February 23, 2000 

 

The Honorable Phil Gramm, Chairman
U.S. Senate Committee on Banking, Housing and Urban Affairs
534 Dirksen Senate Office Building
Washington, D.C. 20510

 

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

 

Dear Senator Gramm:

 

The Financial Accounting Policy Committee (FAPC) of the Association for Investment Management and Research (AIMR)¹ has been informed that the Senate Banking Committee has scheduled a hearing on March 2, 2000, to review the Financial Accounting Standards Board proposal regarding 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. 

 

We are writing you not only to express our views, but also to speak on behalf of thousands of investment professionals, current and potential investors, creditors, and other users of financial statements. Also, we are writing to express our dismay with the purpose and potential impact of the March 2 hearing. Political intervention by the Congress of the United States is likely to impede the FASB’s ability to promulgate and issue standards for financial reporting that serve the capital markets of the United States. Accounting standards must faithfully represent the economic substance of business transactions and provide information in a neutral manner to all financial market participants. In the specific case of business combinations, the financial markets require an accounting standard that reports the value of those transactions regardless of the “currency” used to effect a combination. Such a standard would provide transparency, and in turn, enhance the ability of financial market participants to assess properly the economic position and future viability of the combined enterprises these transactions produce.

 

We believe the critical issues pertaining to the FASB’s proposed accounting standard are:

 

• The “lifeblood” of United States capital markets is financial information that is: (1) comparable from firm to firm; (2) relevant to investment and financing decisions, (3) a reliable and faithful depiction of economic reality; and (4) neutral, favoring neither supplier nor user of capital, neither buyer nor seller of securities.
• To set accounting standards that meet the above criteria, the Financial Accounting Standards Board (or any other standard setter) must be independent of those persons and organizations, who seek financial reports that serve their parochial interests.
• Transactions and economic events that are similar ought to be reported similarly in financial statements. Alternative accounting for similar events undermines the integrity and usefulness of financial reports.
• The interests of the capital markets and those who invest in them are served when business combinations are formed for their economic benefits, not their accounting outcomes. The accounting “tail” should not “wag” the transaction “dog.”

 

Quality of Information
We urge the Senate Banking Committee to focus on the need for United States capital markets to have comparable, relevant, reliable, and neutral information. As stated above, such information is the “lifeblood” of American capital markets. Information meeting those criteria is essential for the efficient operation of the capital markets, insuring that capital will be allocated to those uses that create the greatest returns commensurate with risk. Capital market participants use financial statement information to analyze the economic performance and financial position of business enterprises. Those analyses are the basis for estimating the company-specific valuations and assessments of future prospects that underlie informed and sound investment decisions.

 

We believe the notion of neutrality is an essential attribute that the Senate Banking Committee should not allow to be discredited by those who testify at the March 2 hearing. It is essential to the production of market-serving financial information. It is one of the basic concepts of accounting and is defined in Statement of Financial Accounting Concepts No. 2, Qualitative Characteristics of Accounting Information (page xii) as follows:

 

Neutrality means that, in formulating or implementing standards, the primary concern should be the relevance and reliability of the information that results, not the effect that the new rule may have on a particular interest. A neutral choice between accounting alternatives is free from bias towards a predetermined result. The objectives of financial reporting serve many different information users who have diverse interests, and no one predetermined result is likely to suit all interests.

 

Richard C. Breeden, former Chairman of the United States Securities and Exchange Commission, spoke of the need for the neutrality of financial information during a Senate Banking Committee hearing on September 10, 1990:

 

The purpose of accounting standards is to assure that financial information is presented in a way that enable decision makers to make informed judgments. To the extent that accounting standards are subverted to achieve objectives unrelated to a fair and accurate presentation, they fail in their purpose.

 

It is our belief that pooling of interests accounting is not neutral, and that the FASB is correct in seeking to have a single method, the purchase method, for all business combinations. Pooling accounting suppresses reporting the value of an economic transaction; it deprives the capital markets of that information. To some extent, it favors those who have the ability to “look through” the financial statements and discriminates against ordinary investors who are much more likely to take financial statement numbers at their face value. Furthermore, even for investment professionals and business managers themselves, the ability to “look through” is short-lived and only a few accounting periods after the combination that ability will disappear as the operations of the acquired company are integrated with those of the acquirer. Thus, financial markets become anemic as they are deprived of their “lifeblood.”

 

Standard-Setting Independence of the FASB
In 1993, the Association for Investment Management and Research published the Financial Accounting Policy Committee’s position paper, Financial Reporting in the 1990’s and Beyond. That publication (copy enclosed) addresses comprehensively, and in detail, matters of financial accounting and disclosure that are of particular interest to the investment community. Its positions on accounting standards and financial reporting are cited frequently in academic research on the behavior of firms, markets, and investors. The following paragraphs, found on pages 76 and 77 of Financial Reporting in the 1990s and Beyond, express our views on the process of setting accounting standards in general, and the role of the Financial Accounting Standards Board in particular:

 

We do not know what the future role of the FASB will be, but at the moment it certainly is the paramount standard-setting organization affecting financial analysis in the United States. Over the years, we have had differences with the FASB, and we have discussed many of them and noted others at various places in this report. Those differences are inevitable given our single-mindedness in seeking information useful in the workings of investment analysis. They in no way subvert our total support of the FASB as an institution. We are on the record in that regard. All of our comments herein are made with the hope of improving its operations, strengthening its perseverance, and raising its stature.

From time to time, the FASB is criticized, disparaged, assailed, censured, and even castigated by various individuals and organizations. Much of that criticism seems to us unwarranted, as we discuss in greater detail below. It seems to be as much an expression of disappointment and disagreement as anything else. In fact, the more we hear of it, the more convinced we are that the FASB is accomplishing its mission. It has undertaken some of the most daunting projects imaginable: financial instruments, post-retirement benefits, reporting income taxes, among others. It has been lobbied incessantly by, among others, the Business Roundtable, various competing government agencies, a variety of financial institution trade associations, and various trade associations and similar groups.

Perhaps the best way to appreciate the virtue of the FASB is to ask who or what could do a better job. The answer is clear. There is no alternative arrangement that would come close to achieving the integrity of the FASB and its ability, by promulgating accounting standards, to compel the propagation of unpopular truth through financial reports. We, in common with others, could hope for standards more beneficial to our needs. Unlike many others, we also encourage the FASB to act more rapidly in considering and issuing standards. We have consistently opposed changes in the board’s operating procedures that act to slow its tempo. We hope it is clear that our position is one of thorough support for the institution, without complete endorsement of all its actions or conduct. [emphasis added]

 

Although the above views were published a few years ago, they are still relevant to the issues surrounding the proposed accounting standard for business combinations. We continue to believe strongly that political intervention should be kept to a minimum with regard to setting accounting standards. Accounting standards should not be promulgated to serve the special interests of select groups of constituents or certain industries. Instead, they should serve the capital markets of the United States and those of its citizens who invest in securities directly or indirectly, through pension funds, mutual funds, and other financial intermediaries.

 

One Method of Accounting
The FAPC is unequivocal in its support of the FASB’s proposal that there be only one method of accounting for business combinations in the United States. We also agree that the purchase method is the one that reflects properly the economics of all business combinations, and that pooling-of-interests should be eliminated. By nature, acquisitions and mergers disrupt an enterprise's operations and financial results, leading to changes in revenue, income, and cash flow trends, as well as affecting the comparability of financial ratios used by investors to evaluate an enterprise's performance. These concerns, in combination with the need for improved international harmonization of accounting standards, make clear the need for a single method of accounting for business combinations. 

 

Comparability between and among business enterprises is obstructed by the application of alternative accounting methods to account for business combinations in different jurisdictions throughout the world. The resultant differences in the content of financial statements from country to country and company to company are, in most instances, material and opaque. The most fundamental differences relate to whether a new accounting basis is established for the assets and liabilities of the acquired enterprise, and the accounting for that new basis in subsequent years.

 

Under the purchase method, all assets and liabilities of the acquired enterprise are recorded at their fair values. That impounds information from the current transaction about the expected future cash flows associated with the assets and liabilities acquired with corresponding enhancement of the predictive value of the financial statements. Under the purchase method, as proposed in the exposure draft, financial statement users will be provided with superior information to assist them in: (1) assessing properly the transaction's economic benefits or risks/drawbacks, and (2) analyzing its impact on the acquirer's future earnings, cash flows, and business operations. Furthermore, the total transaction cost, as well as its excess over book value, will be clearly disclosed. Thus, the effects on the enterprise of a business combination are, under the purchase method, more transparent to shareholders, potential investors, and financial analysts than would be the case with a pooling of interests.

 

The pooling method fails to revalue the assets and liabilities of the acquired enterprise at fair value and the excess, commonly called “goodwill,” is not recorded. Hence, pooling does not faithfully represent the values of the assets and liabilities exchanged, nor does it reveal the actual premium paid by the acquirer in the transaction. Users of financial statements are thus impeded in their attempts to understand the underlying economics of the business combination.

 

Potential Impact on Future Transactions
Corporate managers enter into business combinations for economic and strategic reasons to enhance shareholder value by increasing market share, creating other synergies, or improving overall competitiveness. The method used to account for those combinations should not have a material affect on the “mergers and acquisitions” market. When corporate managers have the opportunity to choose among alternative accounting methods, they may enter into business acquisitions that appear to be beneficial to the enterprise and its shareholders because their detrimental impact is obscured. Those combinations probably will no longer occur in the future because their detrimental impact would be disclosed under the purchase method. We not only do not perceive this result to be unsatisfactory or unacceptable; in fact, it is a salutary prospect. If the economic impact of mergers were made transparent, then corporate managers might be more prudent in their search for the appropriate acquisition or merger candidates. That, in turn, would inexorably lead to more efficient security pricing and capital allocation on a global level.

 

Concluding Remarks

 

The FAPC supports the Financial Accounting Standards Board in its business combinations proposal, which we believe will improve financial accounting and reporting. More importantly, we support unequivocally and in the strongest possible manner, the independence of the FASB to set accounting standards without fear or favor, free from interference by any group except those representing the capital markets of the United States. If you or other members of the Senate Banking Committee have questions or seek amplification of our views, we would be pleased to answer any questions or provide whatever additional information you might request.

 

Respectfully yours,

 

Gabrielle U. Napolitano, CFA Chair Financial Accounting Policy Committee

Georgene B. Palacky, CPA Associate AIMR, Advocacy

 

Enclosure

 

cc: Edmund Jenkins, Chair, Financial Accounting Standards Board
AIMR Advocacy Distribution List
Michael S. Caccese, Senior Vice President, General Counsel & Secretary, AIMR
Patricia Doran Walters, CFA, Vice President, Advocacy, AIMR

 

¹The Association for Investment Management and Research is a global, not-for-profit membership organization of over 40,000 investment professionals from 70 countries worldwide. Through its headquarters in Charlottesville, Virginia, and 94 member Societies and Chapters throughout the world, AIMR provides global leadership in investment education, professional standards, and advocacy programs.