Corporations could write off more than half a trillion dollars this year because of new accounting rules governing old acquisitions.
By Justin Schack
May 2002
On January 11, 2001, America Online acquired Time Warner for a whopping $147 billion in AOL stock. A little more than a year later, the media behemoth admitted that it hadn’t gotten such a great deal. In fact, based on its estimate of the former Time Warner’s value today, AOL paid 37 percent too much. It took a $54 billion charge in the first quarter of 2002 to reflect the reduction in value on its balance sheet.
Companies overpay for acquisitions all the time. But rarely do they own up to it in such dramatic fashion on their financial statements. Nor would they do so now, if they had a choice. But on January 1, 2002, new rules went into effect governing the way companies must account for the premiums they pay for acquisitions. AOL is the most prominent of a slew of companies that are taking huge write-offs as a result. For some, taking the hit may present additional problems, such as putting them in violation of bank loan covenants.
“I think we are going to see way over $500 billion in charges this year alone,” says Robert Willens, who follows tax and accounting policy at Lehman Brothers. “There have been at least five or six big announcements already, and we haven’t even scratched the surface yet.”
Three years ago the Financial Accounting Standards Board prohibited pooling-of-interests accounting, in which an acquirer simply combines, or “pools,” the target’s balance sheet with its own. During the 1990s companies preferred such pooling to the alternative, purchase accounting. In purchase accounting the acquirer accounts for the difference between the actual value of the target’s assets and the acquisition price as “goodwill,” which must be amortized. FASB argues that pooling encouraged companies to overpay for acquisitions.
Predictably, corporate America how-led. FASB held its ground and abolished the practice, but it threw corporations a pretty big bone: Rather than amortizing goodwill, which can create a quarterly drag on earnings for up to 40 years, companies now must write it off if they determine it to be an “impaired” asset , admitting that an acquired company is not worth its purchase price. “You’re acknowledging that you can no longer recover what you paid for it,” says Patricia McConnell, a tax and accounting analyst at Bear, Stearns & Co.
Under the new rule, known as FAS No. 142, companies are required to test for impairment during the first six months of 2002 and annually thereafter. Whether an asset is impaired is a gray area, open to opportunistic interpretation by CFOs, but the rule gives companies an incentive to get the test out of the way quickly. Any write-offs taken after 2002 must be shown as a separate line item in financial statements and therefore are more likely to be identified and questioned by investors. Says Willens, “That is motivating people to take as large a charge as seems justifiable at this point, to get it all out of the way in the most hospitable environment possible.”
Some companies, however, must also consider the impact that a huge write-off might have on their financial health. Consider Qwest Communications International and WorldCom, which both announced multibillion-dollar goodwill charges this year (see table below). “One of the substantive aspects of this is that you can be violating your loan covenants, depending on how they’re written,” notes Willens. “This may be a bit of a deterrent for companies that might otherwise take the biggest hit possible.”
Goodwill write-offs are noncash charges, so the accounting change isn’t likely to have catastrophic consequences. AOL specifically notes in its annual report that the $54 billion charge does not violate any of its bank covenants. Over the long haul, FASB’s actions should have a mostly favorable impact. Highly acquisitive companies may be more frugal in making deals in the first place, knowing that they might have to write off impaired goodwill annually. “It certainly might make companies more rational,” says McConnell. “They will be less likely to overpay in the future.”
Second thoughts
In the 1990s acquirers paid hugely for companies they coveted. But since the adoption of new accounting rules on January 1, several have taken what experts believe to be the first in a tidal wave of write-offs for “impaired goodwill,” acknowledging that their acquisitions weren’t worth the price they paid. A few examples:
Company
Amount of
Amount of
goodwill
write-off
($ billions)
($ billions)
AOL Time Warner
$128
$54
Qwest Communications International
35
20,30
Clear Channel Communications
43
15,25
WorldCom
41
15,20
Vivendi Universal
34
14
Liberty Media Corp.
10.8
1.5,2.0
Boeing Co.
6.4
1.4,1.9
E*Trade Group
0.68
.30,.35
Source: Company reports.
