthermore, we believe that there are some classes, or types, of intangible assets that can be measured more reliably than others. For example, intangibles that are contract-based assets with fixed or definite terms can be measured more reliably than workforce-based assets. The former have more predictable cash flows than the latter, which are very difficult to measure reliably due to the movement of employees from enterprise to enterprise and changes in technology and skill requirements.

 

Issue 9: Amortization of Intangible Assets
The proposed Statement would require an intangible asset (other than goodwill) to be amortized over a period longer than 20 years and, in some circumstances, to not be amortized at all.

 

The FAPC concurs with the Board that the preferred method of amortization is one that reflects the pattern in which the economic benefits of the identifiable intangible assets are consumed.  However, if that pattern cannot be determined reliably, then straight-line amortization is appropriate. We also concur with the presumption that an intangible asset has a useful economic life not to exceed 20 years unless the following are present: (1) the intangible asset generates identifiable cash flows that are expected to continue for more than 20 years; or (2) contractual or legal control over the future economic benefits extends beyond 20 years.  Finally, we agree that some intangible assets, such as FCC licenses, may have useful lives that are indefinite. For these assets, we strongly agree with the requirement in paragraph 50 of the proposed Statement that mandates an annual impairment test.

 

As previously mentioned in the comment letter, we believe that the residual resulting from the acquisition could have intangible assets embodied in it. These intangibles may not be recognized separately because current accounting standards prohibit their separate recognition. We believe that these intangible assets could be measured using the present value of expected future cash flows detailed in the FASB's  Proposed Statement of Financial Accounting Concepts, Using Cash Flow Information and Present Value in Accounting Measurements, and, therefore, should be considered in determining the useful life of the residual or goodwill.

 

Impairment

 

Issue 10: Using Impairment Requirements under SFAS No. 121
The proposed Statement would require that all goodwill be reviewed for impairment in accordance with SFAS No. 121. Goodwill would be tested for recoverability no later than two years after the acquisition date if more than one of the four factors listed in the proposed Statement were present at the acquisition date.

 

The FAPC supports strongly the requirement that goodwill and other identifiable intangible assets be reviewed for impairment on a regular basis, no less than once every two years. Due to the nature of goodwill and other intangible assets, their values fluctuate frequently (and could diminish completely) as a result of technological changes, shifts in market demands, and other external factors. Furthermore, we believe that the factors listed in paragraph 26 of the proposed Statement are relevant when considered together for assessing the recoverability of goodwill at the time of the acquisition and in determining the frequency of the impairment test. 

 

Presentation in the Income Statement

 

Issue 11: Goodwill Charges Shown Net of Tax
The proposed Statement would require that goodwill charges (amortization expense and impairment losses) be presented in the income statement as a separate line item on a net-of-tax basis. Also, enterprises must present a subtotal on the income statement before the goodwill charges, which would include amortization expense related to other intangible assets acquired in a business combination as well as the effects of the step-up in basis of the other net assets acquired. In addition, enterprises would be permitted to present per-share amounts on the face of the income statement for the subtotal before the goodwill charges and for the goodwill charges.

 

The FAPC disagrees strongly with the proposed display that shows goodwill charges (amortization expense and impairment losses) net of tax as an item after operating earnings and as a per-share amount on an enterprise's income statement. This proposed display is inconsistent with the display of depreciation and amortization expenses and impairment losses for other assets. If goodwill is an asset, then it should be treated as such; its amortization and impairment losses should be reflected in the operating earnings of that enterprise.

 

We have always advocated the transparency of goodwill charges, i.e., displayed as a separate item within operating earnings or itemized in a reconciliation of the carrying balance of goodwill in a note to the financial statements.  Furthermore, we believe that the tax effect for goodwill should be provided in a note to the financial statements. A separate disclosure of the tax effect for goodwill is necessary because its tax treatment is not similar to other deductions; there are restrictions regarding its deductibility. Disclosures of material tax consequences are best reported and discussed in the tax footnote.

 

Disclosure Requirements

 

Issue 12: Results of Operations and Balance Sheet Disclosures
This proposed Statement would eliminate Opinion 16's requirement to disclose information about the results of operations on a pro forma basis.   Instead, a condensed balance sheet of the acquired enterprise disclosing both the book values, as reflected in the acquired enterprise's financial records, and the comparable fair values assigned at the date of acquisition would be required in the notes to the financial statements of the acquiring enterprise.

 

The FAPC disagrees strongly with the proposed changes to replace the disclosure of results of operations on a pro forma basis with a condensed balance sheet of the acquired enterprise. We believe firmly that the following disclosures must be required and provided to financial statement users for their assessment of the economic benefits or risks of a business combination:

 

1. allocation of the purchase price to the major categories of assets and liabilities acquired;
   
2. the valuation of goodwill and other purchased intangibles, as well as the relevant assumptions and methodologies used to value these items;
   
3. the impact of changes in accounting principles resulting from the business combination on the financial position of the combined enterprise; and
   
4. discrete and disaggregated financial data reflecting the performance of the target company subsequent to the acquisition, or a pro forma basis income statement.

 

Detailed disclosure on the allocation of the purchase price to major categories of assets and liabilities acquired is essential to (1) the assessment of cash flow statement effects, including  the distortion of cash from operations (CFO) and (2) an accurate analysis of the impact of the combination on financial statement ratios and relationships. The elimination of the pro forma information regarding results of operations would greatly impair the ability of financial statement users to project properly the future earnings and cash flows of the acquirer. Without this information, it would be very difficult to discern the incremental change to the acquirer's revenues and operating margins resulting from the recent acquisition(s) and, in turn, assess the economic benefits or risks of these transactions. The requirement of a condensed balance sheet does not provide the necessary information by major classes of assets and liabilities; such condensed balance sheets are too abbreviated.

 

A discussion of these analyses ⁵ are provided in Attachment A to this comment letter. The need for pro forma financial statements and disaggregated financial data reflecting the performance of the target company subsequent to the acquisition is illustrated in the two cases accompanying Chapter 14. ⁶ Case 14-1 recasts a purchase method acquisition as a pooling to illustrate the impact of the transaction on financial statements, financial ratios and cash flow statement consequences. Case 14-2 reverses the process, accounting for a pooling transaction as a purchase method acquisition. This case provides a comprehensive example of the use of pro forma information. (These cases are provided in Attachment B to this comment letter.)

 

Effective Date and Transition

 

Issue 13 - "Grandfather" Goodwill Accounted for Under Opinion 17
The Board decided that goodwill being accounted for in accordance with ARB No. 43, Chapter 5, "Intangible Assets," would be written off as the cumulative effect of a change in accounting principle when the final Statement is initially applied.  However, for practical reasons, the Board decided to "grandfather" the manner in which previously recognized goodwill is being accounted for under Opinion 17 and the manner in which other previously recognized intangible assets are being accounted for under ARB 43, Chapter 5 or Opinion 17.

 

The FAPC agrees that any remaining goodwill accounted for under ARB No. 43 should be written off as the cumulative effect of the change in accounting principle. This effect should be reflected in the first interim or annual period after this Statement is issued.

 

Issue 14 - Acquired Goodwill and Intangibles from Previous Acquisitions
The proposed Statement would be applicable to goodwill and other intangible assets acquired in transactions initiated on or before the date the final Statement is issued, as well as to those initiated afterward for the following: (1) reviewing goodwill for impairment (including allocating goodwill to individual asset groups), (2) presentation in the financial statements (including the presentation of goodwill charges on a net-of-tax basis), and (3) disclosures (specifically, information about intangible assets by class).  The Board decided that restatement or reclassification would not be required for intangible assets acquired in transactions initiated on or before issuance of the final Statement if it were not practicable to do so because records may not be available.

 

The FAPC agrees with the provisions relating to items (1) and (3) mentioned above, but strongly disagrees with the proposed display of goodwill amortization net of tax on the income statement, as mentioned in our comment of Issue 11.

 

Concluding Remarks

 

The FAPC appreciates the opportunity to express its views on the Proposed Statement of Financial Accounting Standards - Business Combinations and Intangible Assets. If either you,  the Board, or its staff have questions or seek amplification of our views, we would be pleased to answer any questions or provide any additional information you might request.

 

Sincerely,

 

Gabrielle U. Napolitano, CFA
Chair
Financial Accounting Policy Committee

 

Ashwinpaul C. Sondhi
Subcommittee Chair - Business Combinations

 

Georgene B. Palacky, CPA
Associate, Advocacy
AIMR

 

cc:	AIMR  Advocacy Distribution List Michael S. Caccese, Senior Vice President, General Counsel & Secretary, AIMR Patricia Doran Walters, Ph.D., CFA, Vice President, Advocay, AIMR

The attachments for this letter are not available.