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Acquisitions
(Part I)
by WealthEffect Staff

 
 

Acquisitions are an integral component of business strategy
 
  A pooling-of-interests merger occurs when the buyout is paid in stock  
  A purchase occurs when the acquisition is treated as a takeover, not a merger  
 
1.

Companies can grow by expanding their product line or their geographic markets. One quick route to expansion is by acquiring another company. Acquisitions have always been central to history, and business is certainly no exception — one company grows while another, usually a competitor, is assimilated. Growth by acquisition is so basic a concept that it's carried into the future — what sci fi fan wouldn't recognize the ultimate masters of the hostile takeover, the Borg?

Acquisitions are particularly popular with public companies. Beyond the business rationale, there is the practical benefit of publicly-traded stock that can easily be used as currency for takeovers. There is also the personal motivation for CEOs to buy other companies and expand their empires — after all, they get to run the whole show even though they usually own only a small fraction of the shares.

 
 
2.

Prior to 2002, when one company buys the shares of another with its own shares, the acquisition could be accounted for as a pooling-of-interests under GAAP (Generally Accepted Accounting Principles). This stock-for-stock transaction was treated as a merger and the financial statements were restated as if the two companies had always been one.

There are tax advantages to the selling stockholders, who do not have to pay capital gains taxes until the shares of the acquiring company are sold. In the past, there were also tax advantages to the acquiring company related to goodwill.

 
 
3.

Goodwill is created in a purchase transaction, where one company acquires another not as a merger but as a takeover. Goodwill represents the amount by which the purchase price exceeds the book value — the shareholders' equity from the balance sheet — of the acquired company. Not surprisingly, this "excess" amount is defined as the good will built up with customers. Less obvious is the fact that the accounting treatment of this item used to be illogical and irrelevant.
 
 


Acquisitions
(Part II)

 
 

Goodwill amortization should be ignored
 
  In-process R&D should, as well  
  The SEC and the FASB — the new cavalry?  
 
1.

Goodwill is created in purchase transactions and, until 2002, the accounting fashions of the GAAP required that this goodwill be expensed in an item called goodwill amortization. But this was illogical since goodwill grows in value over time — why, then, would you treat it as a depreciating asset?

Simply put, goodwill should be ignored. When analyzing a company, add back any goodwill amortization to the net income to determine true earnings (this will also improve the free cash flow).

 
 
2.

Another consequence of acquisitions is the recent proliferation of in-process R&D write-offs. These occur, particularly in technology buyouts, when the buying company decides that some portion of the seller's research and development is worthless. Accordingly, it takes a large one-time write-off to expense this "worthless" R&D.

Goodwill amortization is an annual expense which investors should ignore but, by and large, do not. In-process R&D is a one-time write-off, and Wall Street tends to ignore expenses which are non-recurring. This, of course, creates a temptation for companies to bunch together some ongoing operating expenses and write them off in a single year as a "non-recurring" charge. If necessity is the mother of invention, trying to please Wall Street is the mother of necessity.

 
 
3.

The Securities and Exchange Commission (SEC) which regulates public companies and the Financial Accounting Standards Board (FASB) which sets the accounting rules have taken a more active role. The SEC is cracking down on which in-process R&D write-offs are permissible.

Beginning in 2002, the accounting rules for goodwill finally came to reflect economic reality. Goodwill no longer needed to be amortized — instead, it is now ignored on the income statement (unless it is determined that the goodwill value listed on the books has declined). Concurrent with this ruling, the FASB eliminated pooling transactions, requiring sensibly that all acquisitions be accounted for as purchases. In addition, the FASB has moved towards a more accurate accounting for the true costs of company stock options, which is long overdue.

Suggestion: Go to Company Options