September 29, 2002
From the desk of Jane Galt:Investment banks are in trouble.
Investment banks are in trouble.
Now, when I was recruiting for I-Banking, we were told that investment banking was pretty much a winner regardless of the market. If stocks went up, they did IPO's; if they went down, companies would be acquiring suddenly-cheaper targets, and there would be plenty of M&A work. Either way, the banks would win. What's even funnier is that the vice presidents and associates feeding us this line actually believed it.
And it sounds plausible. Unfortunately, like many plausible-sounding things, it had a hidden weakness. In this case, it was the great controversy in accounting known as Pooling of Interests Accounting. It's so controversial that they're thinking of eliminating it all together, which sparks the kind of argument that makes accounting types get red in the face and scream at each other, and aren't you glad you don't hang out with people like that?
There are two ways you can account for an acquisition on your balance sheet: pooling, or purchase. In the more conservative Purchase method, you basically take all the assets off the balance sheet of the company being bought and transfer them onto the balance sheet of the purchaser. Meanwhile, you take the money or stocks or what have you that was paid to the shareholders off the purchaser's balance sheet, and presto! you're done.
Well, not quite. Because in financial statements, most assets are recorded at their Historical Cost, otherwise known as What You Paid For Them. Thus your father's Sandy Koufax Rookie Baseball Card would be carried on the family balance sheet at 10 cents.
In these inflationary times, investment bankers have to go through all the assets of the company you're buying and figure out what they're actually worth, rather than what it says on the balance sheet. The price paid for the company will thus be higher, often much higher, than what the financial statements show, which is called the company's book value.
If the merger is accounted for as a purchase, the difference between the purchase price and the book value has to be recorded on the purchaser's balance sheet; otherwise the books don't balance. So an asset called goodwill is created. Because it is presumed to represent the value of depreciable assets, this goodwill number has to be depreciated. That is, every year, net income has to be lowered to reflect the fact that all of these assets have gotten less valuable as time goes on, through wear and tear and what have you.
[But what about the Sandy Koufax card? I hear you cry. That gets more valuable. Well, actually, I lied. Sandy Koufax cards belong to a special class of assets called "marketable securities" -- they trade on a liquid market, and thus their current value can readily be ascertained, so they are recorded on the books at their market value. I was just trying to illustrate the principal, okay?]
Companies really, really don't like having to take a goodwill charge. Which is because ignorant investors see EPS go down and run for the hills. So they try very, very hard to qualify for a different type of accounting treatment, known as Pooling of Interests Accounting.
In theory, a pooling of interests merger isn't about one company buying another; it's about two companies with a lot in common discovering that they were meant to be together. They throw all their worldly goods into one pot and call the new company McNikeSoft. In practice, this is a load of hooey; one company is buying the other. But that doesn't mean we can't all pretend, the way the friends of aging tycoons pretend that his eighteen year old bride is marrying him for his animal magnetism. So. Because it's not a purchase, all the assets simply transfer to the new combined entity just as they were on the balance sheet. No goodwill is recorded, so EPS doesn't take a hit. This is how almost all big mergers get done.
There's a kicker, though; in order to qualify for Pooling of Interest accounting, you can't just pull out a wad of cash and slap it on the counter. The deal has to be done with stock-for-stock: I'll trade you one of my AOL/Time Warners for two of your Time Warner certificates (and don't we wish we'd been an AOL shareholder in on that one!). Doing the kind of stock-for-stock deal that qualifies for Pooling treatment is extremely tax disadvantageous, in general, but the incentive to avoid lowering EPS with a goodwill charge is so high that CEO's are willing to shell out more of their hard-earned cash to the IRS, just to avoid a bookkeeping charge to EPS. No, I never said that private enterprise was perfect.
Thus, even though targets are now cheaper, it doesn't matter, because the potential purchaser's stock is also down. Whereas in the good old days, cash rich companies could go after targets in troubled times, now they have to sit on their hands until their stock price perks up again. About another decade, from the looks of the market on Friday.
So now you know about one of the hottest issues in accounting today, and why M&A hasn't picked up like everyone predicted it would, and also, how all those stupid deals in the late 90's got done. Now, if you go to the tool chest and get a hammer and tap yourself lightly on the forehead a few times, all this information will probably fall right back out and you'll be none the worse for the experience.
Update
Looks like today is my day for looking like an idiot. Several readers have emailed me to point out that they've eliminated pooling-of-interest accounting, and in order to pacify the Investment bankers, have allowed the goodwill to sit on the balance sheet forever, rather than depreciating like it used to.
I could weasel out of that by saying that it doesn't effect my main point, which is that the market was heavily biased towards stock-for-stock transactions during the great M&A idiot boom of the late 90's. Which is true. And in fact, I did know that they'd eliminated pooling; the fact just somehow dropped out of my head while I wrote the post. Darren Roulstone, who teaches accounting at my alma mater, sums it up nicely in an email:
Saw your piece on purchase and pooling accounting. As usual, you describe the issue succinctly with humor and charm. . . I just want to pass on an update: they (the FASB) have actually eliminated pooling-of-interest accounting. In order to do this without angry I-bankers storming Norwalk, CT with flaming torches, they also eliminated the amortization of goodwill that made so many managers wary of purchase accounting. So, firms now use purchase accounting, but goodwill can stay on the balance sheet untouched, with only periodic evaluations for impairment. (Firms continue to amortize any excess purchase price allocated to assets and liabilities other than goodwill and indefinitely lived intangibles.)For details check out FASB statements 141 and 142. For intelligible details, see Stickney and Weil's Financial Accounting... chapter 11 of the tenth edition. (The edition that all of my current students are reluctant to buy as they just managed to pick up a really cheap ninth edition. "Class, the first thing we're going to do is talk about why that ninth edition become so cheap just as the tenth edition was adopted by the intro financial professors.")
Anyway, the main point stands; stock-for-stock means that the countercyclical aspects of M&A that they were touting were, on their face, ridiculous.
As for the commenter who wanted to know about the rest of IB . . . well, there isn't much rest. There's securities issuance, which is in the trashcan until the equities market picks up, or cash flow gets strong enough to support more long-term debt. There's structured finance and related departments. These are the fun folks who brought you Enron's 87 zillion off-balance sheet "special purpose entities" and I don't think we need to ask why they're not doing so hot. Then there are the areas which technically are not part of Investment Banking, such as sales, trading, capital markets, brokerage, research, etc. Obviously, research is undergoing some reverses. Trading is doing fine in some spots, notso-hotso in others, but the overall revenue is simply not high enough to make up for the enormous fees that are being lost in the moribund investment banking business.
[For those of you who get their entire knowledge of how the financial firms work from the summer you took "Liar's Poker" to the beach, trading isn't as lucrative as it was when the S&L's were opening their vaults to the Solomon mortgage traders and inviting them to help themselves.]
And for the multiple emailers who have written to tell me that no one cares about goodwill, because professional investors just back it out of their valuation -- well, theoretically that's true, but in practice, managers were extremely reluctant to take the charge. Everyone I knew who actually worked on such deals told me the same thing: managers were paying hefty extra taxes in order to avoid the goodwill.
Posted by Jane Galt at September 29, 2002 8:59 PM | TrackBack | Technorati inbound links"); ?>