U.S. GOVERNMENT PRINTING OFFICE

64–765CC WASHINGTON : 2000

ACCOUNTING FOR BUSINESS COMBINATIONS:

SHOULD POOLING BE ELIMINATED?

HEARING

BEFORE THE

SUBCOMMITTEE ON

FINANCE AND HAZARDOUS MATERIALS

OF THE

COMMITTEE ON COMMERCE

HOUSE OF REPRESENTATIVES

ONE HUNDRED SIXTH CONGRESS

SECOND SESSION

MAY 4, 2000

Serial No. 106–100

Printed for the use of the Committee on Commerce

(

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COMMITTEE ON COMMERCE

TOM BLILEY, Virginia, Chairman

W.J. ‘‘BILLY’’ TAUZIN, Louisiana

MICHAEL G. OXLEY, Ohio

MICHAEL BILIRAKIS, Florida

JOE BARTON, Texas

FRED UPTON, Michigan

CLIFF STEARNS, Florida

PAUL E. GILLMOR, Ohio

Vice Chairman

JAMES C. GREENWOOD, Pennsylvania

CHRISTOPHER COX, California

NATHAN DEAL, Georgia

STEVE LARGENT, Oklahoma

RICHARD BURR, North Carolina

BRIAN P. BILBRAY, California

ED WHITFIELD, Kentucky

GREG GANSKE, Iowa

CHARLIE NORWOOD, Georgia

TOM A. COBURN, Oklahoma

RICK LAZIO, New York

BARBARA CUBIN, Wyoming

JAMES E. ROGAN, California

JOHN SHIMKUS, Illinois

HEATHER WILSON, New Mexico

JOHN B. SHADEGG, Arizona

CHARLES W. ‘‘CHIP’’ PICKERING,

Mississippi

VITO FOSSELLA, New York

ROY BLUNT, Missouri

ED BRYANT, Tennessee

ROBERT L. EHRLICH, Jr., Maryland

JOHN D. DINGELL, Michigan

HENRY A. WAXMAN, California

EDWARD J. MARKEY, Massachusetts

RALPH M. HALL, Texas

RICK BOUCHER, Virginia

EDOLPHUS TOWNS, New York

FRANK PALLONE, Jr., New Jersey

SHERROD BROWN, Ohio

BART GORDON, Tennessee

PETER DEUTSCH, Florida

BOBBY L. RUSH, Illinois

ANNA G. ESHOO, California

RON KLINK, Pennsylvania

BART STUPAK, Michigan

ELIOT L. ENGEL, New York

TOM SAWYER, Ohio

ALBERT R. WYNN, Maryland

GENE GREEN, Texas

KAREN MCCARTHY, Missouri

TED STRICKLAND, Ohio

DIANA DEGETTE, Colorado

THOMAS M. BARRETT, Wisconsin

BILL LUTHER, Minnesota

LOIS CAPPS, California

JAMES E. DERDERIAN, Chief of Staff

JAMES D. BARNETTE, General Counsel

REID P.F. STUNTZ, Minority Staff Director and Chief Counsel

SUBCOMMITTEE ON FINANCE AND HAZARDOUS MATERIALS

MICHAEL G. OXLEY, Ohio, Chairman

W.J. ‘‘BILLY’’ TAUZIN, Louisiana

Vice Chairman

PAUL E. GILLMOR, Ohio

JAMES C. GREENWOOD, Pennsylvania

CHRISTOPHER COX, California

STEVE LARGENT, Oklahoma

BRIAN P. BILBRAY, California

GREG GANSKE, Iowa

RICK LAZIO, New York

JOHN SHIMKUS, Illinois

HEATHER WILSON, New Mexico

JOHN B. SHADEGG, Arizona

VITO FOSSELLA, New York

ROY BLUNT, Missouri

ROBERT L. EHRLICH, Jr., Maryland

TOM BLILEY, Virginia,

(Ex Officio)

EDOLPHUS TOWNS, New York

PETER DEUTSCH, Florida

BART STUPAK, Michigan

ELIOT L. ENGEL, New York

DIANA DEGETTE, Colorado

THOMAS M. BARRETT, Wisconsin

BILL LUTHER, Minnesota

LOIS CAPPS, California

EDWARD J. MARKEY, Massachusetts

RALPH M. HALL, Texas

FRANK PALLONE, Jr., New Jersey

BOBBY L. RUSH, Illinois

JOHN D. DINGELL, Michigan,

(Ex Officio)

(II)

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C O N T E N T S

Page

Testimony of:

Bible, Peter R., Chief Accounting Officer, General Motors Corporation ...... 89

Dooley, Hon. Calvin M., a Representative in Congress from the State

of California ................................................................................................... 62

Goodlatte, Hon. Bob, a Representative in Congress from the State of

Virginia .......................................................................................................... 59

Hoffman, Gene, Jr., President and CEO, EMusic.com .................................. 98

Jenkins, Edmund L., Chairman, Financial Accounting Standards Board ... 69

Lewis, William Frederick, President and CEO, Prospect Technologies ....... 102

Powell, Dennis D., Vice President, Corporate Controller, Cisco Systems .... 80

Material submitted for the record by:

American Business Conference, letter dated May 3, 2000, to Hon. Michael

Oxley .............................................................................................................. 134

Biotechnology Industry Organization, letter dated May 4, 2000, enclosing

statement for the record ............................................................................... 130

Jenkins, Edmund L., Chairman, Financial Accounting Standards Board,

letter dated May 23, 2000, enclosing response for the record ................... 125

National Association of Manufacturers, letter dated May 3, 2000, to Hon.

Michael Oxley, enclosing material for the record ....................................... 132

Valuing the New Economy, a white paper presented by The Merrill

Lynch Forum ................................................................................................. 136

(III)

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ACCOUNTING FOR BUSINESS COMBINATIONS:

SHOULD POOLING BE ELIMINATED?

THURSDAY, MAY 4, 2000

HOUSE OF REPRESENTATIVES, COMMITTEE ON COMMERCE, SUBCOMMITTEE ON FINANCE AND HAZARDOUS MATERIALS, Washington, DC.

The subcommittee met, pursuant to notice, at 10:08 a.m., in room

2123, Rayburn House Office Building, Hon. Michael G. Oxley

(chairman) presiding.

Members present: Representatives Oxley, Tauzin, Gillmor, Cox,

Largent, Ganske, Lazio, Shimkus, Bliley (ex officio), Towns,

DeGette, Barrett, Luther, Markey, Rush, and Dingell (ex officio).

Also present: Representatives Eshoo and Crowley.

Staff present: Brian McCullough, majority professional staff;

David Cavicke, majority counsel; Linda Dallas Rich, majority counsel; Shannon Vildostegui, majority professional staff; Robert

Simison, legislative clerk; and Consuela Washington, minority

counsel.

Mr. OXLEY. The subcommittee will come to order. The Chair recognizes himself for an opening statement.

I would like to begin by reaffirming my belief in FASB as an

independent private sector entity is best suited to set accounting

standards. Few would want politicians without accounting expertise making highly technical accounting decisions. From time to

time, however, FASB considers an issue which has broad public

policy implications best brought to light through congressional

hearings such as this. In such an instance, the Congress has a responsibility to foster open dialog on the issue. That is precisely why

I have called this hearing today.

FASB proposes eliminating the use of pooling as a proper method

of accounting for business combinations as well as making changes

to the treatment of goodwill. Many of the same arguments have circulated for years both for and against pooling accounting as the

treatment of goodwill. The debate has little changed. What has

changed, however, is the context of the debate. In the information

economy, the magnitude of the implications of eliminating pooling

accounting has increased dramatically. Intangible assets of knowledge-based companies often account for most of the company’s

value or ability to generate revenue in the future.

Central to this debate is the information available to investors

under each accounting method. Arguably, the benefits the elimination of pooling accounting will provide varies. The question we

must answer is whether the information is better, more accurate,

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and as useful under purchase accounting as the information provided under the current pooling method of accounting for these

transactions.

The recording of goodwill is a good example of the different treatment intangibles receive under pooling and purchase accounting.

Some argue pooling accounting distorts book value because it does

not amortize goodwill. The values of the two companies are simply

combined. Others argue purchase accounting artificially reduces

stated income by requiring goodwill write-off without a negative

economic event to support it. In fact, I can understand how many

intangible assets appreciate rather than depreciate over time.

Distinct from which method is more accurate is the issue of

whether requiring a shorter amortization period for goodwill or

even require the write-off of goodwill and other intangibles will actually make mergers and acquisitions uneconomical for businesses.

I suspect mergers will continue. However, the possibility that such

a rule change would artificially slow economic growth without providing any marginal benefit gives me pause.

Though I do not begin to have a solution to this debate, I do urge

those central to this debate to consider all of the options. Perhaps

we need to further examine the changing nature of assets which is

driving our economy. We need to consider whether eliminating

pooling accounting is a negative economic impact that could diminish the competitiveness of U.S. businesses. Finally, we must evaluate whether the proposed changes will actually provide investors

with more useful information about a company.

Today we will hear from those closest to the debate. I thank our

panelists for appearing today and look forward to hearing what

each has to say about this important issue.

The Chair’s time has expired. I recognize the ranking member,

the gentleman from New York, Mr. Towns.

Mr. TOWNS. Thank you, Mr. Chairman, for holding this hearing.

A number of concerns have been raised about the elimination of

pooling as a method of accounting for business combinations. Eliminating pooling accounting, it is argued, could slow the pace of business combinations and hinder the growth of high-tech industry

then by reducing the number of jobs its industry creates. High-tech

companies in particular say that with pooling accounting, many of

the mergers in the high-tech industry which have boosted our economy and the stock market might not have ever happened.

As a New Yorker and the ranking member of this Subcommittee

on Finance, I am concerned about the potential adverse effects. On

the other hand, a number of other companies, investors, consumer

groups and accounting experts argue that pooling is flawed, that it

distorts financial reporting, and that it adversely affects the allocation of economic resources by creating an unlevel playing field for

companies that compete for mergers and acquisitions.

Still others have concluded that both the pooling method and

purchase method of accounting for business combinations are

flawed, and that we need to go back to, should go back to, the

drawing board before moving forward.

There has been some concern lately about traditional accounting.

This is because intangible assets have replaced traditional bricks

and mortar as the backbone of business today. Information, knowlVerDate 11-MAY-2000 13:14 Sep 11, 2000 Jkt 064765 PO 00000 Frm 00006 Fmt 6633 Sfmt 6633 E:\HEARINGS\64765 pfrm01 PsN: 64765
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edge, and human capital are difficult, if not impossible, to value.

They simply do not depreciate the same way tangible assets do. In

fact, they often appreciate.

We should not be forcing companies with mostly intangible assets to apply the accounting method which does not accurately reflect the value of their assets. It seems to me we should be moving

toward a framework that more accurately reflects the value of companies in this information day and age.

Consistency in accounting standards is a desirable goal and one

that I support vigorously, but consistency will not be beneficial if

investors cannot rely on the valuation that the consistent approach

provides.

On that note, Mr. Chairman, I yield back.

Mr. OXLEY. The Chair recognizes the chairman of the full committee, the gentleman from Richmond, Mr. Bliley.

Chairman BLILEY. Thank you. I commend you, Mr. Chairman,

for holding this hearing today.

The draft rule proposal issued by the Financial Accounting

Standards Board will have a significant impact not only on hightech and other companies, but also on our economy. I commend the

FASB’s work in seeking to ensure that accounting rules provide an

accurate and fair picture of a company’s financial status.

In this instance, important questions have been raised as to

whether the Board’s proposal would actually do that, or whether it

would, on the contrary, make it more difficult for investors and

creditors to understand the true status of a company that has resulted from a business combination.

It is not an easy job to get companies to clarify their financial

status. The job has become increasingly difficult. Bricks-and-mortar

assets share the same balance sheet as creativity, innovation and

other intellectual assets. High-tech, biotech, financial, and other

companies thrive on these intangible values. Measuring these intangible values is very difficult, and I recognize that FASB does not

have an easy job to do.

An accounting framework that functions effectively in this new

economy is an important goal we must achieve. There are good arguments both for and against the FASB proposal. Hundreds of

comment letters were received, and the FASB heard from witnesses at hearings in California and New York. I am interested to

know how this information has been received.

I am concerned by claims that FASB’s proposal does more harm

than good. If the proposed changes have a negative effect on our

economy, then these changes become a public policy matter that

Congress must consider. I hope that is not the case, but I do not

think the picture is clear enough at this time to advocate the

changes contemplated in the FASB proposal.

I look forward to hearing the views of our witnesses today, and

I hope that we can begin to answer these important questions.

Thank you, Mr. Chairman.

Mr. OXLEY. I thank the gentleman.

The Chair recognizes the gentleman from Massachusetts Mr.

Markey.

Mr. MARKEY. Thank you, Mr. Chairman, very much. Thank you

so much for having this very important hearing here today so we

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can air out the concerns that I think many of the people who are

right now representing new economy districts such as mine, the

concerns which are being raised by many of the companies which

we represent.

The critics of FASB raise concerns that purchase accounting may

fail to accurately value some of the mergers. These concerns have

been particularly intense among many of the new economy companies whose worth may be less a function of their physical assets,

earnings, or capital, and more a product of intellectual property or

other more intangible assets and goodwill.

Some have advocated that eliminating pooling would discourage

many new e-commerce startup companies from doing a merger because of the cost purchase accounting would impose on such a

transaction.

Today, Mr. Chairman, you have wisely invited Ed Jenkins as

well as a very distinguished panel of corporate leaders with varying

perspectives on FASB’s proposal to eliminate pooling. I greatly respect Ed Jenkins. I admire Ed Jenkins. I think he is an excellent

head of FASB, and I welcome him here today.

I am going to be particularly interested in hearing constructive

ideas on options that FASB may or should consider to address in

terms of their concerns that had been raised about the impact of

purchase accounting on the new economy, and at the same time assuring that investors get the full and fair disclosure which they deserve. I think this is an excellent forum to have that discussion in.

Obviously, we are, as a Nation, in a transformation that is reflected in the earliest stages by particular east coast and west coast

congressional districts, but without question, it is time for us to

have this important discussion.

Mr. Chairman, since we are on the subject of accounting, I would

also suggest to the Chairman that we consider holding a further

oversight hearing on another issue affecting the accounting profession, the disturbing conflicts of interest arising from the fact that

some firms wish to simultaneously serve as consultants to or business partners of companies that they are also auditing simultaneously.

This practice is very disturbing to me. When my brother John

was graduating from Boston College as one of the outstanding finance majors, I asked him why he was not an accounting major instead. He said to me, well, the finance majors play the game, and

the accountants keep score. In this new era, accountants want to

play the game and keep score at the same time, and it does build

in tremendous conflicts that I believe this committee should look

at.

I know that you, Mr. Chairman, and several other members of

the majority have recently written to Arthur Levitt on this subject,

criticizing him as he tries to clamp down on such practices, and I

would hope that we could have a public hearing on that issue as

well so that we can discuss the propriety of accountants also having financial interests in the firms they are allegedly auditing for

public consumption. I think that would be important.

I look forward to this hearing. It is a central issue in the development of the new economy. I thank everyone who has come here

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today. I think it is going to illuminate the understanding of the

subcommittee.

Mr. OXLEY. The gentleman from Illinois Mr. Shimkus.

Mr. SHIMKUS. Thank you, Mr. Chairman. I will be brief. I have

only been a Member for 4 years, two terms. I have never seen a

submission of testimony this large before. It gives members a great

excuse, those who have not covered it prior to the hearing. If more

hearings would have this type of documentation, I would have better excuses for not doing all my homework, Mr. Chairman.

Mr. OXLEY. There are pictures in there, though.

Mr. SHIMKUS. We appreciate pictures.

I do have great respect for FASB, too. I understand the complexity of trying to determine market value in a new era of services, information services, and how do you value that. I am here

to listen and learn. I thank my colleagues for appearing, and also

the members of the next panel.

With that, Mr. Chairman, I yield back my time.

Mr. OXLEY. The Chair is now pleased to recognize the ranking

member of the full committee, the gentleman from Michigan Mr.

Dingell.

Mr. DINGELL. Mr. Chairman, thank you for that courtesy.

Mr. Chairman, I commend you for holding this hearing. It is a

valuable one, and it will be a useful device in achieving the best

judgments as to what should be done on the matters under consideration.

Mr. Chairman, there is probably no stronger defender of the Financial Accounting Standards Board, or FASB, and the independent setting of accounting standards than I have been over my

congressional career. I say this even though I don’t always agree

on every last detail on every accounting standard that FASB has

set.

Making us happy, however, is not their task. Their job is quite

a different one. That is to promulgate standards of high quality

that do not favor any particular interest group and maintain the

credibility of our financial reporting system.

They have an even greater responsibility, and that is to see to

it that our accounting system reports truthfully, factually, fairly,

and correctly to all involved, to the companies, to the shareholders,

to the regulators and everybody else.

Where we have not seen that happen, and I have seen several

instances in this committee, including some railroad mergers where

the reporting of the accounting system was not reliable, major

scandals and major troubles occurred.

The unparalleled success of our capital markets are due in no

small part to the high quality of the financial reporting and accounting standards promulgated by FASB. I would note that this

is very much in contradistinction to what we have seen with regard

to some of the foreign accounting systems and some of the standards that are promulgated through their mechanisms, referring

very specifically to countries in and around the Pacific Rim and in

Asia.

If I have any criticism of FASB, and I would note that I do, it

is that they seem to have a political tin ear and to make a lot of

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powerful enemies. Their decisionmaking process is supposed to be

neutral and thorough and open and informed, and it is all of that.

They do have a tough job to do. I respect that, and I welcome

them here today, as I do all of our witnesses.

On the substance of this hearing, I have not made up my mind

as to what is the right answer. I am not an accounting expert. I

would note that my experience in accounting is bottomed somewhat

on the practice of law and the fact that I once took a mail order

course in accounting to understand what I was dealing with when

I addressed this particular subject in the practice of law.

The 1970 compromise by the FASB to allow both purchase and

pooling accounting for business combinations has been highly controversial, strongly dissented from, and showed serious fault lines

during the merger boom of the 1980’s.

After several years of deliberation and debate, at the urging of

affected parties, FASB has issued an exposure draft that proposes

replacing the pooling of interests method with the purchase method

for almost all business combinations.

Currently companies can use pooling if they meet 12 criteria. I

suspect if there is a criticism of what has happened heretofore, it

has been that the industry has gotten the assumption, correctly or

incorrectly, from FASB that they have arrived at a decision that

this is what is going to occur, and that nothing further is going to

be done on the matter. I think that is unwise, and certainly politically so.

Under the purchase method, an acquiring company records the

value of the acquired company at the cost it actually paid. Under

pooling of interests, the combining companies simply add together

the book value of their assets, leaving investors with no way to determine what price was actually paid or tracking the acquisition’s

subsequent performance.

In an example cited at page 5 of FASB’s prepared remarks in- volving a $10 billion transaction that was accounted for under the

pooling method, the book value of the company being acquired was

only $500 million. The acquisition was reported as $500 million in

the financial statements of the acquired company, and $9.5 billion

in value simply disappeared. Where did it go?

Despite no real change in cash-flows, the pooling method also

creates a false measure of increased earnings, say its critics. Dramatically different results are produced by the two accounting

methods, making it difficult for investors to compare companies, or

indeed even to understand whether or not the accounting system

is producing a reliable and truthful result. This will have another

curious result, and that is possible serious competitive advantages

or disadvantages.

High-tech companies and financial institutions oppose the FASB

proposal, saying if pooling is eliminated or curtailed, it will destroy

their industries, the M&A market, the stock market, and the U.S.

economy. It seems every time anybody has a bad case, they come

in and make these charges. The Congress and everybody else is

supposed to panic.

It may well be that this is the case. If that is so, then maybe we

had better take a hard look at these high-tech companies and see

whether they have any real viability at all.

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Other companies such as General Motors, whose chief accounting

officer will testify today, the respected rating agency Moody’s Investors Service, and the Council of Institutional Investors, the Consumer Federation of America, and other groups representing investors and consumers support the FASB proposal.

Me, I think that we probably ought to just support the gathering

of the truth and seeing to it that accounting, accounting standards,

and things of this kind tell us the truth. Perhaps maybe if we get

that, we will have accomplished our purpose in this particular matter.

In May 1999, a study by Goldman Sachs concluded that the proposed accounting standards will not have a material adverse impact on future business consolidations, although the study identified some industries that might be adversely affected.

I would ask unanimous consent, Mr. Chairman, that that be inserted in the record.

Mr. OXLEY. Without objection.

[The information referred to follows:]

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Mr. DINGELL. I also note that most foreign countries prohibit

pooling or allow it only as an exception.

For example, the United Kingdom and the International Accounting Standards Committee permit pooling only when both companies are the same size or the acquiring entity cannot be identified. Canada is considering a proposed standard much like FASB.

As the managing director of corporate finance at Moody’s noted

in his comment letter to FASB, ‘‘Moody’s supports the objectives of

accounting standards setters to improve the harmonization of accounting standards globally, and welcomes FASB’s proposal to

eliminate the pooling of interests method. We believe that a single

method can improve analytic efficiency, especially in cases where

a single transaction or essentially identical transactions would

produce dramatically different accounting results, and thus enhance the ability of cross-border capital participants to compare,

easily and accurately, alternative investments.’’

As I said at the beginning, I have not made up my mind on the

FASB proposal. It raises a lot of questions, including those relative

to the treatment of goodwill and the valuation of intangible assets.

The FASB is in the process of sifting through better than 400 comment letters, along with the testimony it received in its public

hearings, and is redeliberating all the issues.

I urge the Board to proceed cautiously and carefully in weighing

the costs and benefits to try to achieve the greatest possible good.

I would also urge my friends in the high-tech industry to work with

FASB to develop a compromise or an approach that eliminates current biases and distortions and meets the legitimate concerns of all

parties. On that note, I look forward to today’s testimony on this

important and complex matter.

Mr. Chairman, I again commend you and thank you for calling

this hearing.

Mr. OXLEY. The gentleman’s time has expired.

The gentleman from California Mr. Cox.

Mr. COX. Thank you, Mr. Chairman. Thank you for holding this

hearing today. It is obvious from the comments of the members of

our panel thus far that it is very important for us to examine

FASB’s current proposal to eliminate pooling.

As a member of this subcommittee and a former securities lawyer, I am anxious to hear from our witnesses on their perceptions

of the consequences, both intended and unintended, of FASB’s decision to eliminate the pooling method for mergers.

I would not expect that Congress would want to legislate specific

financial accounting rules for reporting companies, although that is

clearly Congress’s prerogative. I do believe it is important that several important concerns that have been raised about the current

exposure draft have a complete airing in Congress. I also believe

it is important that FASB’s process be both deliberative and transparent.

The purpose of the 1933 and 1934 acts is full and fair disclosure

in order to build and maintain confidence of the public in our capital markets. Congress in the 1933 and 1934 acts made it plain

that the standards of financial reporting and financial statements

issued under these acts are defined pursuant to congressional auVerDate 11-MAY-2000 13:14 Sep 11, 2000 Jkt 064765 PO 00000 Frm 00054 Fmt 6633 Sfmt 6602 E:\HEARINGS\64765 pfrm01 PsN: 64765
51

thority. I prefer to see this authority exercised through delegation

to the SEC and to the FASB.

When, as in this case, the consequences of a change in the rules

go far beyond a determination of the quality of publicly disclosed

financial information and would, in addition, have a potentially significant impact on the entire economy, Congress cannot abdicate its

responsibility. So we are doing today the minimum, I think, that

is required of us. We are beginning a hearing process.

Many questions remain as to why FASB is eliminating pooling

at this time and in this way. Our current reliance—our current national reliance on pooling and purchase as the two means of accounting for goodwill intangibles is as reliable as a two-legged

stool. What FASB appears to be proposing here, rather than an examination of how better to account for intangibles, is to cut out one

of the two legs of the stool, giving us a one-legged stool.

I would hope that in this hearing process we can go beyond the

exposure draft and examine some of the questions that our experience over the last 20 years has raised for us, because over that last

20 years market-to-book value ratios have increased threefold because of intangible assets.

As it has been pointed out by many of our colleagues here this

morning, ideas and intangible assets are an enormous part of today’s economy not because these things are illusory, but because

they are very real and more important than some of the things that

go into making book value a hallowed and very reliable method of

accounting for many, many years.

I think Congress needs to keep our focus. Ideas and intangibles

are driving this economy, and we are responsible, much more than

FASB, to ensure that we do not derail the economy in the United

States.

A recent U.S. Department of Commerce study found that the

Internet economy is alone responsible for 35 percent of the real economic growth in the United States in the last 5 years. So I am interested in our witness’s views as to how FASB’s proposal to eliminate pooling will impact capital flows in this sector of our economy.

Last, Mr. Chairman, I would observe that the pooling method

has been around for decades. It makes it puzzling, therefore, to me

to understand why FASB is changing the rules at this particular

time.

Not very long ago, in 1994 when already I had been in Congress

for 6 years, the AICPA, the American Institute of Certified Public

Accountants, through its Special Committee on Financial Reporting, addressed this very topic. This Special Committee on Financial

Reporting of the AICPA included among its members the current

FASB Chairman Mr. Jenkins.

Here is what their report said, the report from Mr. Jenkins and

his colleagues just a few years ago: ‘‘While it is true that some

users prefer the purchase method and some prefer the pooling

method, most also agree that the existence of the two methods is

not a significant impediment to users’ analysis of financial statements. A project to do away with either method would be very controversial, require a significant amount of FASB time and resources, and in the end, is not likely to improve significantly the

usefulness of financial statements.’’

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So I would like to know why Mr. Jenkins has changed his view

and what has happened in just these last few years to turn that

statement on its head.

FASB does not make its decisions in a vacuum. The accounting

rules it adopts can and in this case surely will have a significant

impact on our economy.

Mr. Chairman, I thank the committee for holding this hearing on

this important issue, and I look forward to hearing from our witnesses.

Mr. OXLEY. The gentleman from Illinois Mr. Rush.

Mr. RUSH. Thank you, Mr. Chairman.

Mr. Chairman, I look forward to today’s hearing on U.S. accounting rules for business combinations.

This discussion is certainly a timely one. Today we have seen an

unprecedented increase in market activity, which has in turn

fueled the booming economy that we currently enjoy. Within the

midst of such growth, there has also been a market increase in

mergers and acquisitions.

This brings us to the problem at hand. The pooling of interests

versus the purchase accounting method is intriguing for several

key reasons. Before we have the pooling method, which reflects the

uniqueness of the high growth economies in that today the merging

of two high-tech companies does not necessarily involve the acquisition of depreciating machinery or office furniture.

Instead, in today’s high-tech market, ideas themselves have

value, and over time that value increases. However, this accommodation for this new asset apparently comes with a price. That price

is transparency. While I am certainly in favor of measures which

sustain and encourage market growth, I remain mindful that the

United States has been at the forefront in encouraging transparencies of markets worldwide. I am of the belief that we should

be consistent in our support of that policy on the domestic front.

Aside from this public policy concern, I am at present most concerned that when the economic climate in this country is not so robust, fiscally weak companies which undergo mergers will use the

pooling method to, if you will, sucker in unwary investors.

There is little doubt in my mind that we need uniformity in the

merger and acquisition information made available to the weekend

warrior who signs onto E*TRADE or any other of the assortment

of easily accessible trading venues. But it is important that in protecting the average investor, the very factor which has encouraged

such high market participation is not damaged.

I am confident that with a sober discussion and analysis by

FASB and others, there can be some reasonable compromise which

will result in clear and uniform means by which investors can

make crucial decisions. At the very least, there should be some examination of whether requiring the purchase method across the

board will, as many argue, deliver a severe blow to our surging

economy.

The challenge is up to the financial pundits to strike this important balance. I certainly hope that we and they will meet this important challenge.

Mr. Chairman, I yield back the balance of my time.

Mr. OXLEY. The gentleman from New York Mr. Lazio.

53

Mr. LAZIO. Thank you, Mr. Chairman, for holding the hearing. I

want to thank you for assembling a great list of witnesses, including our colleagues and Mr. Jenkins, the FASB Chairman Mr. Jenkins.

I want to make mention of a couple of things. First of all, the

gentleman from Michigan made reference to a factual setting

which, ironically or coincidentally, is the same involving AOL and

NetScape, the merger affecting the—the $900 billion merger, only

$500 million of which was accounted by tangible assets.

That merger would likely never have occurred if they were forced to use purchase accounting because of the write-down of $9.5 billion over 20 years under purchase accounting. The economy would

have been deprived of the synergy of that merger, like many others, Travelers and Citi and several others who may well have foregone the option of merging if they were forced to use purchase accounting.

There are some who argue that we need to have a single accounting method, we need to have harmony with our international

neighbors. First of all, even among our international neighbors,

and including the U.K., there are situations where pooling is allowed.

Second of all, why should we harmonize if we are not harmonizing based on the right principles? Why should they not harmonize with us if we have the superior model? If our economy is

making all of the right moves, and the synergies that are being created by our combinations through IT and biotechnology are leading

the world, why shouldn’t they be following us?

There are people who say, why is it that we shouldn’t use purchase accounting, because you can identify the value of the transaction better through purchase accounting? Hogwash. The market

determines the value of mergers and acquisitions. In the end, the

market knows far more than any accounting method and any law

that we can create. We need to have some trust in them.

There are some people who say that the purchase method is a

superior method for giving investors more information. Some would

argue that the information is less relevant, that increasingly the

market is looking for cash-flow valuations and not economic value

analysis, neither of which rely on accounting methods.

There are people who say investors cannot tell how much is invested in a particular transaction, and they cannot track any subsequent performance. Again, the value in the end is determined by

the market. Under any methodology, investors often find it very

difficult to track subsequent performance based on individual combinations.

Some people say we should have one accounting method because

companies who are merging should have only one accounting method. Why should they? Businesses even within the same sectors are

often using maybe different accounting methods for different purposes, including inventory and depreciation and other costs.

In a May 2 letter from the Financial Accounting Foundation,

which funds FASB and helps support its members, they opined

something that I am concerned about. I will quote briefly, if I can:

‘‘at the present time, a few constituents are unfortunately encouraging Members of Congress to intervene in the independent private

54

sector standards-setting process. While full public debate of the

technical merits of a proposed standard is encouraged and appropriate, we do not believe that the standard-setting process should

be subject to governmental intervention when appropriate and extensive due process procedures have been followed by the FASB.’’

I would say, first of all, that I hope this does not have a chilling

effect in terms of people who want to express their first amendment right to speak to Members of Congress, especially when economic impact is taken into account; it seems to me, to this Member, more some of us at the podium than those in FASB, with all

due respect, first of all.

Second of all, I am concerned that the FAF and FASB say on one

hand that their standard-setting process should be free from intervention by Congress, while on the other hand FASB is citing SEC

staffing burdens as one of the reasons for eliminating pooling. Does

that mean that it is wrong for us to inquire into FASB’s process,

but it is okay for the SEC to actually drive the process?

Third, I am interested in hearing from FASB how they proceeded

in considering the elimination of pooling. I want to compliment

them and commend them on the notice and comment process, but

I would much prefer if they look at purchase accounting first, figure out how it can be improved to account for all the intangible assets that companies possess, especially in the IT and biotech sectors. I am interested in hearing why purchase accounting cannot

be retooled for the new economy, and then we can consider the use

of pooling.

I am hoping that FASB Chairman Ed Jenkins can touch on some

of these when he testifies.

Thank you, Mr. Chairman.

Mr. OXLEY. The gentleman’s time has expired.

The Chair is now pleased to recognize the gentlewoman from

California, who is technically not a member of this subcommittee,

although we hope perhaps that will change soon. We are glad to

have her with us. The Chair recognizes Ms. Eshoo.

Ms. ESHOO. Thank you very much, Mr. Chairman, first of all for

extending your courtesy to me to join with your subcommittee

today for this very important hearing, and I salute you for bringing

this hearing into reality, because it is a discussion of an issue that

we all believe, given the excellent opening statements of members

of the subcommittee—it really is a hearing about our national economy, what has made it so, what has contributed to it, and the examination of the proposal that the FASB Board has brought about.

When I first came to the Congress in 1993, I introduced legislation relative to an FASB proposal. It was legislation that respected

the independence of the Board, but it also was legislation regarding

the potential decision of the FASB Board to prohibit a method of

accounting for the value of stock options.

I believe that the conclusion that the FASB came to at the end

of the 1994 was fortuitous because it was good for our national

economy. It spoke to a method of offering stock options that I think

has moved on to be very important for workers and for companies

in our country.

Back then I might say that you could count on one hand the

number of Members that even knew what an FASB was. Today

55

there are more and more Members that know and really look closely to what the FASB Board recommends. This hearing today again

involves a potential decision of that Board, and I think that it is

a proposal that needs to be examined very, very carefully.

There have been some very important developments that have

taken place since I first came here and was introduced. There was

a different Chairman of FASB at that time and some different

issues.

Dennis Powell is going to be speaking today representing Cisco

Systems. Since FASB made its stock option decision and its proposed standard on then business combinations, Cisco Systems has

become one of the most admired, if not the most admired, businesses in America. I say this not just as an advertisement for

Cisco. I think every member wants to examine very carefully what

has given rise to what Cisco represents.

We also have Gene Hoffman who is going to be testifying today,

president of EMusic, an Internet digital music company. When I

was making the case back in 1993 and 1994 about stock options,

I don’t think Gene Hoffman’s business even existed.

So these are not flukes of our national stage or national economy.

As I respect the independence of FASB, I also believe that the Congress has a responsibility to weigh in about issues that affect or

that we think could have a detrimental effect on our national economy.

Mr. Lazio has spoken to and quoted the Financial Accounting

Foundation’s letter that is here before each member of the subcommittee. I, too, would like to underscore that. I think it is very

important for people to weigh in with their opinions, but I have to

tell you that I feel a certain rub, because I don’t think they are just

a few constituents. Even if they were, if there were just a few constituents, I was elected to give voice to my constituents.

Members of the House of Representatives are very unique in that

we enjoy, under the Constitution, direct representation. The Presidency does not enjoy that because the Vice President can move into

the Oval Office based on the prerogatives of the Constitution. The

members of the United States Supreme Court are appointed. If

someone dies over in the U.S. Senate, or they decide to step down,

there can be appointment. We and we alone under the Constitution

of the United States of America enjoy direct representation, so if

I die or step down or I am removed from office, there will be a special election held so that there will be a direct voice of the people

of the 14th Congressional District of California.

So while I welcome the comments of the Financial Accounting

Foundation, I have to say that in paragraph 5, I think they have

a little overstepped their interpretation or their view of Members

of the Congress.

Mr. Chairman, I really welcome this hearing today. Thank you

for inviting me to join with the subcommittee for this hearing, not

being a member of the subcommittee. I do hope to be a member in

the next Congress. I was before the jurisdictions of the subcommittee were split in a previous Congress.

I hope that the Financial Accounting Board representatives will

attempt at least to make the case as to why we would blend with

a European standard when we are the envy of the entire world relVerDate 11-MAY-2000 13:14 Sep 11, 2000 Jkt 064765 PO 00000 Frm 00059 Fmt 6633 Sfmt 6602 E:\HEARINGS\64765 pfrm01 PsN: 64765
56

ative to our economy, how the proposed standard really serves our

national economy well, who has been hurt by the pooling accounting standard that you are making the recommendation about, and

see how those voices that have weighed in and questions—if, in

fact, FASB sees today a better and a newer way of approaching

this.

Some of my colleagues have suggested a compromise. I hope that

you will cover that in your testimony. Thank you to everyone that

is here today that is going to enlighten us.

Again, Mr. Chairman, thank you for your leadership. I could not

mean that more.

[The prepared statement of Hon. Anna G. Eshoo follows:]

PREPARED STATEMENT OF HON. ANNA G. ESHOO, A REPRESENTATIVE IN CONGRESS

FROM THE STATE OF CALIFORNIA

Thank you, Mr. Chairman, for extending to me the courtesy of joining your subcommittee today for this hearing. I commend you for your leadership in holding this

important hearing on this issue which is so critical to our economy.

Mr. Chairman, when I first came to Congress in 1993 I raised questions about

the actions of the Financial Accounting Standards Board (often referred to by its

acronym, FASB). I may have been the first Member of Congress to offer legislation

addressing FASB and their proposal to prohibit a method of accounting for the value

of stock options.

Back then, one could count on one hand how many Members of Congress knew

what a FASB was, and still fewer knew that FASB was a private organization that

exercised a strong influence on our economy through its standard-setting decisions.

I spent just as much time explaining who FASB was to our Colleagues as I did explaining how its decision could have a tremendously negative impact on the New

Economy and the technology industries that drive it.

Today this hearing is about an issue—again involving a potential decision by

FASB. This time it doesn’t involve prohibiting an accounting method for the valuation of stock options, but rather FASB’s intention to prohibit an accounting method

for business combinations and intangible assets.

I find myself again warning of the implications this decision could have and the

potential negative impact on the New Economy and the industries that are still

driving it. As Yogi Berra said, ‘‘It’s deja vous all over again.’’

However, there have been some important developments between 1993 and today,

and they are seated before this subcommittee this morning.

Mr. Dennis Powell is here today representing Cisco Systems. Since the time FASB

made its stock option decision and its proposed standard on business combinations

Cisco Systems has become the most admired business in America.

FASB’s business is to set standards. Let me point out some standards Cisco has

set: In the past three years, IndustryWeek chose Cisco as one of the best-managed

companies in the nation; and Fortune ranked it as one of the best companies to

work for in America.

We welcome Gene Hoffman, President of Emusic, an Internet digital music company. When I was making the case that FASB’s proposal on stock options could

hamper the growth of Internet companies, Mr. Hoffman’s company didn’t exist.

Since 1993, an entire technology industry has been created by entrepreneurs like

Mr. Hoffman.

I raise these examples to demonstrate that the issues we’re discussing today are

not dry and mundane theoretical questions. They are decisions that effect entire industries and our national economy.

This leads me to the issue of FASB’s responsibility and the role it plays in setting

accounting standards. During my legislative career, I’ve become familiar with the

process FASB goes through in its standard-setting and I respect the work its leadership and staff does in developing proposals.

But I remain deeply concerned about FASB’s perception regarding its process of

private-sector standard setting, and the Federal government’s role of steward of the

nation’s economic health.

FASB is not the exclusive forum for the due process given to business standards.

What may appear to the leadership of FASB as threats of government intervention

may, in fact, be the Federal government fulfilling its responsibility as guardian of

the national economy.

57

Put simply: FASB is a private board and accountable to its leadership and its profession. The Congress is a public institution and accountable to the American people.

Again, Mr. Chairman, thank you for holding these hearings and allowing me the

opportunity to participate. I look forward to an interesting and thoughtful discussion regarding these issues and I welcome all of the witnesses here today.

Mr. OXLEY. The Chair recognizes the gentleman from Iowa Mr.

Ganske.

Mr. GANSKE. Thank you, Mr. Chairman. I will be brief because

I want to hear the testimony. I am hear to listen and learn, primarily.

I was intrigued by a quote from Mr. Jenkins on page 3 of his testimony where he quotes an article by Floyd Norris called ‘‘Can Regulators Keep Accountants From Writing Fiction?’’

He says, ‘‘Pooling accounting is ridiculous because it allows corporations to pretend that they paid much less for an acquisition

than they did. Let’s say company A buys company B for $100 million in stock and then a few years later sells company B for $50

million. In reality, it was a disastrous acquisition for company A.

But, thanks to the magic of pooling, company A would have shown

the original acquisition as costing not the $100 million it paid, but

a number that would be far lower, say $20 million, reflecting the

book value of company B. Presto, company A reports a profit of 30

million when it actually lost $50 million.’’

I don’t know whether this is true or not. I am anxious to listen

to the testimony and find out. I yield back.

[Additional statement submitted for the record follows:]

PREPARED STATEMENT OF HON. W.J. ‘‘BILLY’’ TAUZIN, A REPRESENTATIVE IN

CONGRESS FROM THE STATE OF LOUISIANA

Thank you Mr. Chairman.

We are here today to answer one question: Should Pooling of Interest be completely eliminated as an accounting method for Business Combinations?

Well, without a whole lot of thought, I can answer that question fairly easily. The

answer is No, unless either purchase accounting as we know it is improved or we

can all agree on an alternative method of accounting that does not suffer from the

same shortcomings that purchase accounting suffers from.

I have four primary concerns with the FASB proposal to require all merging companies to use purchase accounting.

First, I am not convinced that purchase model accounting makes much practical

sense in today’s new economy. For new economy companies, intangibles make up

a major portion of purchase price allocation not adequately addressed by purchase

model accounting. Put simply, this method provides inadequate guidance on how to

identify and value intangible assets. To the contrary, purchase accounting seeks to

amortize goodwill to expense over a 20 year period in a way that just doesn’t reflect

economic reality.

So essentially, there is a real incompatibility between purchase accounting and

the mechanics of many business combinations that are taking shape in our country.

If FASB’s real concern is ensuring that companies are accurately valued for the

benefit of capital market investors . . . a concern I might add that the SEC shares as

well . . .then it should be promoting an accounting method that makes clear how best

to appraise intangibles—technology, intellectual property, brand identification, patents, and the like—as opposed to asserting that purchase accounting must carry the

day despite that it is defunct in its treatment of intangibles. Furthermore, if FASB

wants accurate valuations, then it should propose something more creative than

simply forcing companies to amortize goodwill over an arbitrary 20 year period—

which we all know often results in synthetically, or artificially, reducing reported

income.

The bottom line here then is that purchase accounting is designed for old world

brick and mortar outfits, and therefore must be revamped itself before I will concede

that it is a better alternative to pooling.

58

Second, I am afraid that eliminating pooling in favor of present-day purchase accounting will significantly reduce merger activity in this country. In 1998, there

were 11,400 mergers in the Unite States alone which accounted for $1.62 trillion

in aggregate value. Significantly, the pooling of interest method was used in 55%

of these mergers.

Over half of the mergers in 1998 relied on the pooling method, and it certainly

makes sense as to why. The ability for a company to deal in stock is what in fact

has enabled many companies to grow, provide more jobs, and eliminate inefficiencies

in our economy. Without the ability to offer stock in exchange for ownership interest

in another entity, many acquiring companies would not even consider some of the

business combinations that they have pursued or achieved to date. This to me is

quite troublesome.

Third, I feel that eliminating pooling at this juncture imposes somewhat of a retroactive hardship on many businesses that have relied upon pooling for years. The

two accounting methods in question have been around for years, and I think, have

effectively served as alternatives to one another—kind of a natural Yen and Yang,

if you will. Precisely because the economics of these methods is so different, companies have always been afforded the opportunity to make a business decision of going

one way or another, depending on the nature of the deal in question. To take pooling off the table at this juncture, without any attempt to retain the flexibility afforded by a two method regime, amounts to nothing more than changing the rules

on business mid-stream.

As a lawmaker, I have always had serious reservations about changing laws in

a retroactive manner. My experience is that this usually leads to harming established industries and businesses in ways that Congress never intends.

Fourth, and finally, I have grave concerns about process in this debate. FASB contends that its administrative process is modeled after the APA, and that it fiercely

adheres to that process. FASB also states that it will make no final decision about

the proposal or consider whether to issue a final standard until it is satisfied that

all substantive issues raised by all parties have been considered. Well, despite that

most of the comments received, as far as I can tell, oppose making purchase accounting the sole method for business combinations, FASB continues to publicly

make the case for the elimination of pooling.

In addition, its actions suggest that FASB is paying little mind to the interested

parties’ recommendations for either retaining pooling or improving purchase accounting in some reasonable fashion.

Furthermore, upon learning that some of its constituents were ‘‘unfortunately, encouraging Members of Congress to intervene in the independent private-sector

standard setting process,’’ the Financial Accounting Foundation (FAF) issued an

open letter criticizing the very notion that Congress should have some say so in the

process of deciding how American businesses disclose financial information. While

I do not deny that FASB’s independence is central to its mission, much like the Federal Reserve’s, the FAF letter gives the impression that independence in this context

means ABSOLUTE independence.

Well, I’m here to say that it is entirely appropriate for Congress to oversee the

FASB and the SEC’s supervision and delegation of its authority to set accounting

standards. After all, this very authority is derived from the ’34 Act, a piece of legislation that was drafted by this very Committee.

In the end, I hope that the FASB will take my concerns to heart and respond with

a plan that makes the most sense for today’s business world.

With that, Mr. Chairman, I yield back the balance of my time. Thank you.

Mr. OXLEY. The Chair is pleased to recognize our distinguished

panel of Members, and as I understand it, you prefer to go first,

Mr. Goodlatte, because you have a markup?

Mr. GOODLATTE. Mr. Chairman, if I may, we are in the middle

of another issue of great interest to the Internet economy, and that

is the tax moratorium extension that I know this committee has

also held hearings on. If I can get back, my substitute is on the

floor of the committee right now.

Mr. OXLEY. The Chair is pleased to recognize the gentleman from

Virginia, Mr. Goodlatte.

59

STATEMENT OF HON. BOB GOODLATTE, A REPRESENTATIVE

IN CONGRESS FROM THE STATE OF VIRGINIA

Mr. GOODLATTE. Thank you, Mr. Chairman.

Mr. Chairman, I very much appreciate your holding this hearing

and allowing me to testify this morning. As you know, the Internet

has fueled our economic growth at such a rapid pace over the last

5 years.

According to the Department of Commerce, traffic volume on the

Internet doubles every 100 days. By October of last year, U.S. Web

pages averaged $1 billion cumulative hits per day. In comparison

to other forms of communication, the U.S. Postal Service delivered

101 billion pieces of paper mail in 1998. Estimates for e-mail messages sent in 1998 ranged from $618 billion to 4 trillion. The impact of the Internet on our daily lives is mind-boggling.

For businesses, the impact is equally great. The Internet econ- omy has grown to $507 billion in 1999 from $301 billion in 1998.

It is expected to grow to $1 trillion in 2001 and $2.8 trillion by

2003. The Internet economy accounts for 2.3 million jobs, that was

last year, 35 percent of the U.S. real economic growth between

1995 and 1998, and its share of the U.S. economy nearly doubled

between 1977 and 1998, growing from 4.2 percent to 8.1 percent.

This development has been spurred by the ability of companies

to innovate, and the growth of the new economy has occurred because startup companies have been able to combine creative thinking with low barriers to entry in the form of low costs and regulations. These characteristics of the new economy must be protected

in order for small companies to continue reacting and adjusting.

One way in which these characteristics are threatened is the ongoing review by the Financial Accounting Standards Board of accounting rules governing business combinations. In today’s rapidly

growing technology and information markets, the need for maintaining an accounting system that is best suited to handle the

growing trend of the technology sector mergers is key.

The pooling system of accounting has made possible some of the

most important mergers of our time, creating innovative new companies and benefiting consumers. If the use of pooling had not been

permitted, the unifications of NetScape and America Online,

CitiCorps and Travelers, NationsBank and Bank of America and

the Daimler-Chrysler merger quite possibly would never have

taken place.

Current regulations allow many high-tech companies to use the

pooling method by allowing corporations to easily merge without

attaching a goodwill accounting charge. This charge is the amount

paid in an acquisition that is added to the fair market value of a

company’s tangible assets.

If the Financial Accounting Services Board proposal is implemented, it would require that all mergers be viewed not as the

melding of separate entities, but as a direct purchase, forcing companies to accept the purchase method of accounting. That would be

a big mistake. This system may have worked for the bricks-andmortar corporations of the past, but in the age of high-tech companies whose value lies in information, the purchase method of accounting has no place. Forcing these high-tech, high-performance

companies to use the direct purchase accounting system will only

60

serve to stifle growth and limit our country’s edge in this information age.

We should take every opportunity to support and ensure continued innovation and expansion in this technology sector that has

done so much to energize our economy.

I support clear and understandable accounting rules, which do

need adjustments from time to time. I agree with those who believe

that we should thoroughly examine possible adjustments to current

standards. However, the type of wholesale changes currently under

consideration should be abandoned.

I therefore believe that the Commission designated by Geoffrey

Garten, Chairman of the Securities and Exchange Commission, to

study the role of intangible assets in the new economy should be

allowed to complete its work. We should then examine the Commission’s conclusions in the broader context of how intangible assets

are reported in a rapidly changing economic environment.

I would urge the FASB to follow its stated mission to ensure that

its standards ‘‘reflect changes in methods of doing business and

changes in the economic environment.’’ However, single-shot, piecemeal changes to accounting standards should not be the mode of

operation. Pooling accounting is essential for small startups and

new online businesses. These ventures act as a magnet for capital

investment, lower costs, create new jobs, and fuel economic growth.

Acting in a piecemeal manner to alter existing accounting principles could threaten this growth by limiting the availability of capital and restricting the expansion of this new sector of our economy.

I am hopeful that the FASB will step back, take a deep breath,

and see the forest that is the new economy rather than the trees

that are the individual accounting standards. I look forward to

working with you and others who are concerned that our system

of accounting standards should move along with the rest of the

economy into the new century, Mr. Chairman.

I might add that while we are enjoying and experiencing tremendous dynamic growth with many of the companies in this new

Internet economy, there are others who are struggling, others with

good ideas, with good intellectual property, but who should nonetheless have the ability to make sure that if there is an appropriate

merger that can strengthen their situation, as I think the AOLNetScape merger is an excellent example, we should have the opportunity to do that with accounting principles that support that

kind of combination and take into account that the value of intellectual property in this information economy is very, very different.

I am being signalled that my vote is needed in the Committee

on the Judiciary. Thank you for allowing me to testify.

[The prepared statement of Hon. Bob Goodlatte follows:]

PREPARED STATEMENT OF HON. BOB GOODLATTE, A REPRESENTATIVE IN CONGRESS

FROM THE STATE OF VIRGINIA

Thank you for allowing me to testify before you this morning. As you know, the

Internet has fueled our economic growth at such a rapid pace over the last five

years. According to the Department of Commerce, traffic volume on the Internet

doubles every 100 days. By October of last year, U.S. web pages averaged one billion

cumulative hits per day. In comparison to other forms of communication, the U.S.

Postal Service delivered 101 billion pieces of paper mail in 1998. Estimates for eVerDate 11-MAY-2000 13:14 Sep 11, 2000 Jkt 064765 PO 00000 Frm 00064 Fmt 6633 Sfmt 6621 E:\HEARINGS\64765 pfrm01 PsN: 64765
61

mail messages sent in 1998 range from 618 billion to 4 trillion. The impact of the

Internet on our daily lives is mind-boggling.

For businesses, the impact is equally great. The Internet Economy has grown to

$507 billion 1999 from $301.4 billion in 1998. It is expected to grow to $1 trillion

in 2001, and $2.8 trillion by 2003. The Internet Economy accounts for 2.3 million

jobs last year, 35% of U.S. real economic growth between 1995 and 1998, and its

share of the U.S. economy nearly doubled between 1977 and 1998, growing from 4.2

percent to 8.1 percent.

This development has been spurred by the ability of companies to innovate, and

the growth of the new economy has occurred because start-up companies have been

able to combine creative thinking with low barriers to entry in the form of low costs

and regulations. These characteristics of the New Economy must be protected in

order for small companies to continue reacting and adjusting. One way in which

these characteristics are threatened is the ongoing review by the Financial Accounting Standards Board of accounting rules governing business combinations.

In today’s rapidly growing technology and information markets, the need for

maintaining an accounting system that is best suited to handle the growing trend

of technology sector mergers is key. The ‘‘pooling’’ system of accounting has made

possible some of the most important mergers of our time, creating innovative new

companies and benefitting consumers. If the use of ‘‘pooling’’ had not been permitted, the unifications of Netscape and America Online, Citicorp and Travelers,

NationsBank and Bank of America, and the Daimer Chrysler merger quite possibly

would have never taken place.

Current regulations allow many high-tech companies to use the pooling method

by allowing corporations to easily merge without attaching a goodwill accounting

charge. This charge is the amount paid in an acquisition that is added to the fair

market value of a company’s tangible assets. If the Financial Accounting Standards

Board proposal is implemented, it would require that all mergers be viewed not as

the melding of separate entities, but as a direct purchase, forcing companies to accept the purchase method of accounting. This system worked for the bricks and mortar corporations of the past, but in the age of high-tech companies whose value lies

in information, the purchase method of accounting has no place.

Forcing these high-tech, high performance companies to use the direct purchase

accounting system will only serve to stifle growth and limit our country’s edge in

this information age. We should take every opportunity to support and ensure continued innovation and expansion in this technology sector that has done so much

to energize our economy. I support clear and understandable accounting rules which

do need adjustments from time to time, and I agree with those who believe that we

should thoroughly examine possible adjustments to current standards. While we

should should step back and determine the benefits and disadvantages of the various methods of business reporting, we should avoid the type of wholesale changes

currently being considered.

I therefore believe that the commission designated by Jeffrey Garten, Chairman

of the Securities and Exchange Commission, to study the role of intangible assets

in the New Economy should be allowed to complete its work. We should then examine the Commission’s conclusions in the broader context of how intangible assets are

reported in a rapidly changing economic environment. I would urge the FASB to follow its stated mission—to ensure that its standards ‘‘reflect changes in methods of

doing business and changes in the economic environment.’’ However, single-shot

piecemeal changes to accounting standards should not be the mode of operation.

Pooling accounting is essential for small start-ups and new online businesses.

These ventures act as a magnet for capital investment, lower costs, create new jobs,

and fuel economic growth. Acting in a piecemeal manner to alter existing accounting

principles could threaten this growth by limiting the availability of capital and restricting the expansion of this new sector of our economy. I am hopeful that the

FASB will step back, take a deep breath, and see the forest that is the New Economy, rather than the trees that are individual accounting standards. I look forward

to working with you, Mr. Chairman, and others who are concerned that our system

of accounting standards should move along with the rest of the economy into the

new century. Mr. Chairman, thank you for having me here today.

Mr. OXLEY. Thank you. Thank you for your leadership on this

issue.

Our very patient colleague and good friend, the gentleman from

California, who has been here for a long time and listened to a lot

of opening statements, we appreciate your patience, and the Chair

62

is now pleased to recognize the Honorable Cal Dooley from California.

STATEMENT OF HON. CALVIN M. DOOLEY, A REPRESENTATIVE

IN CONGRESS FROM THE STATE OF CALIFORNIA

Mr. DOOLEY. Thank you, Chairman Oxley. I was privileged to

hear the statements of the various members of the committee. I

really am in agreement with most of the sentiments that were expressed.

I would also at this time like to ask unanimous consent that two

letters that myself and Anna Eshoo and others have sent to Chairman Levitt of the Securities and Exchange Commission as well as

Chairman Jenkins of FASB be included in the record.

What might well appear to be an arcane accounting matter could

prove to be something that has significant public policy implications. That is why I commend you for having this hearing today.

In many ways, the issue we are touching on today really is a reflection of how we are changing from an industrial-based economy

to an information-based economy, and how many of the companies

that are now providing the engine and the energy for the growth

of jobs as well as the creation of wealth are doing so not necessarily

by the production of hard assets and taxable assets that would

characterize a lot of the older industries within the United States.

I think what we have to understand is some of the accounting

systems that were developed back in the industrial age are no

longer as effective in identifying and accounting for the real value

of the companies in this new economy. There has not been an accounting system that has been developed that can accurately measure the precise value of human and intellectual capital. Yet, in the

new economy businesses, it is human and intellectual capital that

are the foundations and the most important elements in assessing

a company’s true worth.

I am concerned that FASB’s decision draft takes the approach

that you can define the value of goodwill and intangible assets.

Furthermore, it goes as far to assume that they are wasting assets

and that they should be depreciated, and that they will lose all

value in a period of no more than 20 years.

Intellectual capital is critical to the success of any company. In

this information age, many of these companies would be most adversely impacted by FASB’s draft proposal. Their value is to be intellectually innovative, their ability to bring products to market

very quickly, their ability to adapt and have market penetration,

and it puts a premium on these companies that are the entrepreneur innovators that have the ability to match up and coordinate innovations quickly with well-executed product delivery effort.

I think we are at the point now where we have to be concerned

about making a change in the way that we account for mergers and

acquisitions that would have some significant adverse impacts. The

potential impact, I think, was identified to some extent by an article that was in the Wall Street Journal today which talked about

in the first quarter of this year, there was over $22 billion in investment and 1,557 startup companies. That was an increase over

the first quarter of 1999 of $6.1 billion.

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What I am concerned about is that if you make this change in

accounting practices, you can have a significant adverse impact on

the dollars. There is venture capital and risk capital going into

these startups. These startups we are talking about, not every one

is going to mature to the point that they are going to have IPOs.

Some are going to be acquired or assimilated through mergers.

If we are not allowing pooling to be utilized, there is a great concern that the real intellectual capital, the goodwill that is identified

with those companies, will not be able to be recognized. We will put

downward pressure on the values of these companies that will

make them less attractive to eventually be acquired or merged into

others. What that has the potential of doing, I think, is harming

the United States’ clear superiority and having the greatest relative advantage in the technology sector.

FASB and others have talked about trying to make our system

more consistent with other international standards. Why would we

want to do that? It is clear that the United States is the leader in

this area. I don’t think we ever want to adopt a system that could

impede the flow of venture capital into the technology sector, which

is so very, very important. What we have to be concerned with in

the public policy issue here is make sure we do not have a reform

in our accounting practice which reduces or impedes the flow of

capital into high-risk investments.

It also is going to have the impact of decreasing the ability of a

lot of these startup companies to attract employees and human intellectual capital. I also think it has the risk of almost contributing

to greater consolidations, because E*TRADE probably would not

have purchased Teledyne if we did not have the ability to use pooling. It probably would have resulted in that company being purchased by one of the bigger financial institutions. I don’t think that

is something we want to encourage by adopting an accounting practice.

Just in closing, I also want to make it clear that pooling is not

a system without some imperfections. It has some imperfections.

We also at the same time have to acknowledge that purchase accounting also has some major imperfections.

Before we move forward with eliminating pooling, I think we

have to step back and say, is it time for us to start from a broader

context in trying to determine what is the most effective way to

value our companies. I am very concerned we are taking a piecemeal approach here.

I also want to commend Mr. Jenkins for his openness and willingness to have a dialog with a lot of us who have spent a lot of

time on this. I am hopeful through this issue and continued discussion and dialog that we can come up with a system that will ensure

that we can continue to have the most robust venture capital system in the world which is leading to some of the greatest advancements in technology and the creation of some of the most exciting

companies in the world.

[The prepared statement of Hin. Calvin M. Dooley follows:]

PREPARED STATEMENT OF HON. CAL DOOLEY, A REPRESENTATIVE IN CONGRESS FROM

THE STATE OF CALIFORNIA

Mr. Chairman, Ranking Member Towns, distinguished colleagues and friends on

the Finance Subcommittee, I want to thank you for the opportunity to appear before

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you today to talk about a matter of great importance in the economy—the question

of how companies account for mergers and acquisitions. I would also like to submit

for the record two letters that a number of us have sent to Chairman Levitt of the

Securities and Exchange Commission and Chairman Jenkins of the Financial Accounting Standards Board with our concerns about this issue.

As I am sure you are all aware, the tremendous performance we have seen in the

technology sector in the past decade is attributable not only to the wealth of creative

ideas in this country, but also to the capital that helps to turn those ideas into products and services and brings them to the market. It is the technology community’s

success at combining these two essential ingredients that has turned it into the

powerful economic engine it is today. That engine, in turn, has helped to propel the

entire economy into the longest expansion in U.S. history. Furthermore, it is changing the complexion of the economy. More and more, we are realizing the value of

intangible assets, not just at Internet start ups, like ‘‘eGM’’ for instance, but at

bricks and mortar companies like... GM! Put simply, the ‘‘Old Economy’’ is becoming

the ‘‘New Economy.’’

FASB’s Proposal

Mergers and acquisitions, or business combinations, are an important means by

which ideas and capital are paired in the technology sector and throughout the economy. FASB, the Financial Accounting Standards Board, is currently considering a

proposal that will alter the method by which many businesses account for business

combinations. This proposal would require companies to account for all such combinations as purchases, with the acquiring company being forced to write off any

goodwill included in the purchase price as a charge against earnings over the course

of several years.

Naturally, this proposal poses serious concerns for the technology sector because

of the large difference that often exists between technology companies’’ book and

market values. This is a legitimate concern and I think that FASB, by only addressing part of the issue through the elimination of pooling, is still not addressing the

core problem. If they are going to take on this issue, they need to take a more comprehensive approach.

Pooling and Purchase are Both Flawed

Experts can and do argue over whether, as FASB has determined in its Exposure

Draft on Business Combinations, all business combinations are purchases and

should be accounted for as such. What really concerns me and a number of others

in Congress and the private sector is the process that FASB has followed. It is moving to force the use of purchase accounting for all mergers and acquisitions without

giving due consideration to the fact that purchase does not adequately account for

so many of the intangible assets that companies possess today. In other words,

FASB is considering the elimination of pooling in a vacuum and neglecting to consider the fact that many consider both pooling and purchase to be flawed and inadequate methods of accounting for business combinations. This is an important point

that has been lost in all of the rhetoric about how the tech sector is seeking special

treatment from FASB by urging them to keep pooling, so I want to reiterate it: pooling and purchase are both flawed and inadequate methods of accounting for business

combinations. This is especially true for companies with large amounts of intangible

assets, such as financial and pharmaceutical companies. It’s not just about the technology sector.

Given that many believe that neither method adequately accounts for many of the

intangible assets one finds in today’s businesses, the development of a method of

accounting that does effectively deal with intangibles should be pursued before we

scrap the old ones. The elimination of pooling without paying any attention to

what’s left over is like blowing up the old bridge that gets us across the river before

the new one is built.

The Need for Oversight

FASB’s process illustrates why it is so important that the Finance Subcommittee

is exercising its congressional oversight authority today. I feel confident in saying

that none of us here wants to compromise the integrity and independence of FASB.

At the same time, however, it is appropriate for us to focus on the potential economic consequences of FASB’s proposals; to think about whether or not the benefits

of their proposals outweigh the costs; and to ask the hard questions. In the end,

congressional oversight on contentious issues doesn’t weaken the process, it

strengthens it. What weakens the process and its product is when FASB stubbornly

ignores the concerns of its constituents; and when the Financial Accounting Foundation, which oversees, funds, and appoints the members of FASB, characterizes conVerDate 11-MAY-2000 13:14 Sep 11, 2000 Jkt 064765 PO 00000 Frm 00068 Fmt 6633 Sfmt 6621 E:\HEARINGS\64765 pfrm01 PsN: 64765
65

gressional interest and concern about a FASB project as ‘‘Explicit or implicit

threats, . . .’’ as they have in a May 1, open letter.

I remain convinced that if FASB has ears to hear, we can still persuade them to

address the serious concerns we have about the flaws in purchase accounting first

before abolishing pooling.

In closing, I want to thank you again for allowing me to appear today to discuss

this issue. I commend you for holding this hearing. I also want to commend FASB

Chairman Ed Jenkins for his patience and thoughtfulness in dealing with others

and me on this issue. In fairness to him, FASB is not a committee of one, and I

know we all recognize that he has a tough job. I believe that his continued openness

and willingness to discuss our concerns is key to coming to some sort of resolution

on this matter.

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Mr. OXLEY. Thank you, Mr. Dooley, for your excellent testimony.

The committee will stand in brief recess while we empanel the

next group.

[Brief recess.]

Mr. OXLEY. The subcommittee will reconvene.

Let me introduce our distinguished panel, second panel; Mr. Edmond L. Jenkins, Chairman of the Financial Accounting Standards

Board; Mr. Dennis D. Powell, vice president, corporate controller

from Cisco Systems, San Jose, California; Mr. Peter R. Bible, chief

accounting officer for General Motors Corporation from Detroit; Mr.

Gene Hoffman, Jr., president and CEO of EMusic, Redwood City,

California; finally, Dr. William Frederick Lewis, president and

CEO, Prospect Technologies, here in Washington, DC, on behalf of

the U.S. Chamber of Commerce.

Gentlemen, welcome to all of you. Mr. Jenkins, we will begin

with you.

STATEMENTS OF EDMUND L. JENKINS, CHAIRMAN, FINANCIAL

ACCOUNTING STANDARDS BOARD; DENNIS D. POWELL, VICE

PRESIDENT, CORPORATE CONTROLLER, CISCO SYSTEMS;

PETER R. BIBLE, CHIEF ACCOUNTING OFFICER, GENERAL

MOTORS CORPORATION; GENE HOFFMAN, JR., PRESIDENT

AND CEO, EMUSIC.COM; AND WILLIAM FREDERICK LEWIS,

PRESIDENT AND CEO, PROSPECT TECHNOLOGIES

Mr. JENKINS. Thank you, Mr. Chairman. I certainly appreciated

all of the comments from the members of this committee this morning. Please be assured at the outset that those comments are important to me and to my fellow Board members at the FASB, and

we will be considering them carefully as we proceed with our redeliberations on this important subject.

I am Edmond Jenkins, Chairman of the Financial Accounting

Standards Board. Behind me is Kim Petrone, the project manager

on the subject of today’s hearing.

I am very pleased to be with you today. I plan to discuss something about the due process of the FASB and our proposed standard to improve the accounting for business combinations. I have

brief prepared remarks, but I would respectfully request that my

full statement and supporting materials, referred to as the biggest

package ever, be entered into the public record.

Mr. OXLEY. With some trepidation, it is so ordered.

Mr. JENKINS. Thank you, Mr. Chairman. I wouldn’t want to have

to carry them all back.

Mr. Chairman, the FASB is an independent organization, one

that is funded entirely by the private sector. Our mission is to set

accounting and reporting standards to protect the consumers of financial information. Most notably, those consumers are investors

and creditors. Those consumers rely heavily on credible, transparent, and comparable financial information for effective participation in our great capital markets.

To quote a recent letter from the Association of Investment Management and Research, the leading organization of investment professionals in the United States with over 40,000 members, ‘‘The

‘lifeblood’ of United States capital markets is financial information

that is: (1) comparable from firm to firm; (2) relevant to investment

70

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.’’

This notion of neutrality is a fundamental element in our standard-setting process. To create or tolerate financial reporting standards that bias or distort financial information to favor a particular

transaction, a particular industry or special interest group undermines the credibility and value of that information and the proper

functioning of the capital markets and impairs investors’ capital allocation decisions.

It is important to remember that our standards affect all public

and private nongovernmental organizations, not just companies in

one or two industries.

Our decisionmaking process is thorough. It is open to public observation and provides numerous opportunities for all interested

parties to actively participate in and express their views. The

issues that the FASB addresses are necessarily difficult ones for

which reasonable people can and do hold differing views. As you

know, we have often made significant changes to our proposals in

response to concerns that have been raised.

The subject of this hearing is our proposal to improve the accounting for business combinations. The current accounting in this

area was established in 1970. That accounting requires that business combinations be reported using either of two very differing

methods, the purchase method or the pooling of interests method.

Those two methods produce dramatically different financially reporting results for essentially the same or similar economic transactions.

Under the purchase method, the acquiring company records the

net assets of the acquired company at the price paid, including any

intangible assets, that have so often been referred to this morning

as the most important assets of the new economy companies, to the

extent that they can be separately identified and reliably measured. The excess of the purchase price paid over the fair value of

the acquired company’s net assets is recorded as an asset called

goodwill.

The purchase method is consistent with the accounting for all

other acquired assets. All purchases, whether a piece of machinery

or a patent or a royalty right, are recorded at the price paid and

are generally charged against earnings over their useful economic

life.

An alternative to the purchase method, the pooling method is

only available if 12 specific criteria are met. A key criterion is that

the consideration exchanged must take the form of stock rather

than cash or debt. However, it is important to note that stock can

also be used as consideration in a purchase accounting acquisition.

In contrast to the purchase method, under the pooling method

the book values of the combining companies are simply added together. There is no recognition of the full price paid and, therefore,

no charge in the recorded amount of the acquired company’s net assets to reflect their fair value, no recognition of these important intangible assets not previously recorded, and no resulting goodwill,

and thus the true cost of the transaction is not reflected in the income statement.

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Congressman Ganske referred to the article in the New York

Times by Floyd Norris. Congressman, let me confirm for you that

this is a real transaction. The numbers have been changed, but it

is a real transaction, and, in fact, under pooling of interests accounting, the company did record a profit of $30 million in our example when it really lost $50 million. That is a true example.

As you are aware, a key requirement of our proposal is that all

business combinations would be accounted for under one method,

the purchase method, and that the pooling of interests method

should be eliminated.

The rationale for that proposed decision includes the following

points: First, the pooling method ignores the values exchanged in

a business combination, while the purchase method reflects them.

Second, having two disparate methods of accounting for essentially the same transaction makes it difficult for investors to compare companies that have used different methods to account for

their business combinations.

Third, because future cash-flows are the same, whether the pooling or purchase method is used, a boost in earnings under the pooling method reflects artificial accounting differences rather than

real economic differences.

The important point is that under either purchase or pooling accounting, the future cash-flows are the same, and the impetus to

have an acquisition or not should really not be influenced at the

end of the day by the method of accounting.

Fourth, under the pooling method, financial statement users cannot tell how much was invested in the transaction, nor can they

track the subsequent performance of that investment in future

years.

Congressman Dingell made reference to my testimony in the ref- erence to the $9.5 billion that simply disappeared in the transaction. That is, as Congressman Lazio pointed out, the AOLNetScape transaction, and there was, in fact, no reporting of the

$9.5 billion in the financial statements of the combined company.

Thus, it was impossible for investors to relate subsequent performance against 95 percent of the purchase price paid for the acquired

company.

I would also like to emphasize a couple of things that our proposal does not do. First, our proposal does not preclude companies

from entering into business combinations that are stock-for-stock

transactions. Second, our proposal does not make significant

changes to the current basic accounting model where accounting for

intangible assets.

Congressman Goodlatte in his testimony referred to the Garten

panel, the panel set up by Chairman Arthur Levitt to look at value

creation in the new economy. I would like to read from the enabling article with respect to that panel because intangibles are nowhere mentioned in it.

‘‘The purpose is to assemble a panel of experts and other

thoughtful individuals to assess the capital markets’ understanding

of the recent changes in the economy attributable to technological

innovation and globalization; it is to identify the changing forces

now driving the value creation of business enterprises; it is to assess whether the investment community and the financial markets

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adequately understand these changes based on the information currently being made available in the marketplace.’’

There is no recognition in that of intangibles whatsoever.

Since first adding our project on business combinations to its

agenda in 1996, the Board has held over 40 public meetings. We

have issued two preliminary documents, an exposure draft for public comment that has been referred to here this morning, and carefully analyzed and discussed at public meetings over 400 comment

letters received from a broad range of companies, investors, and

other constituents.

In February of this year, we held 4 days of public hearings to discuss the proposal with interested constituents. Over 40 individuals

testified.

In April we began our redeliberations of all of the issues contained in the proposal. This redeliberation process will include numerous public meetings held over the next several months. At

those meetings, the Board will carefully consider the comment letters, the public hearing testimony, what we learn from this hearing, and all other relevant information provided by interested parties. Let me assure you that no final decisions will be made until

that process is completed.

We presently expect to complete our work and be in a position

to issue a final standard by no earlier than the end of the year

2000. That estimate may change depending on the progress of our

deliberations. We will not rush to a conclusion.

In closing, I want to be clear that the FASB understands and

supports the oversight role of the subcommittee. We will carefully

consider what we learn from this hearing, from the testimony of

Congressmen Dooley and Goodlatte.

Let me assure you again, Mr. Chairman and members of this

subcommittee, that our open due process and our independent and

objective decisionmaking will be carefully and fully carried out. To

do otherwise would jeopardize the very foundation upon which the

FASB was created and for which it has proven invaluable to the

U.S. capital markets and to investors and creditors, the consumers

of financial information.

Thank you very much, Mr. Chairman.

[The prepared statement of Edmund L. Jenkins follows:]

PREPARED STATEMENT OF EDMUND L. JENKINS, CHAIRMAN, FINANCIAL ACCOUNTING

STANDARDS BOARD

Summary

A key requirement of our proposal to improve the accounting for business combinations is that all business combinations would be accounted for under one method, the purchase method, and that the pooling-of-interests method (‘‘pooling method’’) should be eliminated.

The proposal’s requirement to eliminate the pooling method will benefit investors,

creditors, and other financial statement users by providing more information and

more relevant information about all business combinations. The proposal’s provisions also will benefit those consumers by improving the comparability of financial

reporting, thereby making it possible to more easily contrast companies that participate in business combinations.

The proposal will also benefit companies that prepare financial statements and

the auditors of those statements by providing a single method of accounting for all

business combinations. Having one method will reduce certain costs to companies

and auditors, both monetary and nonmonetary, which are currently related to the

existence of the pooling method. In addition, having one method benefits companies

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by leveling the playing field for competition among companies in the business combinations market.

In April, we began our redeliberations of all of the issues contained in the proposal. As part of that process, we will carefully consider the comment letters, public

hearing testimony, what we learn from this hearing, and all other relevant information provided by interested parties. No final decisions will be made until that process is completed.

Mr. Chairman, Members of the Subcommittee, I am Edmund Jenkins, chairman

of the Financial Accounting Standards Board (‘‘FASB’’ or ‘‘Board’’). With me is Kim

Petrone, the project manager on the subject of today’s hearing. I am pleased to be

here today. I plan to discuss the due process of the FASB and our proposed standard

to improve the accounting for business combinations (‘‘Proposed Standard’’). I have

brief prepared remarks, and I would respectfully request that my full statement and

supporting materials be entered into the public record.

What Is the FASB and What Does It Do?

The FASB is an independent private-sector organization. We are not part of the

federal government and receive no federal funding. We are funded entirely from private-sector sources, primarily voluntary contributions and sales of publications.

Our mission is to establish and improve standards of financial accounting and reporting for both public and private enterprises. Those standards are essential to the

efficient functioning of the economy because investors and creditors rely heavily on

credible, transparent, and comparable financial information.

The FASB’s authority with respect to public enterprises comes from the US Securities and Exchange Commission (‘‘SEC’’). The SEC has the statutory authority to

establish financial accounting and reporting standards for publicly held enterprises.

For over 60 years the SEC has looked to the private sector for leadership in establishing and improving those standards. Therefore, the FASB may be viewed as an

independent private-sector alternative to government regulation.

The focus of the FASB is on consumers—users of financial information such as

investors, creditors, and others. We attempt to ensure that corporate financial reports give consumers an informative picture of an enterprise’s financial condition

and activities and do not color the image to influence behavior in any particular direction.

To quote a recent letter from the Financial Accounting Policy Committee of the

Association for Investment Management and Research, the leading organization of

investment professionals in the United States with over 40,000 members:

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.

The notion of neutrality is a fundamental element of our standard-setting process.

The FASB’s Rules of Procedure explicitly require that the Board be objective in its

decision making to ensure the neutrality of information resulting from its standards.

Neutrality is an essential criterion by which to judge financial reporting standards, because information that is not neutral loses credibility and value. For example, surely, we would all agree there would be little value to Congress or the federal

government of purposely altered and manipulated information about the rate of inflation or about unemployment.

Similarly, to create or to tolerate financial reporting standards that bias or distort

financial information to favor a particular transaction, industry, or special interest

group undermines the proper functioning of the capital markets and impairs investors’’ capital allocation decisions.

As former SEC Chairman Richard C. Breeden stated in testimony before Congress

almost a decade ago:

The purpose of accounting standards is to assure that financial information

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

The FASB sets standards only if, in the Board’s independent judgment after carefully considering the input from all interested parties, there is a significant need

for the standard and the costs the standard imposes are justified by the overall benefits. The objective, and implicit benefit, of issuing an accounting standard is increased credibility and representational faithfulness of financial reporting. However,

the value of that improvement to financial reporting is usually impossible to measure and the Board’s assessment of an accounting standard’s benefit to companies

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that prepare financial reports and to investors and creditors that use financial reports is unavoidably subjective.

The US capital markets are the deepest, most liquid, and most efficient markets

in the world. The unparalleled success and competitive advantage of the US capital

markets are due, in no small part, to the high-quality and continually improving

US financial accounting and reporting standards. As Federal Reserve System Chairman Alan Greenspan stated in a June 4, 1998 letter to SEC Chairman Arthur

Levitt:

Transparent accounting plays an important role in maintaining the vibrancy

of our financial markets . . . An integral part of this process involves the Financial Accounting Standards Board (FASB) working directly with its constituents

to develop appropriate accounting standards that reflect the needs of the marketplace.

What Process Did the FASB Follow in Developing Its Proposed Standard?

Because the actions of the FASB affect so many organizations, its decision-making

process must be thorough. The FASB carefully considers the views of all interested

parties—users, preparers, and auditors of financial information. Our Rules of Procedure require an extensive due process that was modeled on the Federal Administrative Procedure Act, but it is broader and more open in several ways. It involves public meetings, public hearings, and exposure of our proposed standards to external

scrutiny and public comment. The Board makes final decisions only after carefully

considering and understanding the views of all parties.

The FASB’s due process for developing a new financial reporting standard is best

illustrated by describing the process followed in developing the Proposed Standard:

• When we began the project in 1996, we established a business combinations task

force comprising individuals from a number of organizations representing a

wide range of the Board’s constituents. (Attachment 12 lists the members and

their affiliations.) The first public meeting of the task force was held in February 1997.

• In June 1997, we published for public comment a Special Report that contained

some of the Board’s initial tentative decisions about the project’s scope, direction, and content. We received 54 comment letters in response to the Special

Report.

• In November 1998, we held the second public business combinations task force

meeting to discuss issues related to the project.

• In December 1998, we published for public comment, in participation with other

members of an international organization of accounting-standard-setting bodies,

a Position Paper that addressed a number of issues related to the methods of

accounting for business combinations. We received 148 comment letters in response to the Position Paper.

• We held over 40 public meetings since 1997 to address the issues associated with

the methods of accounting for business combinations and the accounting for

goodwill and other purchased intangible assets and to consider constituent comments.

• After each meeting, we updated a paper that summarized all of the Board’s decisions. The updated paper was available on the FASB webpage and was sent by

mail to anyone who requested it.

• Our weekly newsletter, Action Alert, announced each meeting in advance and reported a summary of the results of each meeting. (In addition, press reports of

some of the meetings were available in certain business publications.)

• The Board and staff discussed the project on business combinations and intangible assets with representatives of companies and trade associations and with

investors and creditors at dozens of liaison meetings, public conferences, and forums throughout the US and the world.

• In September 1999, we published for public comment an Exposure Draft (the Proposed Standard) that contains proposed changes to the existing standards of accounting for business combinations and intangible assets. We received approximately 200 comment letters in response to the Exposure Draft.

• In connection with the issuance of the Exposure Draft, we prepared and issued

the following explanatory documents to assist constituents in understanding the

Board’s proposed decisions: ‘‘September 1999 FASB Exposure Draft, Business

Combinations and Intangible Assets: An Overview’’ (Attachment 4); ‘‘FASB

Business Combinations Project: September 1999 FASB Exposure Draft, Business Combinations and Intangible Assets: Frequently Asked Questions’’ (Attachment 9); FASB Viewpoints, ‘‘Why Eliminate the Pooling Method?’’ (Attachment

7); and FASB Viewpoints, ‘‘Why Not Eliminate Goodwill?’’ (Attachment 8). All

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of the documents were available on the FASB webpage and were sent by mail

to anyone who requested them. • We held four days of public hearings in February 2000 (two days in San Francisco

and two days in New York City) to discuss the Exposure Draft with interested

parties. More than 40 individuals and organizations testified. • In March 2000, the business combinations task force met with members of the

Board and staff to discuss a number of issues raised in the comment letters and

at the public hearings.

What’s Wrong with the Present Accounting for Business Combinations?

There are few areas in the current accounting literature that need reform

more than business combination accounting...

JACK T. CIESIELSKI, CPA, CFA, President, R.G. Associates, Inc.,

Investment Research/Investment Management, 11/29/99.

The current accounting for business combinations is governed by the requirements

of APB Opinions No. 16, Business Combinations, and No. 17, Intangible Assets,

which were issued in 1970 by the Accounting Principles Board (‘‘APB’’) of the American Institute of Certified Public Accountants.

Under APB Opinions 16 and 17, business combinations are reported using either

of two very disparate methods—the purchase method or the pooling-of-interests

method (‘‘pooling method’’). Those two methods produce dramatically different financial reporting results for essentially the same or similar economic transactions.

Under the purchase method, the acquiring company records the net assets of the

acquired company at the price paid, including any intangible assets to the extent

they can be separately identified and reliably measured. The excess of the price paid

over the fair value of the acquired company’s net assets is recorded as an asset

called goodwill, which is subsequently charged against earnings over time.

The purchase method is consistent with the accounting for all other acquired assets—all purchases, whether a piece of inventory or a patent, are recorded at the

price paid and are generally charged against earnings over their useful economic

life.

In contrast to the purchase method, under the pooling method, the book values

of the combining companies are simply added together. There is no recognition of

the full price paid. There is, therefore, no change in the recorded amount of the acquired company’s net assets to reflect their fair value, no recognition of intangible

assets not previously recorded, and no resulting goodwill, and thus the true cost of

the transaction is not reflected in the income statement. By not recognizing that

cost, the future earnings of the newly combined company are artificially inflated.

In commenting on what’s wrong with the pooling method, a September 10, 1999

article in the New York Times entitled ‘‘Can Regulators Keep Accountants from

Writing Fiction?’’ by Floyd Norris, states:

Pooling accounting is ridiculous because it allows corporations to pretend that

they paid much less for an acquisition than they did. Let’s say Company A buys

Company B for $100 million in stock, and then, a few years later, sells Company B for $50 million. In reality, it was a disastrous acquisition for Company

A. But thanks to the magic of pooling, Company A would have shown the original acquisition as costing not the $100 million it paid but a number that could

be far lower—say, $20 million—reflecting the book value of Company B. Presto:

Company A reports a profit of $30 million when it really lost $50 million.

In addition, an article entitled ‘‘Big Banks Debunked,’’ by Amy Kover, in the February 21, 2000 edition of Fortune describes what’s wrong with the use of the pooling

method in several recent business combinations in the financial services industry:

Used just for stock transactions, pooling of interest allows the acquirer to add

to its books only the book value of the acquired company—not the full price it

paid for the target. That’s a pretty neat trick if you’ve paid a fat premium for

an acquisition, as Banc One did for First USA (43% over the market value),

First Union did for CoreStates (18% over), and NationsBank did for Barnett

(37% over). In the magic of pooling-of-interest accounting, those premiums simply vanish.

What’s so useful about that? Well, because the acquisition appears to add little to the surviving company’s equity base—even as it captures all the extra

earnings from the acquired company—the new bank’s return on equity looks as

if it’s on steriods. The effect is anything but trivial. For example, when Michael

Mayo of Credit Suisse First Boston recalculated each bank’s cash return on average tangible equity as if it had used purchase accounting, Bank One’s 1998

return on equity went from 27% to 12%. At First Union, it fell from 35% to

11.8%. And Bank of America’s 29% return on equity dropped to about 10.8%.

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As Dale Wettlaufer of Legg Mason says, ‘‘The end result is that the cash return

on tangible equity is a totally bankrupt measure.’’

To use the pooling method, 12 specific criteria must be met; a key criterion is that

the consideration exchanged takes the form of stock rather than cash or debt. The

vast majority of business combinations today, including the many stock-for-stock

transactions that fail to meet one or more of the pooling method criteria, are accounted for using the purchase method.

As the pace of business combinations has increased over recent years, the availability of two different accounting methods for very similar transactions that

produce dramatically different levels of information to the market has become more

and more problematic. A study of business combinations of public corporations over

the period 1992-1997 found that the quantity and dollar magnitude of pooling method transactions rose dramatically from 105 transactions valued at $16.9 billion in

1992 to 321 transactions valued at $213.8 billion in 1997 (Attachment 6). A letter

from the Consumer Federation of America to the FASB commented on that phenomenon: Over the last decade, a tidal wave of merger activity has swept through nearly every corner of the American economy. According to the Federal Trade Commission, the number of federal pre-merger filings has nearly tripled since the

beginning of the decade, from 1,529 in 1991 to an estimated 4,500 last year.

The market value of those mergers has risen even more dramatically, from $600

billion in the previous peak year of 1989 to more than $2 trillion in 1998. And

several factors, not least passage this year of the financial modernization legislation, lead us to conclude that this activity is unlikely to abate any time soon.

Ensuring that investors get complete and accurate information about the effects

of mergers is, thus, a timely and important issue for the Financial Accounting

Standards Board to tackle.

Beginning in the early 1990s, the Financial Accounting Standards Advisory Council (‘‘FASAC’’), a group composed of over 30 senior-level individuals from business,

public accounting, professional organizations, and the academic and analyst communities, consistently ranked a possible project on improving the accounting for business combinations as a high priority for the Board. (Attachments 10 and 11 provide

a listing of the members of FASAC and their affiliations and a description of

FASAC, respectively.) At the July 1996 FASAC meeting, members indicated overall

support for adding a project on improving the accounting for business combinations

to the Board’s agenda.

The Board agreed with the recommendation of FASAC and, in the fall of 1996,

decided to add to its agenda a project on accounting for business combinations.

Among the more significant reasons that led the Board to reach that decision included the following:

• The Board wanted to address perceived flaws and deficiencies in APB Opinion 16.

One significant flaw is the fact that two economically similar business combinations can be accounted for using different accounting methods that produce dramatically different financial results. The availability of two methods makes it

difficult for financial statement users to compare the financial reports of companies that use different methods of accounting for business combinations. • Many believe that having two accounting methods affects competition in markets

for business combinations. Companies that cannot meet all of the conditions for

applying the pooling method believe they face an unlevel playing field in competing for a target against those that can apply that method. Because companies that can use the pooling method do not have to account for the cost of the

investment or its subsequent performance, some believe those companies are

willing to pay more for a target than companies that cannot use that method. • There has been a continuous need to interpret APB Opinion 16. Despite the fact

that APB Opinion 16 was issued almost 30 years ago, the volume of inquiries

about its application remains high, an indication that the existing literature

might be in need of significant repair. Many of those inquiries are concerned

with whether a specific transaction meets the criteria for use of the pooling

method. • Because of the rapidly accelerating movement of capital flows globally, there is a

need for financial reporting to be comparable internationally. Part of the Board’s

mission includes promoting international comparability of financial reporting,

and accounting for business combinations is one of the most significant areas

of difference in accounting standards. In most parts of the world, the pooling

method is either prohibited or used only on an exception basis.

• Finally, the Board took note of the historical justification of the pooling method.

(Attachment 4 contains a summary of the history of the pooling method.) The

Board observed that the pooling method has been regularly challenged since the

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term pooling-of-interests was first coined in the 1940s. The APB considered

eliminating the pooling method when APB Opinion 16 was developed in the late

1960s. Although the pooling method was retained, the slimmest possible majority approved Opinion 16—six members of the APB dissented from the decision.

Three of the six dissenters to APB Opinion 16 stated:

[Opinion 16] seeks to patch up some of the abuses of pooling. The real

abuse is pooling itself. On that, the only answer is to eliminate pooling.

What Does the Proposed Standard Require and Why?

Three of the key requirements of the Proposed Standard and a brief summary of

the Board’s basis for those requirements are described below. Paragraphs 92-366 of

the FASB’s Exposure Draft provide a detailed description of the basis for all of the

Board’s decisions.

Proposed Requirement #1: The purchase method of accounting would be required for all business combinations. Use of the pooling method would be prohibited.

Basis: In current practice, the underlying economics of the transactions to which

the pooling method is applied are often similar, if not identical, to the underlying

economics of those transactions that are accounted for by the purchase method.

Under the pooling method, however, investors and creditors are being provided with

less information—and less-relevant information—than is provided by the purchase

method. That is because the pooling method ignores the values exchanged in a business combination transaction, whereas the purchase method records those values on

the face of the balance sheet. As a result, the pooling method does not provide users

of financial reports with full information about how much was invested in the combination. More important, because the investment is not fully recorded in the financial reports, the pooling method does not provide investors and creditors with the

information they need to assess the subsequent performance of that investment and

compare it with the performance of other companies.

For example, in one very visible acquisition that was accounted for under the

pooling method, the value of the stock issued as consideration by the acquiring company was about $10 billion. The book value of the company acquired was only $500

million. The acquisition, therefore, was reported at $500 million in the financial

statements of the combined company, and $9.5 billion of value ($10 billion less $500

million) simply disappeared. There was no reporting of the $9.5 billion in the financial statements of the combined company; thus, it is virtually impossible for investors to relate subsequent performance against 95 percent of the purchase price paid

for the acquired company.

The example is not unique, a study of a sampling of 756 pooling method transactions of public corporations entered into over the period 1992-1997 found that

$267 billion of assets, constituting about 66 percent of the total acquisition price,

went unreported in the financial statements (Attachment 6).

The information that the pooling method provides about individual assets and liabilities is also less complete and less comparable than that provided by the purchase method. It is less complete because the pooling method does not record any

acquired assets or liabilities that were not previously recorded, including valuable

trademarks, customer lists, and other intangibles, and thus ignores their presence,

even though they were acquired at a cost and can be separately identified and reliably measured.

In contrast, the purchase method reveals those hidden assets and liabilities by recording them. Moreover, the acquired assets and liabilities that the pooling method

does record are not measured on a basis that is comparable with how acquisitions

generally are measured (that is, at the values exchanged in those transactions), as

does the purchase method. Because the values exchanged are not recorded, subsequent rate-of-return measures are artificially inflated.

Proposed Requirement #2: The maximum goodwill amortization period would

be reduced from the current 40 years to 20 years.

Basis: The Board based this proposed requirement on a number of factors. The

Board observed that the rapid pace of technological change was shortening product

life cycles and requiring enterprises to reinvent themselves more regularly in order

to survive. Thus, in general, the average useful economic life of goodwill has been

diminishing since 1970. That observation was supported by evidence provided by

companies, including those that participated in limited field tests.

The Board also observed that in current practice the amortization period used by

many companies, including those in the technology and financial services industries,

is generally less than 25 years.

Finally, the Board observed the relatively recent decisions of several other national accounting standards-setting bodies that have addressed this issue. Those

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bodies have generally concluded that goodwill should have a presumptive useful life

of 20 years or an absolute maximum amortization period of 20 years.

Proposed Requirement #3: Companies would be required to present goodwill

amortization as a separate line item on the income statement, preceded by a subtotal, to make the charge to earnings more transparent to investors and creditors.

Basis: The Board decided that goodwill amortization should be presented as a

separate line item in the income statement because goodwill is a unique asset, the

useful life of which cannot be determined precisely. In addition, some investors and

creditors often weigh goodwill amortization differently from other expenses in their

financial analysis, and the proposed presentation would benefit those users.

Intangible Assets: It is important to note that the Proposed Standard would not

require the separate valuation, reporting, and amortization of intangible assets that

are not reliably measurable, such as many forms of knowledge-based intangible assets so often associated with technology companies. A review of the comment letters

and public hearing testimony reveals that this point has continued to be a source

of some confusion for some constituents. To clarify, under current accounting standards and the Proposed Standard, only purchased intangible assets that can be separately identified and reliably measured, like many trademarks and customer lists,

are required to be separately valued, reported, and amortized over their useful economic lives.

Unlike current accounting, however, the Proposed Standard does provide certain

circumstances in which intangible assets are not amortized. The Proposed Standard

provides that, if an intangible asset has an indefinite useful economic life and meets

certain other criteria, the asset shall not be amortized until its life is determined

to be finite. Thus, if an intangible asset was increasing in value, the Proposed

Standard would provide circumstances in which that asset would not be amortized.

The Board is aware of, and the FASB staff is actively participating in and monitoring, various studies and research currently being planned or performed by various constituent groups that might be relevant to the accounting for intangible assets. In addition, the FASB staff is currently performing independent research in

this area. The scope of our research involves determining whether changes in the

US economy should result in changes in the type of information included in financial statements and the manner in which that information is presented and delivered to users. That research includes a review of the accounting treatment for intangible assets.

The Board will carefully evaluate the results of the studies and research of the

constituent groups and FASB staff. We anticipate that those results might help us

expand our understanding of financial reporting issues related to accounting for intangible assets. Those results might also assist in developing future formal agenda

projects of the Board.

Who Will Benefit from a Change in the Accounting for Business Combinations and

How?

The Proposed Standard will benefit the public—investors, creditors, and other

users of financial statements—as well as companies that prepare and audit those

reports.

The Proposed Standard’s requirement to eliminate the pooling method will benefit

investors, creditors, and other financial statement users by providing more information and more relevant information about all business combinations. The Proposed

Standard’s provisions also will benefit those consumers by improving the comparability of financial reporting, thereby making it possible to more easily contrast

companies that participate in business combinations.

Many consumers have expressed support for elimination of the pooling method.

As one example, a letter from the Financial Accounting Policy Committee of the Association for Investment Management and Research states:

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...

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.

Many companies that prepare financial reports also agree. Those companies that

have written letters to the FASB supporting the elimination of the pooling method

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include IBM Corporation, Eaton Corporation, American Electronic Power, General

Motors, Caterpillar, Inc., IMC Global, and PPG Industries, Inc., to name a few. The

IBM Corporation letter stated:

IBM agrees with the FASB that all business combinations are acquisitions

and, thus, we support the FASB’s proposal to eliminate the pooling-of-interests

method of accounting for a business combination. We believe that financial

statement users are ill-served by the existence of two methods to account for

the same economic transaction. We agree with the FASB that using the purchase method to account for all business combinations will increase the comparability of financial statements and will reflect the true economics of the

transaction, that is, an arm’s length investment that should be accounted for

at the fair value of the assets and liabilities that are acquired.

The Proposed Standard will also benefit companies that prepare financial statements and the auditors of those statements by providing a single method of accounting for all business combinations. Having one method of accounting for all business

combinations will reduce certain costs to companies and auditors that are currently

related to the existence of the pooling method.

For example, the availability of the pooling method often puts companies and

their auditors under pressure to employ that method because it typically produces

higher reported earnings and rates of return subsequent to a business combination

than the purchase method. Moreover, because the pooling method is applied retroactively, the comparative earnings reported for periods preceding the combination

are also higher than under the purchase method—even before the companies were,

in fact, combined.

As a result of those pressures, companies often must bear significant costs, both

monetary and nonmonetary, in seeking to use the pooling method. In positioning

themselves to try to meet the 12 criteria for applying that method, companies may

refrain from engaging in appropriate economic actions that they might otherwise

undertake, such as asset dispositions or share reacquisitions. They also may incur

substantial fees from auditors and consultants in seeking to meet those criteria. The

efforts to meet those criteria also may lead to conflicts between companies, auditors,

and regulators with respect to judgments about whether the criteria have been met,

thereby adding uncertainties and their attendant costs to the process and raising

questions about the operationality of those criteria.

A report published by the Silicon Valley office of McKinsey & Company, an international consulting firm, stated:

The fear that purchase accounting, by lowering reported earnings, will destroy shareholder value is a myth. In fact the opposite is true. Efforts to qualify

for such treatment actually destroy value. FASB’s proposal to eliminate pooling

accounting is a blessing in disguise. Why? Because the transition to purchase

accounting will require corporations to adopt more robust deal evaluation processes and enhance their shareholder communications.

Similarly, a letter to the FASB from the Financial Institutions Accounting Committee of the Financial Managers Society (‘‘FIAC’’), a group of 15 financial professionals working in executive level positions in the thrift and banking industries,

stated:

Formal research supports the proposition that reporting firms consume substantial resources in structuring transactions solely to achieve a favorable financial reporting outcome. Lys and Vincent (1995) report that AT&T paid at

least $50 million (and possibly as much as $500 million) to achieve pooling-ofinterests accounting for its acquisition of NCR. . . . A single method of accounting for business combinations would redirect these corporate resources into

more productive areas.

In addition, having one method of accounting for business combinations benefits

companies by leveling the playing field for competition among companies in the

business combinations market. The ability—or inability—to use the pooling method

often affects whether a company enters into a business combination and also affects

the prices they negotiate for those transactions. Companies that cannot use the

pooling method because they cannot meet the criteria required for its use (for example, criteria that prohibit certain share acquisitions) often conclude that they cannot

compete for targets with those that can meet the criteria.

Many companies that cannot use the pooling method believe that companies that

can use it often are willing to pay higher prices for targets than they would if they

had to use the purchase method because they do not have to account for the full

cost of the resulting investment. Thus, by using the pooling method, they can understate the income statement charges (primarily related to goodwill and other intangible assets).

In a letter to the FASB, KeyCorp explained:

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Since most publicly-traded companies are gauged by EPS performance, there

is a strong incentive to use the ‘‘earnings-friendly’’ pooling method. The desire

to avoid the earnings consequences of the purchase method has almost certainly

resulted in uneconomic behavior. It is well understood in the investment banking community that a company is willing to ‘‘pay’’ more for a target if the pooling method is available for the resulting transaction. Clearly, there is a view

that the pooling method results in a type of accounting arbitrage...

Even though using the pooling method rather than the purchase method might

result in being able to report higher per-share earnings following the combination,

the fundamental economics are not different because the actual cash flows generated following the combination will be the same regardless of which method is

used. As a result, the added earnings reported under the pooling method reflect artificial accounting differences rather than real economic differences.

To the extent that the markets respond to artificial differences, they direct capital

to companies whose financial reporting benefits from those differences and they direct capital away from companies whose financial reporting does not benefit. As a

result, markets allocate capital inefficiently rather than efficiently. While inefficient

allocation of capital may benefit some companies and even some industries, it imposes added costs on many others, depriving them of capital that they need and capital they could employ more productively. The outcome is detrimental to those companies—but more important, to the capital markets as a whole.

What Happens Next?

On April 12, 2000, the Board began the next significant stage of its work on the

business combinations project. That stage will involve redeliberation of all of the

issues contained in the Proposed Standard. As part of that redeliberation, the Board

will carefully consider the feedback it has received through the comment letters,

public hearing testimony, the testimony at this hearing, and any and all relevant

information provided by interested parties.

The Board will hold as many public meetings as necessary to thoroughly discuss

all of the feedback received and to decide what modifications or clarifications to the

Proposed Standard are appropriate. The Board will not make any final decisions

about the Proposed Standard or consider whether to issue a final standard until it

is satisfied that all substantive issues raised by all parties have been considered.

The Board presently expects to complete its work and be in a position to issue

a final standard by no earlier than the end of the year 2000. That estimate may

change depending on the progress of the Board’s redeliberations. Any final standard

will be effective no earlier than the date of its issuance.

In closing, I want to be clear that the FASB understands and supports the oversight role of this Subcommittee. We will carefully consider what we learn from this

hearing. Let me assure you, Mr. Chairman and members of the Subcommittee, that

our open due process and our independent and objective decision making will be

carefully and fully carried out. To do otherwise would jeopardize the very foundation

upon which the FASB was created, and for which it has proven invaluable to the

US capital markets and to investors and creditors—the consumers of financial information.

Thank you, Mr. Chairman. I very much appreciate this opportunity and would be

pleased to respond to any questions.

Mr. OXLEY. Thank you, Mr. Jenkins. Once again we appreciate

your cooperation and openness throughout this entire process. As

the other member said, it has been a pleasure to work with you in

such a manner.

Before I introduce our next witness, let me introduce our good

friend Joe Crowley, from New York, who is not a member of the

committee, but is interested in this subject and has agreed to be

with us this morning. Welcome.

Mr. Powell?

STATEMENT OF DENNIS D. POWELL

Mr. POWELL. Good morning. Thank you for inviting me to this

hearing.

I am vice president and corporate controller for Cisco Systems.

Cisco is the worldwide leader in networking, with revenues curVerDate 11-MAY-2000 13:14 Sep 11, 2000 Jkt 064765 PO 00000 Frm 00084 Fmt 6633 Sfmt 6602 E:\HEARINGS\64765 pfrm01 PsN: 64765
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rently approximating $17 billion per year. We are a multinational

corporation with more than 28,000 employees and 200 offices in 55

countries. In the U.S. we have significant operations in California,

Texas, Massachusetts, and North Carolina.

The two methods of accounting that we are discussing today,

purchase and pooling of interests, have been generally accepted in

practice since 1945. In 1970, the Accounting Principles Board studied and discussed the pros and cons of the two accounting methods

and issued APB16 entitled ‘‘Business Combinations,’’ which reaffirmed the validity of both the purchase and pooling of interests

method.

This viewpoint was again reaffirmed in 1994 by a task force commissioned by the American Institute of Certified Public Accountants, as we heard earlier, to study the usefulness of financial reporting. This report, entitled ‘‘Improving Business Reporting, a

Customer Focus,’’ concluded after 3 years of study that a project to

do away with either method would be very controversial, require a

significant amount of FASB time and resources, and at the end is

not likely to improve significantly the usefulness of financial statements.

So the arguments for and against the pooling and purchase

methods of accounting haven’t changed for the past 30 years. We

are still debating the same issues.

However, the problems with the purchase method are still with

us, but the implications today are much more severe than they

were in 1970. In 1970, most of an acquisition price was allocated

to tangible, hard assets. Today, for knowledge-based technology

companies, most of the acquisition price is allocated to intangible

assets and very little to hard assets.

For example, since 1993, Cisco has acquired over 50 companies amounting to over $19 billion. Of these acquisitions, only $900 million or 5 percent is attributed to hard assets; $18 billion or 95 percent of the acquisitions would be left to allocate to intangibles or

goodwill. So the limitations of the purchase method have become

much more problematic. Yet the new FASB proposal would force all

acquisitions to be accounted for under the purchase method, without having solved its defects.

The most significant defect of the purchase method is the accounting for goodwill once it is recorded as an asset on the balance

sheet. The FASB proposal requires that goodwill be treated as a

wasting asset and requires that it be amortized over 20 years. This

model incorrectly assumes that goodwill declines in value over

time, which artificially reduces net income and misrepresents economic reality.

For example, we studied four technology mergers that occurred

in 1996 and 1997. The results of the four companies in the study

are summarized in attachment B to my testimony. As you can see

from that exhibit, the purchase accounting model significantly reduced actual earnings by an average of 48 percent because of the

amortization of goodwill. This would suggest that goodwill has declined in value. However, over the same period, goodwill actually

increased from the date of the merger by an average of 43 percent.

Based on the above study, it is clear that in successful mergers,

the presumption that goodwill is a wasting asset is not valid. GoodVerDate 11-MAY-2000 13:14 Sep 11, 2000 Jkt 064765 PO 00000 Frm 00085 Fmt 6633 Sfmt 6602 E:\HEARINGS\64765 pfrm01 PsN: 64765
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will increases in successful acquisitions and declines rapidly in unsuccessful acquisitions. Goodwill does not decline radically over 20

years. The FASB model simply does not report true economic performance.

The FASB argues that the pooling of interests method provides

investors with less information and less relevant information than

provided by the purchase method because the pooling method ignores the values exchanged, whereas the purchase method records

these values on the face of the balance sheet.

I disagree that the pooling method provides less information. At

the time of a merger, the number of shares exchanged and the related share values are known, so the value of the transaction is

known. Furthermore, the pooling method of accounting reports a

more conservative balance sheet, reports the results of operations

more accurately, and presents investors and creditors with more

relevant information to assess subsequent performance of the combined entities than the purchase method.

If I could refer you to attachment C as an illustration, if companies A and B would combine, the pooling method would report a

combined equity of zero dollars, in the example that I provided.

However, the purchase model creates an inflated equity of $4,000,

giving the impression that these two anemic companies have been

made well simply by combining.

Furthermore, because the purchase method incorrectly assumes

that goodwill reported on the balance sheet declines over 20 years,

the combined companies’ operations are artificially reduced from

the actual performance under purchase accounting. The pooling

method more faithfully reports true economic performance as illustrated in the attachment C.

Finally, application of the purchase method would mislead the

reader of the financial statements, the combined financial statements, into believing that the revenues had increased 100 percent

from $2,500 in year 1 to $5,000 in year 2. However, the pooling

method would correctly reflect the true view that sales had been

flat between the 2 years because this method requires that previously reported financial statements be restated to report the combined operations as if they had always been together. In this case,

both years 1 and 2 would reflect sales of $5,000.

In summary, the pooling method reports a more conservative balance sheet, more accurate income, and a better comparison of operations and a truer picture of sales trends.

In conclusion, the U.S. accounting rules for business combinations, which includes both the pooling and the purchase methods,

has for the past 50 years generated and supported the strongest

capital markets in the world. Before the FASB radically changes

these accounting rules to a model that will certainly stifle technology development, impede capital formation, and slow job creation in this country, the FASB should make sure that the new

proposed method is without question the absolute correct answer.

In reality, the FASB’s proposed standard does not improve financial reporting, it merely changes it. Worse yet, the proposed

changes require companies to use a purchase model that does not

work for companies in the new economy, where most of the acquisition value cannot be attributed to hard assets, forcing companies

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to report an arbitrary net income number that is irrelevant and

misleading.

We believe that, first, the FASB should retain the pooling of interests method of accounting. The pooling method of accounting

continues to have broad support, as evidenced by two-thirds of the

respondents to the current FASB exposure draft, and all of the Big

5 accounting firms disagreed with the FASB’s plan to eliminate

pooling accounting.

Second, revise the purchase method to correct its deficiencies,

such as charge purchased goodwill directly to shareholders’ equity,

or amortize it through comprehensive income, or reduce goodwill

only when it has actually declined in value, or the impairment

method; and then limit the allocation of purchase price only to

those intangibles that can be objectively and reliably valued; and

third, engage a task force which would include evaluation experts

to develop adequate guidance on how to identify, value and account

for intangible assets for new economy companies.

I agree with Mr. Jenkins in his statement with respect to the

Garten Commission. It was not commissioned to address this point.

As a member of that commission, I can verify that. What that

means, though, I think, is that someone needs to address this

issue, because it is not being addressed today. I think that is the

FASB’s job. I think they should do that before they issue their pronouncement.

Thank you very much.

[The prepared statement of Dennis D. Powell follows:]

PREPARED STATEMENT OF DENNIS D. POWELL, VICE PRESIDENT, CORPORATE

CONTROLLER, CISCO SYSTEMS, INC.

INTRODUCTION

My name is Dennis Powell. I am Vice President and Corporate Controller for

Cisco Systems, Inc.

Cisco is the worldwide leader in networking with revenues currently approximating $17 billion per year. We are a multinational corporation with more than

28,000 employees in 200 offices and 55 countries. In the U.S., we have significant

operations in California, Texas, Massachusetts and North Carolina.

BACKGROUND

The two methods of accounting—‘‘Purchase’’ and ‘‘Pooling of Interests’’—have been

generally accepted in practice since 1945. In 1970, the Accounting Principles Board

studied and discussed the pros and cons of the two accounting methods, and issued

APB16 ‘‘Business Combinations’’, which reaffirmed the validity of both the purchase

and pooling of interests methods.

This viewpoint was again reaffirmed in 1994 by a task force commissioned by the

American Institute of Certified Public Accountants to study the usefulness of financial reporting. This report, entitled ‘‘Improving Business Reporting—A Customer

Focus’’ concluded, after three years of study, that, ‘‘A project to do away with either

method would be very controversial, require a significant amount of FASB time and

resources, and in the end is not likely to improve significantly the usefulness of financial statements.’’

The arguments for and against the pooling and the purchase methods of accounting haven’t changed over the past 30 years—we are still debating the same issues.

However, the problems of the purchase method are still with us, and the implications today are much more severe than they were in 1970. In 1970, most of an acquisition price was allocated to tangible, hard assets. Today, for knowledge-based

technology companies, most of the acquisition price is allocated to intangible assets—and very little allocated to hard assets. For example, since 1993, Cisco has acquired over 50 companies amounting to $19 billion. Of these acquisitions, only $900

million, or 5%, is attributed to hard assets—$18 billion or 95% would be left to alloVerDate 11-MAY-2000 13:14 Sep 11, 2000 Jkt 064765 PO 00000 Frm 00087 Fmt 6633 Sfmt 6621 E:\HEARINGS\64765 pfrm01 PsN: 64765
84

cate to intangible assets or goodwill. So the limitations of the purchase method have

become more problematic. And yet the new FASB proposal would force all acquisitions to be accounted for under the purchase method, without having solved its defects.

GOODWILL AMORTIZATION

The most significant defect of the purchase method is the accounting for goodwill

once it is recorded as an asset on the balance sheet. The FASB proposal requires

that goodwill be treated as a wasting asset, and be amortized ratably over 20 years.

This model incorrectly assumes that goodwill declines in value over time, which artificially reduces net income and misrepresents economic reality. In reality, the

value of goodwill is dependent upon the success of the merger, and is not a function

of time.

For example, we studied four technology mergers that occurred in 1996 and 1997,

which were reported as poolings. We then recast the poolings as if they were purchases, and restated the financial statements for periods after the acquisition to

show the impact of goodwill amortization. The results of all four companies in the

study are summarized on Attachment B. The purchase accounting model significantly reduced actual earnings by an average of 48% because of the amortization

of goodwill. This would suggest that goodwill has declined in value. However, over

this same time period, goodwill has actually increased from the date of the merger

by an average of 43%.

Based on the above study, it is clear that in successful mergers, the presumption

that goodwill is a wasting asset is not valid. Goodwill increases in successful acquisitions and declines rapidly in unsuccessful acquisitions. Goodwill does not decline

ratably over twenty years—the FASB model simply does not report true economic

performance.

INTANGIBLES

Regarding valuation of other intangible assets, the FASB proposal obligates companies to identify and value all intangible assets, without giving adequate guidance

on how these assets should be separately identified and valued. There are no standards in the valuation community to provide any consistency or reliability around the

valuation of these intangibles.

At risk is a loss of credibility in financial reporting. FASB must provide more

guidance and tools around how their requirements should be implemented.

COMPARABILITY

The FASB has stated that elimination of pooling solves a comparability issue between purchase transactions and pooling transactions. But elimination of pooling

simply trades one comparability issue with a set of new comparability problems.

First, mandating the purchase method creates significant comparability issues between companies who grow from internal organic development and those who grow

through acquisition.

For example, a company that generates significant goodwill from its internal operations will report no goodwill value while the company that acquires goodwill

through a merger will report the ‘‘value’’ of the goodwill at the time of the acquisition. So, while both companies may have the same value of goodwill, only the company who obtained the goodwill through a merger will report any amount on its balance sheet.

Secondly, elimination of pooling prevents comparability within the same company—in comparing operations before the acquisition, which do not include the activities of the acquired company, to operations after the acquisition, which do include the activities of the acquired company. Eliminating pooling does not solve the

comparability issue.

I believe the comparability issue would be more effectively addressed by correcting

the inherent problems of the purchase method than by eliminating pooling accounting as an option.

DEFENSE OF POOLING ACCOUNTING

The FASB argues that the pooling method provides investors with less information—and less relevant information—than provided by the purchase method, because the pooling method ignores the values exchanged whereas the purchase method records these values on the face of the balance sheet. I disagree that the pooling

method provides less information. At the time of a merger, the numbers of shares

exchanged and related share values are known, so the value of the transaction is

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known. Furthermore, the pooling method of accounting reports a more conservative

balance sheet, reports results of operations more accurately and presents investors

and creditors with more relevant information to assess subsequent performance of

the combined entities than the purchase method. Using Attachment C as an illustration, if Companies A and B would combine, the pooling method would record a

combined equity of $0. However, the purchase method would create an inflated equity of $4,000, giving the impression that these two anemic companies had been

made well by simply combining.

Furthermore, because the purchase method incorrectly assumes that the goodwill

recorded on the balance sheet declines over 20 years, the combined company’s operations are artificially reduced from its actual performance under purchase accounting. The pooling method more faithfully reports true economic performance as illustrated in Attachment C.

Finally, application of the purchase method would mislead the reader of the financial statements of the combined financial statements into believing that the revenues had increased 100%, from $2,500 in Year 1 to $5,000 in Year 2. However, the

pooling method would correctly reflect the true view that sales had been flat between the two years, because this method requires that previously reported financials be restated to report the combined operations as if they had always been together; in this case both Years 1 and 2 would reflect sales of $5,000.

In summary, the pooling method reports a more conservative balance sheet, more

accurate income, a better comparison of operations and a truer picture of sales

trends.

SUMMARY

In conclusion, the U.S. accounting rules for Business Combinations, which includes both the pooling and purchase methods, has for the past 50 years, generated

and supported the strongest capital markets in the world. Before the FASB radically

changes these accounting rules to a model that will certainly stifle technology development, impede capital formation and slow job creation in this country, the FASB

should make sure the proposed new method is without question, the absolute, correct solution. In reality, the FASB’s proposed standard does not improve the accounting—it merely changes it. Worse yet, the proposed changes require companies

to use a purchase model that does not work for companies in the New Economy,

where most of the acquisition value cannot be attributed to hard assets, forcing companies to report an arbitrary, artificial net income number that is irrelevant and

misleading.

We believe the FASB should:

(1) Retain the pooling of interests method of accounting. The pooling method of accounting continues to have broad-based support. Two-thirds of the respondents

to the current FASB exposure draft and all of the Big 5 accounting firms disagreed with the FASB’s plan to eliminate pooling accounting.

(2) Revise the purchase method to correct its deficiencies, such as:

(a) Charge purchased goodwill directly to shareholders’ equity, or amortize it

through comprehensive income, or reduce goodwill only when it has actually

declined in value; and

(b) Limit the allocation of purchase price to only those intangibles that can be

objectively and reliably valued;

(1) Engage a task force, which would include valuation experts, to develop adequate

guidance on how to identify, value and account for intangible assets for New

Economy companies.

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Mr. OXLEY. Thank you.

Mr. Bible?

STATEMENT OF PETER R. BIBLE

Mr. BIBLE. It is a pleasure to be with you here today, especially

a fellow Buckeye, Mr. Chairman. In the land of Wolverines and

Spartans, it is kind of lonely up there.

To put my comments in context, Mr. Chairman, I think it is important to understand that the General Motors Corporation is a

participant in both the new and the old economy. Some of our new

ventures, eGM, Trade Exchange, Hughes Electronics, are among

some of the darlings on Wall Street as the high-tech industry.

Those businesses have been built on purchase accounting acquisitions.

Presently there is an exchange offer for $9 billion for GM-1 and

2 shareholders to exchange their one and two-thirds shares for

shares of Hughes. I am not sure how their growth through nonpooling transactions has impeded their value.

Now to my written testimony.

The act of bringing together two or more independent businesses

to function as one business is known by many names on Wall

Street and in the media. For purposes of my testimony here today,

I will use the term ‘‘business combinations’’ to refer to that act.

A business combination can be and often is a very significant financial and cultural event in the life of a business. That financial

significance is the very heart of the topic of your hearings, and that

is the combined income statement of the businesses subsequent to

the business combination.

Why the income statement, you ask? The answer is, that is

where investors and other users of financial statements look to see

if the business combination was accretive, a good thing, or dilutive,

a bad thing, to net income and earnings per share, two of the key

determinants for stock price for many businesses.

Why is this the very heart of the topic of your hearings, you ask?

The answer is, under purchase accounting, the difference between

the amount paid for a business and the historical net book value

of that business’s net assets or equity find its way to the income

statement over time as expenses. This dilutes net income and earnings per share of the combined businesses.

Under the pooling method, however, that difference between the

amount paid for a business and the historical net book value of

that business is never recognized in the financial statements of the

combined businesses; thus, the game. Therefore, at worst, net income of the combined businesses is equal before and after the business combination. Accordingly, a business combination on an economic basis could be and often is dilutive, but that dilution is never

reflected in the income statement of the businesses.

The contrarion to this view would tell you that investors and analysts are not ignorant, and they can see through the differences

between purchase and pooling of interests accounting. This may be

true, but in today’s world of ‘‘you’re as good as your last quarterly

results,’’ memories fade fast.

The Accounting Principles Board in their Opinion 16 recognizes

that there are business combinations that represent a uniting of

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shareholders’ interests, or what is referred to in today’s world as

a merger of equals, that would be best accounted for by combining

the historical financial statements of the combined businesses.

To define this type of business combination, the Accounting Principles Board put in place 12 tests to be passed. Since its issuance

in August 1970, Wall Street and others have been gainfully employed navigating around the 12 tests in AB16.

This has given rise to countless interpretations of the pooling of

interests rules by the Accounting Principles Board, the Financial

Accounting Standards Board, the Emerging Issues Task Force, and

the Securities and Exchange Commission.

Do mergers of equals really exist? Sure, just like Michael Jordan

and Jack Nicklaus exist, but they are rare, and to define them is

close to impossible.

I mentioned earlier in my testimony the cultural significance of

business combinations. Perhaps that is why the term ‘‘merger of

equals’’ is often used in the press to describe an acquisition. I

would be shocked if you do not hear today that the Financial Accounting Standards Board’s Proposed Statement on Business Combinations will bring a plague on high-tech and startup businesses.

You should ask those testifiers on what basis the stock of a hightech or startup business trades: net income or revenue?

Not being in the proposed standard affects the recognition of revenue. If your concern is there, talk to the SEC on their staff accounting bulletin 101.

Historically, many acquisitions have been accounted for using the

pooling of interests method because of the use of stock as the currency. It is often the case that, for tax reasons, stock is a more efficient currency than cash.

In closing, as you will see in my written testimony, there are several provisions of the proposed standard that I do not agree with.

However, I do support the elimination of the pooling of interests

method.

Thank you very much.

[The prepared statement of Peter R. Bible follows:]

PREPARED STATEMENT OF PETER R. BIBLE, CHIEF ACCOUNTING OFFICER, GENERAL

MOTORS CORPORATION

The act of bringing together two or more independent businesses to function as

one business is known by many names on Wall Street and in the media. For purposes of my testimony here today, I will use the term ‘‘business combinations’’ to

refer to that act. A business combination can be, and often is, a very significant financial and cultural event in the life of a business. That financial significance is

at the very heart of the topic of your hearings, and that is the combined income

statement of the businesses subsequent to the business combination. Why the income statement you ask? The answer is: that is where investors and other users

of the financial statements look to see if the business combination was accretive (a

good thing) or dilutive (a bad thing) to net income and earnings per share, which

are two of the key determinants of stock price for many businesses. Why is this at

the very heart of the topic of your hearings, you ask? The answer is: under purchase

accounting, the difference between the amount paid for a business and the historical

net book value of that business’ net assets or equity finds its way to the income

statement over time as expenses. This dilutes the net income and earnings per

share of the combined businesses.

Under the pooling of interests method, however, that difference between the

amount paid for a business and the historical net book value of that business is

never recognized in the financial statements of the combined businesses. Therefore,

at worst, net income of the combined businesses is equal before and after the busiVerDate 11-MAY-2000 13:14 Sep 11, 2000 Jkt 064765 PO 00000 Frm 00094 Fmt 6633 Sfmt 6621 E:\HEARINGS\64765 pfrm01 PsN: 64765
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ness combination. Accordingly, a business combination on an economic basis could

be, and often is, dilutive, but that dilution is never reflected in the income statement. The contrarion to this view would tell you that investors and analysts are not

ignorant and can see through the differences between purchase and pooling of interest accounting. This may be true but, in today’s world of ‘‘you’re as good as your

last quarterly results,’’ memories fade fast. The Accounting Principles Board in their

Opinion No. 16 recognized that there are business combinations that represent a

uniting of shareholders interest, or what is referred to in today’s world as a merger

of equals, that would best be accounted for by combining the historical financial

statements of the combined businesses. To define this type of business combination,

the Accounting Principles Board put in place twelve tests to be passed. Since its

issuance in August 1970, Wall Street and others have been gainfully employed navigating around the twelve tests in Opinion No. 16.

This has given rise to countless interpretations of the pooling of interests rules

by the Accounting Principles Board, the Financial Accounting Standards Board, the

Emerging Issues Task Force, and the Securities and Exchange Commission. Do

mergers of equals exist? Sure they do, just like Michael Jordan and Jack Nicklaus

exist, but they are rare and to define them is close to impossible. I mentioned earlier

in my testimony the cultural significance of business combinations. Perhaps that is

why the term ‘‘merger of equals’’ is used so often in the press to describe an acquisition. I would be shocked if you did not hear today that the Financial Accounting

Standards Board’s Proposed Statement on Business Combinations will bring a

plague on high-tech and start-up businesses. You should ask those testifiers on what

basis the stock of a high-tech or start-up business trades: net income or revenue?

The topic of your hearing has no affect on revenue. Historically, many acquisitions

have been accounted for using the pooling of interest method because of the use of

stock as the currency. It is often the case that, for tax reasons, stock is a more efficient currency than cash.

In closing, as you will see in my written testimony, there are several provisions

of the Proposed Standard that I do not agree with. However, I do support the elimination of the pooling of interests method.

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Mr. OXLEY. Thank you, Mr. Bible.

Mr. Hoffman.

STATEMENT OF GENE HOFFMAN, JR.

Mr. HOFFMAN. Mr. Chairman, thank you very much for holding

the hearing. Thank you very much for inviting me and giving me

the opportunity to speak. I will submit my written testimony for

the record, and speak quickly, hopefully remaining in my time

here, on some of the various topics that are brought up.

First of all, let me tell you what EMusic is and where I came

from and what I do. We have a unique perspective on intangibility,

as we are one of the few companies that actually sells no physical

goods whatsoever. We actually sell downloadable music in the form

of bits over the Internet for 99 cents a song or $8.99 an album.

We also own or operate, or I should say operate,

RollingStone.com, to which we sell advertising and sponsorship

revenues and drive downloadable music sales from the Internet at

that magazine’s Web site.

Because of this, we are uniquely impacted by intangible accounting. Unlike Cisco, which is probably one of the tech leaders, frankly, we do not even ship a box. When we make or made approximately $2.8 million in gross profits last quarter, all of that was directly delivered over the Internet; no physical goods; no pick, pack

and ship; no warehouses. We are always in stock.

It is interesting when we look at these issues, because what we

are really concerned with overall is the handling of intangible accounting. I think my associate from Cisco said it well. My concern

is that the purchase method accounting has yet to really well understand those issues that are fully intangible.

One of the issues I would like to point out specifically is—and before I go too deep in this, I want to say that again, I have a different and unique perspective. I am the son of an accountant, hardVerDate 11-MAY-2000 13:14 Sep 11, 2000 Jkt 064765 PO 00000 Frm 00102 Fmt 6633 Sfmt 6602 E:\HEARINGS\64765 pfrm01 PsN: 64765
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ly an accountant myself, and the youngest NASDAQ CEO, so I look

at this, again, from a very different perspective than many companies in the space.

There seems to be a prevalence of a concern that this is just a

technology company situation. I want to challenge any company to

admit that they are not a technology company. Every single company is a technology company. Even my associate here from General Motors admits to the fact that GM is a technology company,

a very good and successful technology company. Even the auto division strives with Armstrong and other programs to become more of

a service and an intangible asset-based business.

So these are issues for any company that looks at strong growth

and the ability to monetize, the ability to be weighed against their

intangible assets.

I want to make an interesting point and bring the tangible assets

a little bit more home to the everyday American. Twenty years ago

a song was written by Don McLean called American Pie. Well, that

song as an asset. It faded from memory, so in some ways, yes, it

absolutely decreased in value, but with no expenditure by the original songwriter, a small artist we all have heard of once in a while

called Madonna decided to rerelease that song. That intangible

asset, the ownership of the copyright in American Pie, has tremendously increased in value without any expenditure of asset, any expenditure of cash, any expenditure of promotion by the original

copyright owner. That is an important aspect, now, very specific to

my industry, but telling in the same way that this happens in software companies and others.

Brand names and other pieces, part of which—for example, our

own public disclosures are heavily laden with the write-down of

goodwill for the acquisition of Tunes.com, RollingStone, the EMusic

name, the music rights themselves are heavily laden with.

One other important point I want to make, we have heard from

various people who have had quite a bit more accounting experience than I do, but anyone who does a pooling acquisition absolutely shows a cost. When AOL acquired NetScape, there was a

dilutionary cost. It was a direct impact to earnings per share.

This brings me to what I think is the most important issue facing us. I personally do not really concern myself with whether or

not pooling will really be an available and acceptable accounting

method in the future. What concerns me is is it truly transparent

to not have it.

Let me make my point here. Currently when the average mother

and father, a 40-year-old, tries to evaluate my company and other

companies in technology space, and I will use the company

Excitehome, which actually did a purchase method acquisition of

Excite, there are now two different disclosures that are looked at.

There are cash basis pro forma and earnings per share.

For the not-as-sophisticated investor who does not have access to

sell and buy side analysts and equities analysts and all the other

levels of information that your mutual funds and pension funds

have, it is very difficult to understand the difference between pro

forma and actual EPS.

Most people are used to AT&T in the classic sense, where EPS

was the No. 1 way they judged a company. Growth in EPS, actual

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EPS, was how they looked at companies. The elimination of pooling

means a direct double charge in some senses to EPS, both

dilutionary and then the write-down of the goodwill, the acquisition

itself. That is the issue. The issue really is not how we account for

it, it is are we providing the level of disclosure and the level of

transparency to the individual investor.

I am not concerned about California Teachers Pension Fund. I

am quite sure that with the type of assets they bring to bear, they

will be able to easily evaluate my firm and other firms quite like

me to figure out whether or not we are actually performing and

whether or not that merger was actually a good, positive, accretive

merger, or simply a bad mistake and something that should never

have happened before.

What I am concerned with is the person who today bought 1,000

shares at the opening of the market because they thought that

what we were doing was the right thing, and they looked at our

EPS and were concerned, how could they lose this much cash, because your average individual investor does not know the difference between losing cash and losing goodwill, frankly.

That really is the summation of my concerns. As long as we look

at this issue in a careful and slow manner, because this is a very

important change, we are talking about changing 40-some plus

years of generally accepted accounting principles, as long as we

first tackle the issue that has arisen around intangible assets—and

again, I put my company to the table here and say that very few

companies that ever come before you have no tangible assets, period. Even Cisco has inventory, chips and boxes and various pieces

that they are going to sell. I can show you a hard drive. That is

my inventory. Is it the value of the hard drive itself, or is it the

8 percent of the U.S. music market that is represented by the files

included in that which, in the offline world, generated $1.2 billion?

That is an interesting question. As long as we address that question first and then tackle how we do business combinations, I am

comfortable.

But as an entrepreneur, I am not comfortable if there is a significant disincentive for a smaller, but larger than my firm, company

to have a disincentive because of the EPS impact that a buying

company like mine would have to acquiring my company. That is

a disservice to my shareholders, as much as it would be a positive

service to say this is a write-down in my income statement.

Thank you.

[The prepared statement of Gene Hoffman, Jr. follows:]

PREPARED STATEMENT OF GENE HOFFMAN, JR., FOUNDER, PRESIDENT, AND CEO,

EMUSIC.COM, INC.

Introduction.

It is a pleasure to take part in this morning’s hearing on FASB and the important

issue of purchase and pooling accounting. My remarks today will focus on public policy and not accounting technicalities. I am not a CPA. I am an entrepreneur. First,

let me take a few moments to tell you about EMusic. Since it was founded in January 1998, EMusic has established itself at the forefront of how new music will be

discovered, delivered and enjoyed in the next decade. In addition to having the

Internet’s largest catalog of downloadable MP3 music available for purchase,

EMusic operates one of the Web’s most popular families of music-oriented Web

sites—including RollingStone.com, EMusic.com, DownBeatJazz.com, and IUMA. The

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company is based in Redwood City, California, with regional offices in Chicago, Los

Angeles, New York and Nashville.

EMusic.com is the Web’s leading site for sampling and purchasing music in the

MP3 format, which has become the standard in the digital distribution of music.

Through direct relationships with leading artists and exclusive licensing agreements

with over 650 independent record labels, EMusic.com offers music fans an expanding collection of more than 100,000 tracks for purchase—individual tracks for 99

cents each or entire downloadable albums for $8.99. EMusic.com features top artists

in all popular musical genres, such as Alternative (Bush, Kid Rock, They Might Be

Giants, Frank Black), Punk (Blink-182, The Offspring, Pennywise), Jazz (Duke

Ellington, Dizzy Gillespie, Louis Armstrong, Concord Records), Blues (John Lee

Hooker, B.B. King, Buddy Guy), Hip Hop (Kool Keith, The Coup), Country (Willie

Nelson, Merle Haggard, Patsy Cline), Rock (Phish, Goo Goo Dolls, David Crosby),

World (Nusrat Fateh Ali Kahn, Lee ‘‘Scratch’’ Perry) and Vintage Pop (Liza

Minnelli, Eartha Kitt, Judy Garland).

To give you an idea of how fast the downloadable music industry is growing, the

company has now sold over 1 million songs in the popular MP3 format since its

launch. This total includes single-track sales as well as tracks included as part of

albums and special collections. In addition, EMusic.com’s catalog has grown to offer

more than 100,000 high-quality MP3s for sale from over 650 independent labels.

I am the youngest CEO in NASDAQ. I am twenty-four years old. I am one of

those freaks of nature in the high tech world—but in a very good sense. I am very

proud of the fact that I have taken ideas and created companies with my friends

and with many new people that I have been fortunate to meet along my journey.

EMusic is my third company. My first, PrivNet, I created while in college. I sold

it to PGP, Inc., and went to work for PGP. PGP was sold in 1997 to Network Associates. While at EMusic I have bought four companies. Creating companies, jobs, economic wealth—all depend on sound accounting principles supported by well thought

out public policy. EMusic is a young company that has grown by acquisition. So far

EMusic has done purchase transactions because we are not poolable. But I will come

back to that point shortly.

It is important to understand that EMusic represents significant intangible assets. Many companies in the New Economy do not nor will not have any physical

assets. Their value is either between the ears of their employees or on the hard

drives of their computers and networks. EMusic digitally delivers music to consumers. Our only physical asset is a farm of computer servers; but frankly, I prefer

to outsource that to a vendor who really knows that business better than I do and

can do it for me more cheaply than I can on my own. So far my earnings are not

too significant; they are increasing however. I am in a loss basis. I can tell you that

my intangible losses are much more significant than my cash base losses because

I do write down a lot of intangibles.

Purchase vs. Pooling

I don’t think good public policy here should make this an either or discussion.

There are problems with both purchase and pooling accounting. At the high level

the overall process has flaws. FASB needs to fix purchase accounting first before

it can go after pooling. There is a large problem in the high tech community: the

growing disparity between book value and market value. FASB has yet to effectively

engage the high tech community on this issue. I have testified to FASB on this issue

and invite them here today before this Committee to meet with me at my offices

in Silicon Valley to continue the conversation after this hearing is over. We really

need a better method for measuring intangibles. As more economic wealth moves

into intangibles, the accounting methods and their supporting public policy have to

keep up. By not fixing purchase accounting and by eliminating pooling accounting

FASB only makes matters worse for the New Economy. Moreover, there will be no

improvement in the flow of information about companies out to the markets and investors. As we all know the past few years have enabled more Americans to directly

invest in the stock market and individual companies. Many Americans do so via the

Internet; many have stock from their employers; many have their retirements and

investments in stocks and mutual funds. Transparency and the flow of information

are critical to the success of democracy; the same is true in an increasingly democratic, egalitarian and participatory stock market.

The Entrepreneur’s Dilemma: An Example.

As an entrepreneur I have two options to perform a transaction. I can utilize purchase accounting method and I have to take an EPS impact in the future, or I can

do pooling, which obviously has positive benefits for myself as a high tech company

and an intangible asset company. Those companies who have built their intangible

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assets from ground zero don’t have that hit against their earnings, frankly, because

those intangible assets have never been valued. But when I buy a company that has

valued its intellectual property assets (i.e., its intangible assets), that value is

against my doing business. Simply put, the valuation process is not black and white.

A company can see the value of its assets increase without doing anything. For example, an artist such as Madonna can perform an old song and increase its value

even though the song is owned by a company unrelated to Madonna and her record

label. The problem is that valuation is confusing, and if it is confusing to companies

in the business who know or should know as much as there is to know about valuing intangibles, then where does this leave the individual investor and institutional investors? One of my biggest concerns here is how intangible assets are valued because I am not sure that the public really knows what stated assets are really

worth or are not worth. Institutional investors may be able to get down into the details and ascertain from their own perspective what value may be but the average

Josephine is not likely to decipher what is and what is not included in a company’s

pro forma presentation of earnings before they make their personal investment. Notwithstanding the great amount of information available to individual investors via

the Internet the average individual investor simply does not have access to the analysts that companies and institutions do.

This touches upon an even larger public policy issue. And this issue underscores

why it is so important for the Congress to increase its scrutiny of FASB and how

it changes the accounting rules. This larger public policy issue is a matter of who

gets the information, in what form and when. Individuals may not get all the information at all, in a useable form, or at the last moment after others have seen it

and made their move in the market. This is an increasing market inefficiency given

the expanding amount of capital flowing into the market from individuals and the

growth of margin debt.

Conclusion.

When so much of the value of the American economy is tied up in intangibles,

in intellectual property, how the pieces of intellectual property are perceived is really the driver of value and not the methodology of some accounting practice or rule.

If the market is being driven more by perception than by the principles and rules

that government, industry and professionals have set out, then effective governance

no longer works and the anarchy of the market has taken over. This is not fair to

individuals and is not reflective of our nation’s democratic values. Intellectual property is an extremely important part of our nation’s export economy. Jack Valenti

of the Motion Picture Association of America (MPAA) and others have testified to

Congress that movies and other content products have contributed to America’s economic bottom line. Whether it is Hollywood in southern California or Silicon Valley

in northern California, ideas and intellectual property are drivers of our nation’s

economic growth and international economic influence. Valuation of intangibles like

intellectual property must be grounded on sound public policy and democratic values. In closing, I want to leave a clear impression with you. The current process is

flawed and FASB needs to fix purchase accounting first before they should do anything with regard to pooling or other rules. The big problem for high tech companies

is the fact that current purchase rules do not provide investors with better or more

useful information. The high tech community has been engaged on this issue

through organizations such as TechNet but to date the feed back from FASB has

been less than satisfactory. While I am not in favor of any new governmental role

here or in any new body charged with setting accounting standards, we do need to

work together in a new way to develop a better method for measuring intangibles

such as intellectual property. FASB’s proposal to require all companies to use purchase accounting will only make these issues worse and will not improve the flow

of information to investors, especially the individual. I am pleased that Congress is

exercising its proper oversight over the FASB process on this important economic

issue and look forward to working with the Congress in the future on this issue.

Mr. OXLEY. Thank you, Mr. Hoffman.

Mr. Lewis?

STATEMENT OF WILLIAM FREDERICK LEWIS

Mr. LEWIS. Mr. Chairman and members of the committee, my

name is Bill Lewis. I come to you today as president and chief executive officer of Prospect Technologies, an advanced computer technology and international Web-based firm providing numerous comVerDate 11-MAY-2000 13:14 Sep 11, 2000 Jkt 064765 PO 00000 Frm 00106 Fmt 6633 Sfmt 6602 E:\HEARINGS\64765 pfrm01 PsN: 64765
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puter solutions to governments, associations, and commercial firms.

I also appear today as a member of the United States Chamber of

Commerce Small Business Council.

Mr. Chairman, I appreciate this opportunity to comment on the

FASB’s proposal, and I commend you for holding these hearings. I

also ask that my full written testimony be included in the record.

Mr. OXLEY. Without objection, all statements will be made part

of the record.

Mr. LEWIS. Thank you, sir.

When firms combine, there are two long-standing accounting

methods for combining financial statements, the pooling method

and the purchase method. Historically each has worked reasonably

well and has given firms the opportunity to accurately reflect to

their shareholders their balance sheet and income statements.

I believe that FASB’s proposal to eliminate the pooling method

is unjustified. Remember, again, with the pooling method the balance sheets of each partner in the merger is simply added together.

Furthermore, its adoption may have a dramatic negative impact on

our economy.

I strongly disagree with FASB’s assertion that all of business

combinations should be accounted for as purchases rather than

mergers. This fact ignores the reality that business combinations

may vary substantially as to the traits of the combining entities

and aspects of the combining transactions. Clearly many of today’s

combinations do not meet FASB’s assertion that one firm necessarily gains control over the other.

Furthermore, forced use of purchase accounting, with its creation

and amortization of goodwill, can result in misleading financial

statements. Often the benefit, the very synergy of combining two

companies, continues and grows over time, rather than depreciating.

I can speak extensively to this point as 2 years ago Prospect

Technologies merged with a computer hardware manufacturing

service support firm. Once this marriage, marriage of our two

firms, occurred, Prospect Technologies, now formed from two firms,

was able to enter into markets which heretofore it was impossible

for either company to enter and penetrate by themselves.

To arbitrarily force the financial statements to reflect a write-off

of goodwill, an item which can significantly distort an Internet or

.com, if you will, firm, distorts financial information, giving misleading indications of the combined firms’ profitability. It understates the firm’s bottom line, which in turn would hamper a firm’s

ability to attract outside capital, go public, or, in more simple

terms, grow and make jobs.

With this ruling, as CEO of Prospect Technologies, I would look

very carefully at merging with another firm to expand our growth,

form new jobs, and help fuel the American economy.

One FASB rationale for eliminating pooling is to reduce the

SEC’s staff time devoted to mergers and acquisitions using this

method. Another is to harmonize or force convergence of our accounting standards with international conventions.

Staffing constraints should not force the rejection of a useful and

workable accounting approach, nor should the international ‘‘standVerDate 11-MAY-2000 13:14 Sep 11, 2000 Jkt 064765 PO 00000 Frm 00107 Fmt 6633 Sfmt 6602 E:\HEARINGS\64765 pfrm01 PsN: 64765
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ards’’ for which universal consensus is lacking be a motivating or

driving force on this.

Mr. Chairman, it is my opinion that over the past several years

United States technology and information-based firms have been

the preponderance of buyers of firms. It appears that the world

looks to us in terms of getting accurate or reasonable pictures in

terms of what the accurate portrayal of a financial statement is,

not vice versa.

I am not asking Congress today to adopt accounting standards or

even to establish an official oversight board over Mr. Jenkins and

his fine work that he has done at FASB, but rather to encourage

FASB to rethink this rush to judgment. There are no egregious

market failures driving this proposal for change. However, as

pointed out by many on this panel, including my colleague Mr.

Hoffman, there are legitimate concerns over the proper accounting

for intangibles or goodwill especially prevalent in the high-tech

Internet, the .com companies.

To ameliorate this situation, various groups and commissions

have been delegated to examine this issue. I believe you will find

under way studies currently done by the Brookings Institute and

another one done by a graduate school of business. Clearly, as the

owner of a high-tech Internet company creating jobs and fueling

this economy, I ask you not to take action until these study groups

have come back—these study groups I mentioned before have come

back and helped us understand the nature of this problem by shedding light on the wide disparity that has been pointed out by Mr.

Powell in his testimony here as well as in the Senate between what

the market value of the firms are and what the book value is.

As a small business owner, I believe we have time to wait and

evaluate. Prudence dictates that this is the action we should so

take.

Mr. Chairman, thank you very much for having me here today.

[The prepared statement of William Frederick Lewis follows:]

PREPARED STATEMENT OF WM. FREDERICK LEWIS, PRESIDENT AND CHIEF EXECUTIVE

OFFICER, PROSPECT TECHNOLOGIES, ON BEHALF OF THE U.S. CHAMBER OF COMMERCE

Mr. Chairman and members of the committee, I am Bill Lewis, President and

Chief Executive Officer of Prospect Technologies a small business headquartered in

the District of Columbia. Our firm employs 23 individuals dedicated to providing information solutions for corporations and government agencies both here in the

United States and internationally. Our business includes computer hardware manufacturing, computer software, and Internet and Web based solutions. I also come before you as a member of the U.S. Chamber of Commerce’s Small Business Council.

Working with organizations like the U.S. Coast Guard, the Federal Maritime

Commission, the Department of Defense, Princeton University, Enterprise Rent-aCar, the Government of the District of Columbia and McGraw Hill, we provide solutions that help to dramatically improve business processes through the use of technology and the Internet. Our work has received a great deal of recognition including

winning Vice President Gore’s Golden Hammer Award for streamlining government,

cutting through red-tape, and improving the quality of customer satisfaction that is

delivered by the Federal Government. This year we have been nominated again for

this prestigious award by the Federal Maritime Commission for automating all of

the FMC’s service contracts and amendments filings via the Internet and the Web.

Mr. Chairman, we appreciate the opportunity to testify on the issue of accounting

for business combinations, in particular the question of whether the pooling-of-interests method of accounting should be eliminated. We commend you for holding these

hearings.

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We oppose the decision of FASB to prohibit the use of the ‘‘pooling-of-interest

method of accounting’’ for all business combinations and to force the use of the ‘‘purchase method’’ with the subsequent amortization of goodwill over, at most, a twentyyear period. Not only will changes in this longstanding practice and the adoption

of new standards not further the goals of providing more accurate, transparent and

reliable financial statements, but they also may well have a substantial negative impact both on the economy’s and my company’s ability to grow.

Prospect Technologies

I am the CEO of a thriving private company, Prospect Technologies, and I am

looking for opportunities to expand my business. Two years ago I merged with PC’s

& Systems, Inc., a computer hardware manufacturing and services company. The

transaction was reported using the pooling-of-interests of both companies and combination of our two historical balance sheets. However, in spite of Prospect Technologies recording this on its balance sheet as a simple sum of the assets of the two

firms, the result of the merger created a synergy that allowed us to bid and win

contracts that would not have been possible by either of the two previous companies

individually.

Due to the positive results that the recent merger has had on the growth of my

business, I am looking to combine with other businesses in the near future, especially with other Internet firms—‘‘dot com’’ related businesses—whose assets may

be largely made up of ‘‘goodwill.’’ If I am required to use the purchase method of

accounting, with its adverse effects on reported earnings, I may have second

thoughts. If the combination results in a company that is required to amortize a

large amount of goodwill, then the emerging enterprise will have a diminished capacity to access capital. For a growing company that reinvests most of its cash flow

into its future revenue, even the smallest variance in its apparent profitability could

have a major impact in capital formation. Moreover, if in the future, I were to decide

to ‘‘go public,’’ artificial reductions of net income due to the use of purchase accounting could make such an offering less appealing.

Pooling-of-interests vs. Purchase Accounting

When firms combine, there are two alternative methods for computing and reporting for financial statement purposes the combined entity: the pooling-of-interest

method and the purchase accounting method. Each combination is evaluated according to a 12-factor test. Those combinations that meet all 12 factors must use the

pooling-of-interest method, whereas those failing any of the 12 factors must use the

purchase accounting method.

Under the pooling method, the balance sheets of each partner in the merger are

simply added together. The new entity reports the combined historical book value.

Under purchase accounting, one firm must be designated the acquirer and the other

the acquiree. The acquired firm’s identifiable assets are valued at current fair market value, and the difference between the fair market value of those assets and the

purchase price is recorded as an intangible asset—goodwill. The financial statement

of the combined entity is reported as the combination of the acquiring firm’s historical book value and the acquired firm’s fair market value plus the goodwill. Thereafter, over the years, the goodwill must be ‘‘written-off’’ or charged against reported

income. As a result, under purchase accounting, there is a subsequent drag on reported earnings. The magnitude of this drag will depend upon the proportion of intangible assets in the acquired firm and the length of the amortization period—currently 40 years, but shortened to 20 under FASB’s proposal.

The pooling-of-interest method of accounting is a generally-accepted method that

has been in use for a long time. It is not, as some recent press accounts have alluded, an artificially advantageous method designed to bolster financial statements

so that its proponents can boost stock prices or attract outside financing. If all of

the 12 requisites are present to permit its use, pooling-of-interests requires the combining companies to add the historical book values of assets, liabilities and shareholder equity, and presents them on integrated financial statements. If one or more

factors are not met, then use of purchase accounting is required. In fact, because

of its restrictive nature, this pooling method can have a potential downside. For instance, if a company that recently engaged in a pooling-of-interest transaction found

its stock price artificially depressed and good business sense indicated a repurchase

of its shares on the market, it would be prohibited from making that repurchase.

Use of the purchase method of accounting is not without its problems, too. The

calculation and reporting of intangible assets and goodwill is dependent upon subjective and speculative ‘‘measurement.’’ The accounting profession continues to grapple with how to properly value intangible assets and goodwill, and, as of yet, there

are no clear-cut solutions.

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Technical Issues

FASB’s decision to eliminate the pooling-of-interest method and to shorten the allowable amortization period of goodwill to 20 years is based on two assertions: first,

that all business combinations are equivalent to a purchase where one firm acquires

another and gains control; and second, that all goodwill and other intangible assets

degenerate over time. We disagree on both counts.

Clearly, many of today’s combinations do not meet FASB’s assertion that one firm

gains control. For example, when the new entity has a combined board of directors,

management and staff, no clear-cut control is established. In such cases, the exposure draft states that one firm will be designated the acquirer based on the ‘‘evidence available’’ without stating what that evidence is or how it should be weighted

in the decision process. We do not believe that disallowing a longstanding accounting method that addresses such an ambiguity without prejudice against either partner, and substituting a methodology that may ultimately rely on an arbitrary decision, is an improvement. When a market activity does not fit an accounting model,

arbitrarily forcing it rarely achieves the desired result.

We also disagree with FASB’s assertion that purchase accounting, with its creation and amortization of goodwill, will result in more accurate or more reliable financial statements. While some intangible assets are definable, measurable, and

have discernable lives, many do not. For example, the same exclusive shopping mall

part of a nationally-recognized web site would have a very different value then one

as part of a simple family Web site created by any one of you or your children. Its

value—and concomitant ‘‘goodwill’’—would be determined by ‘‘on what Web site it

was located.’’

Furthermore, it is hard to see how the purchase accounting convention—which

lumps intangible assets that are unidentifiable or identifiable but not measurable

into an amorphous category called goodwill that is immediately assumed to depreciate in value—provides more accuracy. The excess of the purchase price over the

fair market value of the identifiable assets, i.e., the goodwill, is the result of a complex interaction. In past times, it was interpreted as the premium paid for the value

of the ‘‘ongoing’’ concern—the brand name and the customer and community relationships. While these factors are still part of goodwill today, intangible assets in

the new economy are much broader and more pervasive. Education, management

style, and entrepreneurial spirit can easily represent the bulk of assets in today’s

information technology-driven firms. Whereas, goodwill in the old economy may

have been a depreciating asset, goodwill in the new economy may not be. The

synergies achieved by modern combinations create intangible assets that are designed to appreciate in value. That is why the free market values them so highly.

Plus, I have seen this first hand when I merged my firm Prospect Technologies with

another firm two years ago.

While purchase accounting may have been useful for acquisitions of firms with a

large percentage of physical assets, it is inadequate for combinations of firms composed primarily of intangible assets, especially when those intangible assets are

largely unidentifiable, immeasurable and of indeterminate lives. It is hard to see

how combining the historical book values of an arbitrarily designated acquiring firm

with the estimated market value of an arbitrarily designated acquired firm and

some dubious measure of goodwill yields a more reliable financial statement than

a combination of book values, especially if the combined entity engages in successive

combinations. Moreover, resorting to the approach of forcing a ‘‘write-off’’ of an intangible asset merely because accountants cannot understand or quantify it, is unacceptable.

A better course of action might be to examine the issues surrounding the accounting of intangible assets and goodwill, and to develop suitable methods for addressing

this problem before prohibiting a longstanding and well-understood accounting

method. We urge FASB to adopt this more cautious approach.

General Policy Considerations

In addition to the previously discussed technical objections, we believe that the

proposed action by FASB has broad economic ramifications as well. We understand

that FASB should, indeed must, be concerned primarily with the ‘‘relevance’’ and

‘‘reliability’’ of financial information, and not the economic consequences. However,

the Exposure Draft states two reasons for undertaking this project, neither of which

are relevance and reliability concerns. One concern was the increasing amount of

staff time at both the SEC and FASB being devoted to mergers and acquisitions

using the pooling-of-interest method. The other concern was a desire to achieve

international convergence of accounting standards given the increase in international capital flows. We believe proposals to change accounting standards underVerDate 11-MAY-2000 13:14 Sep 11, 2000 Jkt 064765 PO 00000 Frm 00110 Fmt 6633 Sfmt 6621 E:\HEARINGS\64765 pfrm01 PsN: 64765
107

taken for staffing and/or international policy considerations ought to also include domestic economic considerations in the evaluation process.

The fact that SEC staff are being asked to devote more time to business combinations using the pooling method is as much an indication of the increased importance

of the high technology sector in today’s new economy, as it is an indication of excessive use of what some might call a ‘‘loophole.’’ Today’s high technology firms are

composed primarily of intangible assets. They are in many cases relatively cash poor

and, as such, are not in a position to buy other firms. They do, however, wish to

create synergistic value through business combinations, and the financial markets

have voted their approval. While we share FASB’s belief that accounting standards

must remain credible and reliable, the current method is well established and widely understood and, in our view, clearly meets that standard. Staffing constraints

should not be sufficient cause for changing a useful and workable approach.

We find FASB’s other rationale equally non-compelling. There is no plan currently

in place to achieve convergence of accounting standards for business combinations.

Some countries allow the pooling method, some do not, and others allow it in fairly

restrictive circumstances. If we want to adjust our standards on the basis of achieving convergence of international policy, then we should have assurances from the

other countries of a similar commitment in advance, and the decision process to

adopt such changes should include domestic economic consequences.

The technology and financial services sectors have played a crucial role in our current position as a world leader. One reason for the success of these sectors has been

their ability to grow. We do not believe that this opportunity for economic growth

should be curtailed because of staffing constraints or the desire to adjust our standards to conform to our international competitors, especially when there is no consensus abroad. We should not change our standards without more compelling reasons.

Prospect Technologies and the U.S. Chamber of Commerce urge FASB to reconsider its position and withdraw its exposure draft on this issue until the issues surrounding the proper accounting of intangibles has been vetted and all concerned

parties have had the opportunity to digest the findings. The issues at stake are of

great concern to our members and to all who want to encourage the continued economic growth we are currently enjoying.

In conclusion, I would like to add that we are not asking Congress to adopt accounting standards or to establish an official oversight role, but rather to encourage

FASB to rethink this rush to judgment. While having its faults, the current accounting framework has worked well. There are no egregious or exigent market failures

driving this proposal for change. There are legitimate concerns over the proper accounting for intangibles and various groups and commissions have been delegated

to examine this issue.

Clearly, let us not take action until these groups help us by shedding light on this

growing problem. As a small business owner, I believe we have time to wait and

evaluate. Prudence dictates that we do so. Thank you.

Mr. OXLEY. Thank you, Mr. Lewis.

Thanks to all of our panel.

The Chair recognizes himself for 5 minutes for questions.

Now I know why I avoided an accounting class, which is literally

right across the street from my fraternity house. But I am reminded of our good friend, Dick Armey, the Majority Leader, who

was introduced recently and said that he was an economist. His

mother wanted him to be an accountant, and he didn’t have the

personality.

Anyway, this has actually been an interesting debate. Let me

begin with just a general question to our panelists, and I will go

the other way this time and end with Mr. Jenkins.

This is a general question. How would the elimination of pooling

accounting make financial statements more or less accurate for investors and creditors under those circumstances? Mr. Lewis?

Mr. LEWIS. As I understand it, one of the issues, and I will just

point to one right off the bat, is the amortization of the goodwill

issue.

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We have heard today and we understand that merging and synergy is one of the reasons why companies come together and merge.

That is considered to be a depreciable asset.

I can tell you from personal experience when I did a merger, or

a marriage as I rather call it, it was not for a depreciable asset,

it was for increased asset. Yet, by FASB rules, I would have to take

that as a depreciation expense against my balance sheet, not over

40 years, but over now 20 years. That could significantly reduce

my—artificially significantly reduce my income statement to my

stakeholders and stockholders in my firm. That is one of the issues

right off the bat.

Mr. OXLEY. So that was less accurate.

Mr. LEWIS. Yes.

Mr. HOFFMAN. To answer that directly, less accurate.

One other consideration that factors into the consideration, generally when we are talking about intangible assets, the only really

fair way to value this is based on the market. That value is based

on comparables.

An interesting presentation I have seen by others, I will try to

briefly describe the concept, if you have three companies, one of

which decides to do two complimentary technologies, both in-house

and build them from scratch, then one company does part of that

technology, and the third does the other part. Two and three

merge. Comparability is lost, especially on an EPS basis and a balance sheet basis, even though, frankly, the actual success of the

business is about the same. So basically, now, you are forced to

look only pro forma, which is a different number than what is reported publicly in the SEC filings.

So basically now you are relying on, frankly, Wall Street sell side

analysts and the PR machines of these individual companies to

state what the reality of their competitiveness is on a comparable

basis. That is a concern because sophisticated investors have no

real issue being able to ascertain the difference there. The unsophisticated investor, which, frankly, I think is the SEC’s larger

mandate, is the one who has a difficult time seeing the difference.

Mr. OXLEY. Thank you.

Mr. Bible?

Mr. BIBLE . Mr. Chairman, I can make it more accurate. There

is an accounting fiction out there. That is, equity has no cost to it.

The reality is cash and stock of a company both represent the currency.

The accounting fiction is if I use stock, I don’t have to account

for the economics of that transaction, and the example the gentleman brought up over here is a perfect example.

Mr. OXLEY. Thank you.

Mr. Powell?

Mr. POWELL. Mr. Chairman, I think that elimination of pooling

would make the financial statements less accurate. The reason is

that it forces companies to go through a pooling method that is not

equipped to deal with intangible assets, which represents 90 to 95

percent of the purchase price of acquisitions today. It assumes that

they depreciate over time, and, in fact, that is not the case. As I

mentioned in my case, if a good acquisition, it increases, it does not

decrease. Therefore, the earnings per share number that would be

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reflected in purchase transactions would be inaccurately reflected

in the financial statements.

Investors would make bad decisions as result of that, and companies would make decisions about whether they should make that

investment based on whether they could afford the hit to their

earnings that was a fictitious hit.

Mr. OXLEY. Mr. Jenkins?

Mr. JENKINS. Clearly, I believe they would be more accurate and

comparable, Mr. Chairman, because all companies would account

for acquisitions in the same manner. All companies would account

for acquisitions based on the value of the currency that they use,

whether it is stock or cash or a combination of the two.

If I could quote really from a study made by an investor, Credit

Suisse First Boston, with respect to bank acquisitions that were accounted for as pooling of interests, Credit Suisse First Boston recalculated each bank’s cash return on tangible equity as if it had used

the purchase method of accounting rather than the pooling method

of accounting.

Bank One, for example, in its acquisition of First Chicago, the

1998 return on equity went from 27 to 12 percent. At First Union

it fell from 35 percent to 11.8 percent. BankAmerica’s return fell

from 29 percent to about 10.8 percent.

The premium paid for these acquisitions ranged from 18 percent

to 43 percent over the market value of those acquisitions at the

time. Without reflecting the acquisition price paid, investors lose

track of how much of their wealth, how much of their dilution was

involved in these acquisitions, and they never can find it out again.

Mr. OXLEY. Your statement is that those were bad acquisitions?

Mr. JENKINS. No, not at all. They may not have been bad acquisitions, but their subsequent performance with respect to those acquisitions, their rate of return, rather than reflecting 27 percent,

really should have reflected 12 percent. The 12 percent return may

have been an appropriate and a profitable return. It may have been

a very good acquisition.

I am certainly not saying, for example, the example that we use

mostly around here, the AOL-NetScape acquisition was a bad acquisition. All I am suggesting is that the investors needed to have

the information with respect to the excess of the purchase price

over the underlying value, underlying amounts that were, in fact,

recorded under pooling accounting.

Mr. OXLEY. Aren’t you in essence looking in your rear-view mirror at this?

Mr. JENKINS. All investors need to evaluate subsequent performance against the investment made.

Mr. OXLEY. I thought that is what markets were all about, that

people made those decisions in the marketplace based on their broker’s advice, based on the particular company that was advising

them.

Mr. JENKINS. The markets do, in fact, make those decisions, but

they make them on information, on transparent information. They

cannot make it if they have no information.

Financial statements, financial presentations have been widely

acknowledged as being perhaps the single most important area of

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information in assessing and keeping strong our capital markets

and providing a level playing field between investors and sellers.

Mr. OXLEY. Our time has expired.

I recognize the gentleman from Michigan, the ranking member

of the full committee, Mr. Dingell.

Mr. DINGELL. Thank you, Mr. Chairman.

Gentlemen, is there anybody down there at the committee table

who would take issue with the fact that the purpose of accounting

is to get the truth so that the government regulatory process and

investors and the market may function efficiently and correctly according to the law? You all agree with that?

Let us take the gentleman, the second from your left, if you

please. I would like you to focus your attention, if you please, on

this question.

Two firms merge. They have the choice of using pooling, or they

have the purchase accounting for the acquisition. Are the results

going to be exactly the same in terms of their reports and the accounting on that particular acquisition?

Mr. HOFFMAN. The reports as reported——

Mr. DINGELL. The answer is, there will be a difference between

the two methods of accounting; will there not?

Mr. HOFFMAN. There will be a difference in what is reported, yes.

Mr. DINGELL. Let’s take a look. One is going to say one thing

under one method, the other—the other method will give you a different result. The two results are different. Which will be the true

result?

Mr. HOFFMAN. The problem is that that is not something that is

easy to say. I don’t necessarily say one result is better than the

other. What my biggest concern——

Mr. DINGELL. You have two statements, one of which says one

thing, one of which says another. Neither of them agree with the

other. You have two different results. Only one of two differing results may be true. Which of the two results will be true?

Mr. HOFFMAN. That is an awful assumption that one is actually

accurate at all.

Mr. DINGELL. I am making the rather generous assumption that

one is correct and one is not. It may well be that both are incorrect.

Mr. HOFFMAN. I think that is partially what the concern is here,

sir.

Mr. DINGELL. We now, Mr. Bible, have ourselves in a situation

where we have—Mr. Bible, would you give us the answer, your

view on that?

Mr. BIBLE. On the question you rose with Mr. Hoffman?

Mr. DINGELL. You have two statements coming in with different

results. One may be true. If it is, the other is not. Which is true,

using the——

Mr. HOFFMAN. What I am trying to say, I would tell you that is

too hard to answer in all cases. The reality is that the balance in

different kinds of transactions is rather complex.

Mr. DINGELL. Mr. Bible, what is your comment?

Mr. BIBLE. The statement that reflects purchase accounting

would be the most accurate. Whether you use cash or stock to do

the acquisitions should not make a difference.

Mr. DINGELL. The gentleman on the end?

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Mr. LEWIS. Mr. Dingell, you, like several in the room, are not a

CPA but do have a legal education.

Mr. DINGELL. I also know how to find truth.

Mr. LEWIS. That is what we are all trying to do, sir. One of the

things my attorney says to me is, it all depends. I believe that is

what we are saying today.

Mr. DINGELL. I am like Harry Truman. I am still looking for a

one-handed economist, because I know I am going to get the truth.

Mr. POWELL. Could I answer that question, Congressman?

Mr. DINGELL. Quickly, Mr. Powell.

Mr. POWELL. I want to back up and say, first of all, you don’t

have a choice as to which method of accounting you use. There are

rules which determine whether you have to use pooling or——

Mr. DINGELL. I am not quarrelling with that. Which am I going

to believe? My problem in a nutshell here is a very difficult one.

I don’t mean to be discourteous to any of you, but there is a vote

on the floor, and our time is limited.

We have two different results. Let us say that a major U.S. hightech company buys another high-tech company. The investors out

there are going to see that if the high-tech acquired uses purchase

or uses the other system, they are going to have two different results.

So then the result—the result of that acquisition is acquired by

a third high-tech company. The question is, who is going to believe

and how will they believe the resulting accounting? You have now

got accounting which can be different, depending on the kind of accounting system used and the assumptions made. How is an investor going to understand what the facts might be, and how is the

market going to properly evaluate the result of that succession of

three or rather two acquisitions?

Mr. HOFFMAN. Mr. Dingell, the answer is, the truth is, what is

the cash situation? The reality is that most of these companies that

we are talking about, as they get more and more layered, and various goodwill charges, and have amortization situations, we start

talking about other things.

The question is, are you continuing to generate more cash? Are

you continuing to grow your ability to generate cash without spending significant assets?

Mr. DINGELL. Some, however, you would note, are, in the language of what I learned back in law school, committing daily acts

of bankruptcy by preferring one creditor over another, making payments when they are incapable of addressing all of their debts.

I am no advocate of any particular view, but you gentlemen are

here before us as a learned panel to advise us as to what the system of accounting should be. I don’t have any views on this, but

I don’t think that we are here in a position where you are able to

tell us that the accounting system that you are suggesting or not

suggesting is going to arrive at the kind of truth that we need to

have a workable, transparent, intelligent marketplace.

The problem that you confront is you are going to get differing

results, results which may or may not be believable. But remember, I remind you, the accounting system is to produce truthful results so that the company’s management can understand what the

hell is going on in the company.

112

The Japanese did not do it, and as a result they have had a continuing period of depression there that has gone on for about 10

years. Other countries have the same situation where, quite frankly, their accounting system lies most diligently to all and sundry.

All I am trying to do is to have you tell me what is an accounting

system which would tell us the truth, which will enable us to do

business? You are here as a strong proponent of one system. I am

asking you to tell me, if you please, what is that one system that

is going to give me the truth?

Mr. OXLEY. The Chairman would inform the members that we

have about 3 minutes left on the vote.

Mr. DINGELL. I apologize, Mr. Chairman.

Can Mr. Jenkins just give us a quick answer, and we will hear

what he has to say?

Mr. OXLEY. Briefly, please.

Mr. JENKINS. I believe there is one method that gives you the

truth.

Mr. DINGELL. What is that?

Mr. JENKINS. That is the purchase method of accounting, I believe, not the pooling of interests method of accounting, for the reasons that I explained in response to Chairman Oxley’s question,

that we need to reflect in the financial statements for the benefit

of investors, the consumers of that information, the price paid for

an acquisition, whether that price be denominated in the currency

called common stock or denominated in cash. That gives the truth.

Mr. OXLEY. The gentleman’s time has expired.

The Chair notes there is a vote on the floor. There may be another one subsequent. The Chair would have the subcommittee in

recess until 1 o’clock to give everybody the opportunity to get something to eat for lunch, and then we will return at 1.

[Whereupon at 12:07 p.m., the hearing recessed to reconvene at

1 p.m., the same day.]

Mr. OXLEY. The subcommittee will reconvene.

Staff informed me a couple of our guests have to leave by 2:15,

is that correct?

Mr. HOFFMAN. Yes.

Mr. OXLEY. We will do our best. We understand if you have to

parachute out of here.

I recognize now the gentleman from Iowa, Dr. Ganske.

Mr. GANSKE. Thank you, Mr. Chairman.

I thank our guests for being patient. This is the way it is when

we have votes. We go back and forth. We have to interrupt these

hearings.

Mr. Jenkins, in one of the addenda to your testimony, you have

quotes from various people in support of the change. I notice that

Warren Buffet is quoted, and he said, ‘‘In essence, there are some

areas that I disagree with this proposed change, but in general I

firmly believe that this nongovernmental organization ought to be

the one doing this.’’

First of all, what were Mr. Buffet’s objections?

Mr. JENKINS. Let me paraphrase what I believe he said.

First of all, I believe he said that we should have one method of

accounting for business combinations, and it should be the purchase method. Where he has some objections then deals with the

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area of accounting for goodwill, and goodwill that arises in a purchase business combination.

Whereas our current proposal requires that goodwill be amortized over a period of not longer 20 years, Mr. Buffet would suggest

that it not be amortized at all but, rather, tested for impairment.

If the goodwill is concluded to have lost some or all of its value,

then a write-down should take place at that point in time.

The difference that Mr. Buffet has with our current proposal is

completely focused on the question of amortization of goodwill.

Mr. GANSKE. Is there merit in his argument? Is there is that

something you are looking at in terms of changing?

Mr. JENKINS. It is something we are looking at. There are a variety of ways that you could address the goodwill question, and certainly I believe at this point in this project, in these redeliberations, and based in particular on what we have heard here and in

our own hearings that we held, that the focal point of the issue is

on goodwill and how it should be treated once it is recognized

under a purchase business combination.

We have already allocated the majority of the time that we expect to spend redeliberating this issue on that very question. The

issue of not amortizing goodwill at all but testing it only for impairment is an approach that we will consider carefully.

There are a variety of other approaches, too. One might say not

limit it to 20 years but leave it to the judgment of management and

the auditors. That is an approach. Another approach is to recognize

it but write it off immediately someplace or another.

There are 4 or 5 different approaches. We are going to be carefully considering all of those and balancing them against the proposal that we made initially in our exposure draft. But we have

reached no final conclusions. We really have not begun our redeliberations in this what I believe is the key focal point of this discussion at this point in time.

Mr. GANSKE. Okay.

Let me see if we can get agreement on this panel. Does anyone

on this panel think that Congress should get involved in writing

the regulation of this? You can just say yes or no going right down

the aisle.

Do you want Congress to—the political process to start really

getting involved?

Mr. LEWIS. No.

Mr. HOFFMAN. We are glad Congress is showing a leadership position in addressing the issue. I don’t think there is any real need

for specific addressment of that issue.

Mr. BIBLE. No.

Mr. POWELL. I don’t believe that Congress should be promulgating accounting principles. However, I do believe that there is a

place for congressional oversight, and that is when it comes to

when this is going to have significant implications on the Nation’s

economy. FASB’s role is not to do that. It is a stated role not to

do that. There has to be a forum someplace that someone is looking

at that.

Mr. GANSKE. I am not arguing against a forum. I am asking specifically, do we go to the floor of the House with a bill? I don’t know

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how much politically aware you are of the situation, but, boy, some

bizarre things can happen on the floor.

Mr. POWELL. We are not in favor of accounting being legislated

on an issue-by-issue basis.

Mr. GANSKE. I assume, Mr. Jenkins, you feel the same way?

Mr. JENKINS. I agree.

Mr. GANSKE. My final question would be this, then. Let us go

back to the actual case as described by Mr. Jenkins that is reported

in the New York Times where the quote is, ‘‘Pooling accounting is

ridiculous because it allows corporations to pretend that they paid

much less for an acquisition than they did. Let’s say company A

buys company B for $100 million in stock, and then a few years

later sells company B for $50 million. In reality, that was a disastrous acquisition for company A, but thanks to the magic of pooling, company A would have shown the original acquisition as costing not the $100 million that it paid but a number that could be

far lower, say $20 million, reflecting the book value of company B.

Presto, company A reports a profit of $30 million when it actually

lost $50 million.’’

I would just like to go down the row here. To me as an individual

investor wanting to really know how much a company owes or has

spent on an acquisition, I just want to know, doesn’t this specific

case strike members of this panel as something of concern?

Maybe we could start on this end. Isn’t there some valid concern

about this type of accounting?

Mr. HOFFMAN. I am going to go ahead and step ahead, if you

don’t mind. There are a couple pieces of data that are missing to

make a real judgment here.

One is, what were the relative valuations of the company at the

time the transaction was done? Did the market fairly value that?

The issue is the capital stock of the corporation. Because when two

companies come together you are talking about a set of shareholders and another set of shareholders, and the relative ownership

of the entire company is diluted based on the shares relegated to

that acquisition.

Mr. GANSKE. I understand that, but I am an investor out there

looking at the balance sheets.

Mr. POWELL. Congressman, could I answer that question?

Mr. GANSKE. Okay.

Mr. POWELL. First of all, I think it is an interesting theory, but,

in reality, it rarely happens often.

I have had this question posed to me before. I had one of the

major banking firms, international banking firms, review this to

find examples of where this had happened, and they could not locate examples where this had occurred. I think that is the first

point that I would like to make.

Mr. GANSKE. But how do you respond to Mr. Jenkins, who gave

several examples of a recalculation by Swiss Credit, for instance,

on bank acquisitions, where there was a difference?

Mr. POWELL. I think that the issue that Mr. Norris is reporting

is a different issue, which is you sold off assets and reported a

gain, when in fact you sold them for less than what you paid for

them. I think—so I would like to speak to the Norris issue, if I

could.

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If you think about the fact that—let’s suppose in the example

that I used, a company A, company B, you have twice as much

stock outstanding. If you are going to sell the company that you expected to generate twice as much income, what happens the day

that you sell that is you have lost your revenue stream and profit

stream, and your income, in the example that I give, is going to go

from $2 a share to $1 a share.

I don’t know many management people that are going to be

around once that happens. To view that in some sort of positive

way is wrong. It is going to be viewed very negatively, and it will

have an impact on that management team.

The other thing is that if you look at one-line types of transactions, as we see in in-process research and development or restructuring charges, analysts have a tendency to discount those

and not give credit to those reductions.

The same thing happens on one-time gains. Management is not

going to look at that gain and give a credit to the management

team for the fact that that one-time gain occurred. They are going

to look more to what is the impact on the earning stream.

The last thing that I would say is if FASB thinks that this is an

issue that is subject to abuse, let us deal with the abuse but not

throw the baby out with the bath water. I think that is the same

position that the committee on corporate reporting of the FDI suggested in their FASB testimony, if there are abuses, let us fix

them, but not throw out the entire methodology.

Mr. OXLEY. The gentleman’s time has expired.

Mr. GANSKE. Maybe Mr. Bible can answer that.

Mr. BIBLE. All I would say is that you all have your constituents.

Our constituents are shareholders. If I give you a tool to make it

look like you are doing better than you actually are, would that be

fair?

Mr. OXLEY. It happens all the time.

Mr. BIBLE. We are trying to get rid of it in the accounting world.

Mr. POWELL. I would turn that around to say, should we be penalized for a negative transaction that in reality does not reflect

the economics of what the transaction is?

Mr. OXLEY. Thank you.

The Chair recognizes the vice chairman of the subcommittee, the

gentleman from Louisiana.

Mr. TAUZIN. I thank the Chair.

Mr. Jenkins, I chair the Subcommittee on Telecommunications.

My interest in these high-tech companies and what they are doing

for the economy stems from that work.

Let me first ask you about our relationship, Congress, to your

agency. I am very pleased to hear you today indicate that concerns

expressed by Members of Congress about the work of FASB, making sure that you account for those concerns, is in fact a relevant

relationship, because I hope it clarifies the open letter that FASB

sent out.

It seemed to indicate that we had no business engaging in any

legislative activity, that that might threaten the independence of

FASB. Your quote is, ‘‘Explicit or implicit threats of increased legislative activity create a real risk of continued viability of private

sector standards setting.’’

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Do you really believe that? Do you believe we don’t have a role

here in oversight, in recommendations and in letters like our chairman has sent to you, urging that you go slow and examine some

of the concerns that have been raised by the other side or concerns

about the purchase method of accounting?

Mr. JENKINS. Congressman Tauzin, I stated in my testimony, not

only here but earlier in my testimony before the Senate Committee

on Banking and Financial Services, that we support and understand and accept the oversight responsibility of Congress. I have no

problems with that.

Mr. TAUZIN. I should hope so.

Mr. JENKINS. Just as a matter of clarification, please, the letter

that you are reading from is not a letter from the FASB, it is a

letter from the trustees of the Foundation. My understanding, having talked with the trustees about that letter, is perhaps it is

inartfully worded.

Mr. TAUZIN. That is not your view?

Mr. JENKINS. I’m sorry.

Mr. TAUZIN. That letter does not reflect your view?

Mr. JENKINS. No, it does not reflect my view.

Mr. TAUZIN. Let me ask you, with reference to another letter,

however, that you did send to Members of the Senate who wrote

to you concerned about problems in the purchase accounting method and addressed recommendations to you, I think the tone of their

letter was, before you go around repealing pooling that you had

better doggoned fix up the purchase accounting. If you have two

systems, neither one of which are working good, you don’t want to

throw one out and accept another equally bad. Fix that up first.

I thought that was a pretty good letter. I thought the chairman’s

letter to you was excellent, particularly when he pointed out that

intangibles do not necessarily depreciate, often they appreciate. If

you set some arbitrary depreciation schedule on intangibles in this

new economy that you will, in fact, be encouraging false and inaccurate information to the public, when the truth is that intangibles

in this new economy may be an increasing and appreciating asset

that investors ought to know about and ought to have real information about.

But you wrote to the Senators in effect saying that, look, we

haven’t made any final decision about this; we are going to consider

everything. But the only thing you did in your letter was to cite

examples of complaints about the pooling method.

As I read your letter, it seems to me you have made some preliminary judgments that you plan to abandon it and go to purchase

accounting, with no necessary attention paid to the flaws in that

system. It seems you are saying we are not interested in your recommendations. We insist that the pooling method is no good. Here

are the reasons why. And, by the way, a whole range of the Board’s

constituents have told us that and you have not paid attention to

them yet because you did not allow them to testify at some Committee on Banking and Financial Services, Housing, and Urban Affairs. That is the gist of your letter.

Is that the way you respond to congressional concerns that the

purchase accounting method has serious flaws in it that ought to

be adjusted for this new economy?

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Mr. JENKINS. I think it is evident that we do intend and have

addressed concerns with respect to purchase accounting. We will

reconsider all of those decisions in our redeliberations.

With specific respect to intangibles, in our proposal we did

change—we did propose to change the current requirement for intangibles, which is in place and has been in place since 1970, that

required them all to be amortized over some common period. We

did change that to permit flexibility on the part of management in

determining the lives over which intangibles should be amortized.

Mr. TAUZIN. The point is, what happens when they are appreciating in value? What happens when 80 percent of the company

is all about knowledge, it is all about eyeballs, about the potential

of this company attracting customers to products that are advertised that surround a package of information, and all of that is appreciating as more and more people come to that site, that e-com

business, and use those services and view those advertisements

and buy those products?

Are you saying that the company has no choice but to write-down

that intangible asset over some arbitrary, fixed period? Is that not

false information?

I notice the ranking minority member, Mr. Dingell, talking about

the search for the truth. But is that not the opposite of the truth?

Mr. JENKINS. I think the first thing we have to do is get the intangibles recognized in the first place. Recognizing intangibles in

the first place does not come about through the use of the pooling

of interests method.

The second point is to your point. Some intangibles are going to

increase, some intangibles perhaps are going to decrease. We don’t

always know. But under our system of accounting, that has been

true for a long time. Some of our—some trademarks of old line

companies increase in value and some decrease, but we generally

don’t recognize them.

Mr. TAUZIN. Mr. Jenkins, I just want to say one thing, and then

ask you a final question.

The first is that of all the things I have seen that can severely

impact the extraordinary growth of this new economy, what you do

here may have more impact than what we do in policy up here.

How you handle this issue and how carefully you handle it and

how well you handle it may well determine whether or not this

new economy continues to grow, whether we inflate or whether we

deflate it.

We are deeply concerned about that. We have tried to express

that to you. I want to second the comments of the chairman of our

committee in his letter to you. I think it is an excellent letter of

concern that I hope you folks have taken seriously.

In his letter he makes a request of you. He requests that FASB

commence a comprehensive study of the accounting treatment of

intangibles, and he further requests that you wait until those results of the separate studies being conducted by the SEC and hopefully by yourselves on this issue might be concluded where we can

all get a good handle, a good look at it.

What is your response to his request?

Mr. JENKINS. I responded in part in my testimony when I made

the point that the one study is not really relevant to dealing with

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intangibles. Mr. Powell, who was a member of that group, concurred in that.

We are beginning in our own process to consider intangibles. We

will be giving careful thought as we go forward as to whether or

not it is or is not appropriate at the end of the day for us to go

forward with this standard without coming to a final conclusion on

accounting for all intangibles.

We do intend—with respect to the intangible that is most significant by a long ways in respect to purchase business combinations,

goodwill, we do intend to carefully consider all of the various alternatives that I described for the Congressman from Iowa in open

meetings before we reach a final conclusion. We will listen carefully

to what we have heard in these meetings.

Mr. TAUZIN. Can I inform the chairman as a result of our conversation today that your answer to him is yes?

Mr. JENKINS. The answer is not necessarily yes, because I cannot

guarantee you that we will solve all of the problems of intangibles

before we go forward.

Mr. TAUZIN. He simply asked that you let all these studies happen, that we have a chance to look at all these studies and get a

chance to analyze the different outcomes of these studies before you

move. Can I inform him at least that that is a likely outcome here?

Mr. JENKINS. We will consider those studies as we go forward.

The outcome——

Mr. TAUZIN. You are going forward as the studies are being

done?

Mr. JENKINS. The timing of those studies is out of our control.

Mr. TAUZIN. So the answer to the chairman is, you may move

even before the results of the studies are in?

Mr. JENKINS. I do not even understand or know what the nature

of those studies are, with all due respect. I can’t commit myself or

my board to the outcome of studies about which I do not know

their approach or anything.

Mr. TAUZIN. Mr. Jenkins, with the indulgence of the chairman,

let me just say, sir, that you are inviting legislative action when

you give an answer like that. When the chairman of our committee—and you have heard the expression, I think, of many members of the legislature that we consider this of such a serious note

that we have asked you to make sure that these studies are in before you make this momentous change in the way these accounting

rules—these generally accepted rules are applied to this new economy—I think you have heard enough of us telling you that over

and over again that when you tell us that you might not wait for

the results of the studies, you might plow ahead with some preconceived notions even, that just invites legislative action.

Mr. JENKINS. We don’t have any preconceived notions. We will

consider all of the evidence. We will consider very carefully and

take very seriously your admonitions to us and what we have

heard today from everyone on this subcommittee, and we will do

our very best to make sure that we consider all of the evidence before we make any decision and the applications of our decision.

Mr. OXLEY. The gentleman’s time has expired.

The gentleman from California, Mr. Cox.

Mr. COX. Thank you, Mr. Chairman.

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I would like to thank each of the members of our panel, some of

whom I had a chance to say thank you to during the break, for

your presence here and your willingness to indulge the Congress’

interest in this.

I think that the topic that Chairman Tauzin has gotten us into

here is worth pursuing in two respects.

First, I think, as I mentioned in an aside to Mr. Jenkins, that

the real issue here is the accounting treatment of intangibles.

There has been a lot of change in our economy over the last many

years, and the relative role played by what we loosely call goodwill

M&A is significantly larger now than ever before.

The second issue that Chairman Tauzin raised that I think is

worth pursuing is what the Congress ought to do in this circumstance. I think my colleague, Mr. Ganske, certainly crystallized, at least with you, this panel, about whether Congress

should write a law and describe the proper accounting treatment

for intangibles in all cases or the proper accounting treatment for

business combinations, managers, acquisitions, and so on.

I would not be inclined to do that myself. Although I think the

best answer to your question, Greg, as to whether it would be a

good idea for Congress to write the accounting standards is, is the

congressional proposal as bad as FASB’s? If it is not, then it would

be superior, at least in that instance.

But I think your question really goes to the precedent we would

be setting and the kind of system we would inherit if we willy nilly

got into the business of writing accounting standards.

What Congress might do, with greater restraint and wisdom,

however, is force a delay, a moratorium until the information is in.

I did that with Internet taxes, and my legislation which I wrote

with Senator Wyden is going to be on the floor next week.

Again, we already have a moratorium in place as a result of legislation I passed a couple of years ago, and the Internet Tax Freedom Act moratorium as a result of what was just reported out of

the Committee on the Judiciary will now be extended a further 5

years, assuming that we are successful on the floor of the House

and on the floor of the Senate, as we were today on the Committee

on the Judiciary, where I think the vote was 29 to 8.

It would not be irresponsible, although it would be quite a

change from the way normally we do business, I think, for Congress to require FASB to look at the information. And if the information is not in before you make your rule, I think it raises serious

questions.

If you don’t know what the studies are about, that scares me

right there, because that is where we ought to be focused.

The bread and butter accounting, as we all learn in business

school or wherever we first learn accounting, is based on a paradigm in which book value is the only thing you can really sink your

teeth into. We recognize book value doesn’t represent real value,

but it is a real number. We know where it comes from, so we put

a lot of our heart and soul into that back value figure.

In that paradigm, goodwill is the fudge factor. But what happens

is that the fudge factor, which is something we never really could

get our arms around, has sort of taken over the universe, in much

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the same way that the Arab mathematicians flirted with the idea

of irrational numbers when they first tried to solve cubic equations.

Remember, Omar Khyam, for example, figured out how to solve

cubic equations but looked at this multiple of the square root of

minus one as a false root. They didn’t know what to do with it.

They screwed around with it for a long time. These days, not only

are we comfortable with the square root of negative 1, but you cannot manage an electric circuit without it.

I think we need to get a little more comfortable with goodwill,

with intangibles, because that is the 21st century. That is really

this hearing ought to be focused on. It is what it really ought to

be about.

If I were to ask you the same unfair question that Chairman

Dingell or former Chairman Dingell, Ranking Member Dingell,

asked a moment ago when he said what is the truth, purchase or

pooling, in an arbitrary transaction, the facts of which none of us

is informed, and if I were to ask you what is the depreciable life

of goodwill, Mr. Jenkins, what is the answer to that?

Mr. JENKINS. I would acknowledge that the amortization of goodwill as a single number is arbitrary, but that doesn’t mean that it

is necessarily wrong. It is an estimate of life. We have had goodwill

being amortized for a long time over varying lives.

While there is an outside limit, there is certainly not a prohibition against using anything shorter than that. And, in fact, in the

many, many acquisitions in the high technology area, for example,

that have not been accounted for as purchase transactions, they

utilize goodwill life that is significantly shorter than 20 years, or

40 years, for the most part.

I think you are correct, that the focal point of this issue is on

goodwill. I acknowledge that. I expect that we will be spending

very much of our time over the next many months as we work on

this issue trying to resolve the goodwill question.

I described several alternatives a few minutes ago that we intend

to reexplore. Many of those concerns and our attention to this come

out of this hearing and out of previous hearings and listening carefully to our constituents.

So I agree with you. The focus is on goodwill. I think we will address it. We have a group that has asked if they can make a presentation to us on a methodology for dealing with goodwill. I do not

know what it is, but we certainly have agreed to do that. We will

be having a public meeting of our board at the end of this month

where that will be displayed for us, and we will carefully consider

it.

I agree with you. That is the focus and where we need to spend

our efforts as we proceed to explore this issue.

Mr. GANSKE. Will the gentleman yield?

Mr. COX. Sure.

Mr. GANSKE. I am trying to get my hands around this goodwill

concept. Let me see if I can put it into a specific example.

In Des Moines, we had a company called Pioneer which was

bought by DuPont at a premium above what the stock was selling

for. So that difference, is that what you would call goodwill?

Mr. JENKINS. No, not necessarily.

Mr. GANSKE. Okay. Because I wonder whether it is part of it.

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Mr. JENKINS. It could be part of it.

Mr. GANSKE. That was premised on the management for Pioneer,

which was well respected, sticking with the new, larger company

for a period of time. It did not work out that way. Management left

rather quick.

I am just wondering whether in fact there aren’t some intangibles that are always going to be intangible, and how well you think

you can actually get your hands around that component of so-called

goodwill.

Do you have a comment on that?

Mr. JENKINS. Yes, I do. I think that is a good example of an intangible that probably cannot be specifically valued but does get

subsumed into goodwill. It is a portion of goodwill.

One could also conclude that if the entire difference between the

market value and the purchase price was due to this management

and then they left, that at that point you ought to write off that

portion of goodwill, because it is no longer there.

That might be what we would say is one of the approaches I suggested to you, that we recognize goodwill, we recognize this need

for superior management to stick around, but we don’t amortize it.

But if they leave, you write it off.

Mr. GANSKE. That is where I see that Dr. Lewis and Mr. Hoffman and everyone else on the panel—you are all very bright, but

let’s say that Mr. Hoffman’s company gets scarfed up by a bigger

guy. I would want Mr. Hoffman to stick with my company, my bigger company. The premium that I would pay for that would include

him. But if he left, I think I would be—I wouldn’t have gotten the

value.

Mr. COX. Let me add to your question another example we might

think about. Let’s say that the Tribune Company and Times Mirror

combined. How much, Mr. Jenkins, did that cost?

Mr. JENKINS. I don’t remember the number.

Mr. COX. No, I mean what is the cost of that combination?

Mr. JENKINS. I think the cost is the consideration that the Tribune Company paid for the Times Mirror.

Mr. COX. Does it matter if they used outstanding shares or newly

issued shares?

Mr. JENKINS. It doesn’t matter if they used outstanding or newly

issued, or if they use cash or shares.

Mr. COX. So your sense—I use that because the Times Mirror

and Tribune Company are roughly comparable in size, and there

are some bragging rights going on about who got whom in the deal.

And if you are from Chicago, there is no question. If you are from

California, there is some question there.

But at least to read the newspapers, which seem to be carrying

fair and full accounts of all of this, they are really going to combine

the operations. That is really what is happening in economic reality. What is the cost of that? What is the economic cost of that

combination?

Mr. JENKINS. I still believe that in that case, and I have not examined it in detail, that you can determine which company acquired the other company.

Mr. COX. What if that is not really what happened?

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Let us back off of that example, if you think that there is a flaw

in my analogy.

Let’s take a situation in which, having done M&A work for a decade, I can tell you happens fairly frequently, and you know this

better than I because you have done this for more of your life, if

you have two partners in a business transaction and they get together—and they really get together, one did not swallow the

other—they get together, they—somebody used the term ‘‘marriage’’ earlier, community property, let us say that is the economic

reality. What is the cost?

Mr. JENKINS. I just think in that case I think the best answer

is to say that you have a new entity. You have put two companies

together. You have created a brand new entity.

Mr. COX. How much in economic terms—to put on your economist’s hat, in economic terms how much did that cost?

Mr. JENKINS. I would say that you would recognize the value of

the assets of both parties that have contributed to that transaction,

the fair value of the assets.

Mr. COX. That is a different question. That is a question of how

you write up the assets on the balance sheet.

My question is, what is the economic cost? Think of this as sort

of a physics question. You have some molecules. They bump into

each other. What is the energy expended? It is that sort of question. In economists’ terms, what is the costs?

Mr. JENKINS. Again, I think it is the fair value of the assets that

they each contribute.

Mr. COX. The assets are still there. The assets did not go away.

They are still there.

Mr. JENKINS. I understand, and you are recognizing all of those

assets from both parties at the fair value when they are contributed.

Mr. COX. You are making a different and valuable point, which

is that this might be a good opportunity to recognize the current

market value of those assets and not run them at the old book

value. If you come up with a better way than purchase or pooling,

probably that is one of the things you will want to take a look at.

Mr. JENKINS. Yes, we are.

Mr. COX. I am asking a different question. I am asking whether

or not there is a real economic cost to the combination. Rather than

trying to beat my answer out of you, let me give you my answer

to that, which is that the cost of the combination is probably the

extra lawyer fees that you paid to file with the SEC and your HartScott-Rodino fees and your extra accounting fees to do whatever is

necessary, and, you know, if it is a big combination, that is a trivial

amount.

In fact, there is no business asset lost or consumed in the transaction. All the cash of the one company and all the cash of the

other company is still there. In fact, they probably got a new joint

bank account and you can see all the money still there. You can

keep your eyeballs on it.

So that a bias in the accounting system that absolutely requires

in that case that somebody be the acquirer and somebody be the

acquiree and that there be a cost of the transaction and that it be

a significant amount and measured in terms of the full value of the

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assets of one of them, that it seems to me to be strange to use a

paradigm that is not always the right one.

To use another one of those ancient analogies, it is like that Procrustean bed where Procrustes stretched all of his victims to fit.

Sometimes it does not work. Purchase accounting is designed with

some paradigms in mind, and it is absolutely perfect for some business combinations, but in other cases it is not.

Mr. Bible has been desperate to get a word in edgewise I think,

with the chairman’s indulgence.

Mr. OXLEY. We will make this the last word edgewise.

Mr. BIBLE. I would add, Mr. Chairman, it depends on what economic school you believe in. But the bringing together of both,

there was a decision made. That is, I can achieve the most value

for my interest by combining with you, Mr. Chairman, in a joint

venture, rather than selling to a third party. I think that is the

economic reality that Ed is speaking of.

Mr. POWELL. Could I make one comment? In reality, this is two

groups of shareholders coming together and combining their interest. No one acquired anyone else.

The reflection of that is that if I own 10 percent of that company

before, I will now own 5 percent of that company. The cost is in

the dilution of me as a shareholder. But in terms of one company

acquiring another, Congressman Cox is exactly right. There was no

cash exchanged. No company gave up assets to purchase this.

There was simply a combining of those two companies, and that is

what pooling is all about.

Mr. BIBLE. No, they made a decision to give up cash to a third

party sale to join with the Congressman in a merger.

Mr. COX. I want to point out that some people think accounting

is boring, but this, you can see, it is just loaded with interest.

Mr. OXLEY. This is put on your helmets.

I recognize the ranking member for a unanimous consent request.

Mr. TOWNS. Thank you, Mr. Chairman.

I ask unanimous consent that I place in the record Congressman

Crowley’s statement and also questions to be answered in writing

to Mr. Jenkins.

Mr. OXLEY. Without objection.

[The prepared statement and questions of Hon. Joseph Crowley

follow:]

PREPARED STATEMENT OF HON. JOSEPH CROWLEY, A REPRESENTATIVE IN CONGRESS

FROM THE STATE OF NEW YORK

Thank you Mr. Chairman for holding this critical hearing and for allowing me to

be here today.

I have a serious concern about the impact of the Financial Accounting Standards

Board’s (FASB) proposal, in its Exposure Draft on Business Combinations and Intangible Assets, to eliminate the pooling of interest’s method of accounting. I am

very concerned that this will have a negative impact on the American economy, particularly on the fast-growing companies driving our increasingly knowledge-based

economy-what people are calling the new economy.

Financial experts have said that the proposal will have the greatest impact on the

financial services, information technology, and pharmaceuticals sectors, areas of our

economy that, according the to Commerce Department, accounted for nearly 30 percent of America’s GDP in 1998. Information technology alone was responsible for

over 28 percent of U.S. real economic growth in 1997. Those percentages represent

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a large number of jobs, both in those industries directly, and in collateral and support industries.

I understand that FASB has received nearly 200 comment letters on its Exposure

Draft. In its own summary of the comment file, FASB noted that more than three

quarters of the letters addressed the proposal to eliminate pooling. Of those, the

banking and high-tech sectors strongly disagreed, and the rest were ‘‘split.’’ This

does not sound like the kind of endorsement of a proposal that compels immediate

action. Rather, with such disagreement on the value of the proposal, I would suggest

the wiser route is to reconsider and address some of the concerns raised.

It is also my understanding that the responses, in fact, were 3 to 1 in favor of

retaining at least some form of pooling, or for not eliminating pooling until significant other issues related to the purchase method, the only remaining method, were

resolved. And these responses include the Big 5 accounting firms. In light of such

significant opposition and the very real concern about the impact of the proposal on

our economy, what is the rush?

The pooling method of accounting has been around for many decades. I know of

no clamor, and no crisis, which demands immediate action on the issue. In fact, only

six years ago, Mr. Jenkins, in a comprehensive AICPA study on business reporting

that he headed before he became FASB chairman, found that ‘‘the existence of the

two accounting methods is not a significant impediment to users’ analysis of financial statements. A project to do away with either method would be very controversial, require a significant amount of FASB time and resources, and in the end is

not likely to improve significantly the usefulness of financial statements.’’ Why then

the rush to act?

It may well be that something needs to be done regarding pooling of interests accounting. I am not an accounting expert. But I am concerned when so many experts

in their field express the kinds of concerns I have been hearing. In fact, I understand that eleven Members of the Senate Banking Committee, a bipartisan majority, have written a letter to the FASB suggesting that it defer its decision on pooling

until the concerns and issues relating to the purchase method have been resolved.

I have also joined Congressman Cal Dooley and a number of my colleagues in sending our own letters on this topic.

FASB has stated the importance it places on international harmonization of accounting standards as justification for this proposal. I would only point out that the

home countries of many of U.S. companies’ strongest competitors permit pooling.

Britain, Germany and Japan all permit some form of pooling. Our economy is the

strongest in the world, based in part on the ability of companies to innovate and

reach productivity through mergers. Do we really want to throw this new hurdle

in front of U.S. companies?

I would hope that FASB is taking these concerns seriously. I certainly do. I urge

FASB to take some more time to consider the very serious concerns raised over this

issue.

Mr. Chairman, once again, thank you for calling this important hearing. I look

forward to working with you and my colleagues on this important issue.

CONGRESS OF THE UNITED STATES

HOUSE OF REPRESENTATIVES

May 4, 2000

The Honorable MICHAEL G. OXLEY

Chairman

Subcommittee on Finance and Hazardous Materials,

Committee on Commerce

2125 Rayburn HOB

Washington, D.C. 20515

DEAR MR. CHAIRMAN: I would appreciate your assistance in including the following questions for Mr. Edmund L. Jenkins, Chairman of the Financial Accounting

Standards Board, in the record for today’s Commerce Subcommittee Hearing on the

Financial Accounting Standards Board’s proposal to eliminate the ‘‘pooling of interests’’ accounting method. I would also like to thank you for your leadership on this

issue and for calling this important hearing.

1) Many knowledgeable people have said that FASB’s decision to eliminate pooling

could have a damaging impact on economic growth. In a recent white paper,

Merrill Lynch concluded that the change could result in a notable decline in the

consolidations that have enhanced productivity, encouraged innovation, and

stimulated dynamism in the U.S. economy. And, a Goldman Sachs study specifically says that FASB’s changes could have a dramatic impact on certain indusVerDate 11-MAY-2000 13:14 Sep 11, 2000 Jkt 064765 PO 00000 Frm 00128 Fmt 6633 Sfmt 6621 E:\HEARINGS\64765 pfrm01 PsN: 64765
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tries, including information technology and medical devices. Why is FASB willing to take the chance that they are right?

2) You have received a number of thoughtful alternative proposals to the elimination of pooling. You have a great deal of concern about the valuation of intangibles. What is the rush to eliminate pooling rather than looking first at the

valuation questions? If the problem with studying the issues is that it will take

some time, why not do it right the first time rather than in a piecemeal fashion,

especially when the consequences of ‘‘getting it wrong’’ could be so severe?

3) A review of the comment letters sent to FASB shows that two-thirds of all of

those who sent comment letters and all of the Big 5 accounting firms advocated

either retaining at least some form of pooling or not eliminating pooling until

significant other issues were resolved. Why is FASB determined to abolish pooling in light of this significant opposition to its decision?

4) Your Exposure Draft specifically states that international harmonization is one

of the reasons for your decision to eliminate pooling. Let’s assume for a minute

that that is a valid goal. Given the fact that countries like the U.K., France,

Japan and Germany permit pooling, at least in some form, how could eliminating pooling here increase international harmonization? Assuming that various foreign and international accounting rules are moving away from allowing

pooling accounting, why should the U.S. be following a trend in Europe or elsewhere rather than encouraging the adoption of U.S. rules?

Once again, thank you for your assistance in this important matter. I look forward to working with you, the Committee and our colleagues who support the burgeoning high-tech economy.

Sincerely,

JOSEPH CROWLEY

Member of Congress

cc: The Honorable Edolphus Towns, Ranking Member

Mr. OXLEY. Should anyone else wish to submit written questions,

that would be acceptable, as well.

The Chair would ask unanimous consent that extraneous materials, including a study called ‘‘Valuing the New Economy,’’ a white

paper, be made part of the record.

Without objection, so ordered.

Gentlemen, thank you very much for your appearance today. Mr.

Cox is correct. We have put a new twist on an old profession, and

that is always exciting. Thank you for your participation.

The subcommittee stands adjourned.

[Whereupon, at 2:04 p.m., the subcommittee was adjourned.]

[Additional material submitted for the record follows:]

FINANCIAL ACCOUNTING STANDARDS BOARD

NORWALK, CONNECTICUT

May 23, 2000

Mr. ROBERT E. SIMISON

Legislative Clerk

Committee on Commerce

United States House of Representatives

Washington, DC 20515

DEAR MR. SIMISON: The following is our response to the questions raised by Congressman Joseph Crowley in his May 4, 2000 letter to Chairman Michael G. Oxley

in connection with the May 4, 2000 hearing of the Finance and Hazardous Material

Subcommittee of the Committee on Commerce (‘‘Subcommittee Hearing’’):

Question 1 Congressman Crowley writes: ‘‘Many knowledgeable people have said

that FASB’s decision to eliminate pooling could have a damaging impact on economic growth. In a recent white paper, Merrill Lynch concluded that the change

could result in a notable decline in the consolidations that have enhanced productivity, encouraged innovation, and simulated dynamism in the U.S. economy. And,

a Goldman Sachs study specifically says that FASB’s changes could have a dramatic

impact on certain industries, including information technology and medical services.

Why is FASB willing to take the chance that they are right?’’

Response: The Financial Accounting Standards Board (‘‘FASB’’ or ‘‘Board’’) has

issued an FASB Exposure Draft, Business Combinations and Intangible Assets (‘‘Exposure Draft’’), for public comment that has proposed to eliminate the pooling-of-inVerDate 11-MAY-2000 13:14 Sep 11, 2000 Jkt 064765 PO 00000 Frm 00129 Fmt 6633 Sfmt 6621 E:\HEARINGS\64765 pfrm01 PsN: 64765
126

terests method (‘‘pooling method’’). The Board will hold as many public meetings as

necessary to carefully evaluate all of the feedback received in response to the Exposure Draft and to decide what modifications or clarifications, if any, to the Exposure

Draft are appropriate. The Board will not make any final decisions about the Exposure Draft, including whether or not to retain the pooling method, or consider

whether to issue a final standard, until it has completed its full due process and

is satisfied that all substantive issues raised by all parties have been carefully considered.

The Board has proposed to eliminate the pooling method because the Board believes that the elimination of the pooling method will benefit consumers—investors,

creditors, and other users of financial statements—as well as companies that prepare those reports, by providing more information, and more relevant information,

about all business combinations.

The Exposure Draft’s provisions also will benefit consumers by improving the

comparability of financial reporting, thereby making it possible to more easily contrast companies that participate in business combinations.

Many consumers have expressed support for elimination of the pooling method.

As one example, a letter from the Financial Accounting Policy Committee of the Association for Investment Management and Research, the leading organization of investment professionals in the United States with over 40,000 members, states:

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...

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.

In addition, Moody’s Investors Services, the leading global rating agency, stated:

Moody’s supports the objectives of accounting standards setters to improve

the harmonization of accounting standards globally, and welcomes the FASB’s

proposal to eliminate the pooling of interests method. We believe that a single

accounting method can improve analytic efficiency, especially in cases where a

single transaction or essentially identical transactions would produce dramatically different accounting results, and thus enhance the ability of cross border

capital market participants to compare, easily and accurately, alternative investments.

Many companies that prepare financial reports also agree. Those companies that

have written letters to the FASB supporting the elimination of the pooling method

include IBM Corporation, Eaton Corporation, American Electronic Power, General

Motors, Caterpillar, Inc., IMC Global, Cigna Corporation, and PPG Industries, Inc.,

to name a few. The IBM Corporation letter stated:

IBM agrees with the FASB that all business combinations are acquisitions

and, thus, we support the FASB’s proposal to eliminate the pooling-of-interests

method of accounting for a business combination. We believe that financial

statement users are ill-served by the existence of two methods to account for

the same economic transaction. We agree with the FASB that using the purchase method to account for all business combinations will increase the comparability of financial statements and will reflect the true economics of the

transaction, that is, an arm’s length investment that should be accounted for

at the fair value of the assets and liabilities that are acquired.

The Exposure Draft’s provisions will also benefit companies that prepare financial

statements and the auditors of those statements by providing a single method of accounting for all business combinations. Having one method of accounting for all

business combinations will reduce certain costs to companies and auditors that are

currently related to the existence of the pooling method.

For example, the availability of the pooling method often puts companies and

their auditors under pressure to employ that method because it typically produces

higher reported earnings and rates of return subsequent to a business combination

than the purchase method. Moreover, because the pooling method is applied retroactively, the comparative earnings reported for periods preceding the combination

are also higher than under the purchase method—even before the companies were,

in fact, combined.

As a result of those pressures, companies often must bear significant costs, both

monetary and nonmonetary, in seeking to use the pooling method. In positioning

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themselves to try to meet the 12 qualifying criteria for applying that method, companies may refrain from engaging in appropriate economic actions that they might

otherwise undertake, such as asset dispositions or share reacquisitions. They also

may incur substantial fees from auditors and consultants in seeking to meet those

criteria. The efforts to meet those criteria also may lead to conflicts between companies, auditors, and regulators with respect to judgments about whether the criteria

have been met, thereby adding uncertainties and their attendant costs to the process and raising questions about the operationality of those criteria.

A report published by the Silicon Valley office of McKinsey & Company, an international consulting firm, stated:

The fear that purchase accounting, by lowering reported earnings, will destroy shareholder value is a myth. In fact the opposite is true. Efforts to qualify

for such treatment actually destroy value. FASB’s proposal to eliminate pooling

accounting is a blessing in disguise. Why? Because the transition to purchase

accounting will require corporations to adopt more robust deal evaluation processes and enhance their shareholder communications.

Similarly, a letter to the FASB from the Financial Institutions Accounting Committee of the Financial Managers Society, a group of financial professionals working

in executive level positions in the thrift and banking industries, stated:

Formal research supports the proposition that reporting firms consume substantial resources in structuring transactions solely to achieve a favorable financial reporting outcome. Lys and Vincent (1995) report that AT&T paid at

least $50 million (and possibly as much as $500 million) to achieve pooling-ofinterests accounting for its acquisition of NCR . . . A single method of accounting

for business combinations would redirect these corporate resources into more

productive areas.

In addition, having one method of accounting for business combinations benefits

companies by leveling the playing field for competition among companies in the

business combinations market. The ability—or inability—to use the pooling method

often affects whether a company enters into a business combination and also affects

the price it negotiates for that transaction. Companies that cannot use the pooling

method because they cannot meet the criteria required for its use (for example, criteria that prohibit certain share acquisitions) often conclude that they cannot compete for targets with those that can meet the criteria.

Many companies that cannot use the pooling method believe that companies that

can use it often are willing to pay higher prices for targets than they would if they

had to use the purchase method because they do not have to account for the full

cost of the resulting investment. Thus, by using the pooling method, they can understate the income statement charges (primarily related to goodwill and other intangible assets).

In a letter to the FASB, KeyCorp explained:

Since most publicly-traded companies are gauged by EPS performance, there

is a strong incentive to use the ‘‘earnings-friendly’’ pooling method. The desire

to avoid the earnings consequences of the purchase method has almost certainly

resulted in uneconomic behavior. It is well understood in the investment banking community that a company is willing to ‘‘pay’’ more for a target if the pooling method is available for the resulting transaction. Clearly, there is a view

that the pooling method results in a type of accounting arbitrage...

Even though using the pooling method rather than the purchase method might

result in being able to report higher per-share earnings following the combination,

the fundamental economics are not different because the actual cash flows generated following the combination will be the same regardless of which method is

used. As a result, the added earnings reported under the pooling method reflect artificial accounting differences rather than real economic differences.

To the extent that the markets respond to artificial differences, they direct capital

to companies whose financial reporting benefits from those differences and they direct capital away from companies whose financial reporting does not benefit. As a

result, markets allocate capital inefficiently rather than efficiently. While inefficient

allocation of capital may benefit some companies and even some industries, it imposes added costs on many others, depriving them of capital that they need and capital they could employ more productively. The outcome is detrimental to those companies—but, more important, to the capital markets as a whole.

Finally, two further clarifications. First, Question 1 states that the ‘‘Goldman

Sachs study specifically says that FASB’s changes could have a dramatic impact on

certain industries, including information technology . . .’’ Unfortunately, the statement is not accurate. The May 29, 1999 Goldman Sachs survey by Gabrielle

Napolitano, CFA, and Abby Joseph Cohen, CFA, to which the question refers, states

that the FASB’s pre-Exposure Draft preliminary decisions on accounting for busiVerDate 11-MAY-2000 13:14 Sep 11, 2000 Jkt 064765 PO 00000 Frm 00131 Fmt 6633 Sfmt 6621 E:\HEARINGS\64765 pfrm01 PsN: 64765
128

ness combinations may adversely affect some industries including the ‘‘healthcare

information technology’’ industry. The survey does not conclude that the Board’s decisions may adversely affect the entire information technology industry as implied

in Question 1. More significant, the overall conclusion of the Goldman Sachs survey

was that the Board’s preliminary decisions, including the elimination of the pooling

method, would ‘‘not have a material adverse effect on future business combinations.’’

Second, Question 1 refers to conclusions of a Merrill Lynch ‘‘white paper’’ on the

impact of the Board’s proposed decision to eliminate the pooling method. For purposes of the Subcommittee Hearing record, it should be noted that in a March 3,

1999 Merrill Lynch ‘‘In-depth Report’’ on regional banks, Sandra J. Flannigan, CFA,

first vice president, Global Securities Research & Economics Group, Global Fundamental Equity Research Department, concluded:

In our opinion...the economics of a ‘‘purchase’’ and ‘‘pooling’’ are the same.

We, therefore, don’t think elimination of pooling-of-interests accounting will halt

consolidation. Indeed, ultimately, required usage of purchase accounting could

generate more transactions given greater comparability from an international

accounting standpoint and fewer earnings reporting/share buyback constraint

issues.

Question 2 Congressman Crowley writes: ‘‘You have received a number of thoughtful alternative proposals to the elimination of pooling. You have a great deal of concern about the evaluation of intangibles. What is the rush to eliminate pooling rather than looking first at the valuation questions? If the problem with studying the

issues is that it will take some time, why not do it right the first time rather than

in a piecemeal fashion, especially when the consequences of ‘getting it wrong’ could

be so severe?’’

Response: Since first adding the project on business combinations to its agenda

in 1996, the Board has held over 40 public meetings, issued 2 preliminary documents and the Exposure Draft for public comment, and carefully analyzed and is

still in the process of discussing at public meetings over 400 comment letters received from a broad range of companies, investors, and other constituents. We have

hardly rushed to complete this project, as Question 2 suggests. As stated in response

to Question 1 above, the Board will hold as many public meetings as necessary to

carefully evaluate all of the feedback received in response to the Exposure Draft and

to decide what modifications or clarifications, if any, to the Exposure Draft are appropriate. The Board will not make any final decisions about the Exposure Draft,

including whether or not to retain the pooling method, or consider whether to issue

a final standard, until it has completed its full due process and is satisfied that all

substantive issues raised by all parties have been carefully considered.

With respect to the issue of the ‘‘valuation of intangibles,’’ feedback received in

response to the Exposure Draft reveals that some constituent concerns, including,

possibly, the concerns raised in Question 2, result from having misread or misunderstood the Exposure Draft’s provisions regarding intangibles. To clarify, those provisions do not require the separate valuation of any intangible assets, such as many

forms of knowledge-based intangible assets so often associated with technology companies, that cannot be separately identified and reliably measured. Under current

accounting standards and the Exposure Draft, only purchased intangible assets that

can be identified and reliably measured, like many trademarks and customer lists,

are required to be separately valued, reported, and amortized over their useful economic lives.

Question 3 Congressman Crowley writes: ‘‘A review of the comment letters sent

to FASB shows that two-thirds of all of those who sent comment letters and all of

the Big 5 accounting firms advocated either retaining at least some form of pooling

or not eliminating pooling until significant other issues were resolved. Why is FASB

determined to abolish pooling in light of this significant opposition to its decision?’’

Response: Many of those commentators that wanted to retain pooling wanted it

retained in only very limited circumstances. Those circumstances were (1) where

there was a true merger of equals (a very rare occurrence) and (2) where companies

under common control were combined (a pooling-method-type result would be required under both current accounting and the Board’s proposal).

The Board is addressing and will resolve all of the ‘‘significant other issues’’ raised

in the comment letters about the proposed accounting for goodwill and purchased

intangibles before it redeliberates whether the pooling method should be retained.

The FASB’s Rules of Procedure provide for an open and thorough due process that

includes analysis and public discussion of the relevant information and persuasive

arguments contained in the comment letters, and other feedback, received in response to an FASB proposal. The Board’s mandate is to establish and improve

standards of financial accounting and reporting that result in credible, transparent,

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and comparable financial information for the efficient functioning of the US capital

markets.

As former US Securities and Exchange (‘‘SEC’’) Chairman Richard C. Breeden

stated in testimony before Congress almost a decade ago:

The purpose of accounting standards is to assure that financial information

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

The US capital markets are the deepest, most liquid, and most efficient markets

in the world. The unparalleled success and competitive advantage of the US capital

markets are due, in no small part, to the high-quality and continually improving

US financial accounting and reporting standards. As Federal Reserve System Chairman Alan Greenspan stated in a June 4, 1998 letter to SEC Chairman Arthur

Levitt:

Transparent accounting plays an important role in maintaining the vibrancy

of our financial markets . . . An integral part of this process involves the Financial Accounting Standards Board (FASB) working directly with its constituents

to develop appropriate accounting standards that reflect the needs of the marketplace.

As stated in response to Question 1 above, the Board will hold as many public

meetings as necessary to carefully evaluate all of the feedback received in response

to the Exposure Draft and to decide what modifications or clarifications, if any, to

the Exposure Draft are appropriate. The Board will not make any final decisions

about the Exposure Draft, including whether or not to retain the pooling method,

or consider whether to issue a final standard, until it has completed its full due

process and is satisfied that all substantive issues raised by all parties have been

carefully considered.

Question 4 Congressman Crowley writes: ‘‘Your Exposure Draft specifically states

that international harmonization is one of the reasons for your decision to eliminate

pooling. Let’s assume for a minute that that is a valid goal. Given the fact that

countries like the U.K., France, Japan and Germany permit pooling, at least in

some form, how could eliminating pooling here increase international harmonization? Assuming that various foreign and international accounting rules are moving away from allowing pooling accounting, why should the U.S. be following a trend

in Europe or elsewhere rather than encouraging the adoption of U.S. rules?’’

Response: Because of the rapidly accelerating movement of capital flows globally,

the Board believes there is a need for financial reporting to be comparable internationally. In response to that need, part of the Board’s mission includes promoting

international comparability of financial reporting, and accounting for business combinations is one of the more significant areas of difference in accounting standards.

For example, in most parts of the world, the pooling method is either prohibited

or used only on a rare exception basis. A recently issued exposure draft from the

Canadian Accounting Standards Board would prohibit use of the pooling method,

the International Accounting Standards Committee has established a Steering Committee on accounting for business combinations that will consider whether the pooling method should be prohibited, and in the United Kingdom, the technical director

of the Accounting Standards Board has stated:

If the US bans pooling, the International Accounting Standards Committee

(IASC) will come under pressure to ban it and then the UK will have to ask

itself whether it wants to be the only country that allows it.

The part of the Board’s mission that includes promoting international comparability is secondary to the Board’s central mission of establishing standards that

result in credible, transparent, and comparable financial information for the efficient functioning of the US capital markets. The Board, and many of its constituents, believes that the proposed elimination of the pooling method is consistent with

the both the Board’s central mission and the Board’s secondary mission.

I hope that my effort to provide thorough answers to the questions posed by Congressman Crowley has been helpful. I would be pleased to meet with the Congressman in person to further discuss any of his concerns.

Sincerely,

EDMUND JENKINS

Chairman

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BIOTECHNOLOGY INDUSTRY ORGANIZATION

WASHINGTON, D.C.

May 4, 2000

BRIAN MCCULLOUGH

House Committee on Commerce

316 FHOB

Washington, DC 20515

DEAR BRIAN: Per my conversation with Jim Conzelman, enclosed for the Finance

and Hazardous Materials Subcommittee’s hearing record are six copies of the testimony BIO presented at the Financial Accounting Standards Board’s (‘‘FASB’’) hearing on February 11, 2000 in New York City.

The biotechnology industry is totally opposed to the FASB proposal to repeal the

‘‘pooling’’ method of accounting. In our industry, more so than in any other industry,

appropriate business combinations are often the only source of capital for struggling

companies. The use of the pooling method of accounting facilitates these arrangements. If pooling is repealed, there will be a dramatic downturn in combinations in

our industry. This will result in many companies simply going out of business.

Thank you for including our testimony in the Committee hearing record. Please

feel free to call if you wish to discuss this matter in greater detail.

Sincerely,

PHILIP J. UFHOLZ

BIO Tax/Finance Counsel

PREPARED STATEMENT OF RICHARD POPS BEFORE THE FINANCIAL ACCOUNTING

STANDARDS BOARD ON EXPOSURE DRAFT

BUSINESS COMBINATIONS AND INTANGIBLE ASSETS

Grand Hyatt Hotel, New York, New York

FEBRUARY 11, 2000

Good afternoon, my name is Richard Pops. I am the Chief Executive Officer of

Alkermes, Inc., a biotechnology research and development company located in Cambridge, Massachusetts. I wish to thank you for allowing me the opportunity to testify today on behalf of the Biotechnology Industry Organization (BIO), the national

trade association that represents over 850 biotechnology companies worldwide.

My testimony will focus on the Financial Accounting Standards Board’s (hereafter, ‘‘the Board’’) proposal that would repeal the ‘‘pooling’’ method of accounting

which allows companies that merge to record their assets in the ongoing entity by

simply combining their assets and liabilities. This testimony will supplement my

comments that were submitted to the Board on December 3, 1999.

If pooling is eliminated, all mergers will be treated as purchases of one company

by another. The result of this mandatory application of ‘‘purchase accounting’’ will

be that biotechnology companies will be required to recognize and value at the time

of the transaction a variety of intangible assets, including goodwill. This asset would

have to be amortized, according to Generally Accepted Accounting Principles

(GAAP), over the course of twenty years. This has at least two important implications for biotechnology companies. Both relate to the critical issue facing entrepreneurs seeking to build and grow successful biotechnology companies: the ability

to raise large sums of capital over a period of several years prior to first profitability.

First, elimination of pooling accounting means a potential delay in profitability for

businesses that merge to build critical mass. Biotechnology companies are unique

in that they typically operate for years (average approximately 14.5 years by BIO’s

estimate) in a loss position. Raising enough money to survive is incredibly challenging. The pooling method of accounting allows a profitable or potentially profitable biotech company to acquire a non-profitable company without incurring an adverse charge to its earnings. In most cases, a merger or acquisition is the only viable

option for the loss company. The alternative, due to a lack of cash flow and resultant inability to continue vital research and development efforts, is frequently financial failure. This is generally not the case in other high technology industries where

profitable companies acquire or merge with other profitable companies in order to

create synergy and improve efficiency. With biotech companies, it is a case of survival. For investors supporting these companies, the timing of profitability is a critical consideration in their investment decision. A delay in profitability due to noncash amortization charges can add years to the time that a biotechnology company

131

operates at a loss. This extends the time that its securities are unattractive to many

investors and, therefore, increases the already difficult task of fundraising.

Second, it means that, once profitable, biotechnology companies that merged to

build critical mass may report significantly depressed earnings per share over the

course of many financial reporting periods. This has the potential to severely damage the company’s overall value. This has a profound effect much earlier in the company’s life as investors make the investment decision prior to profitability. If the

eventual valuation of the company is lower once it is profitable, the present value

of its equity is lower today. This affects the company’s ability to raise capital.

It is important to recognize that for biotechnology companies, tangible book value

is low in comparison to total company value. Biotechnology mergers often occur between companies of similar size, and result in large amortization charges in purchase accounting. The effect of the elimination of pooling accounting is magnified

for small biotechnology companies, where the non-cash amortization charges can

dwarf total profitability of the combined business in the early quarters of profitability.

Biotechnology companies are part of a new generation of companies that presents

a financial profile profoundly different from traditional ‘‘bricks and mortar’’ enterprises. The issue of pooling should be addressed in the context of a larger examination of how GAAP can best handle the financial disclosure for these types of companies. For the same reason that the Board recently decided to defer consideration of

new rules governing in process research and development, because the issue was too

closely intertwined with the treatment of research and development costs generally,

the Board should defer consideration of the pooling issue.

Repeal of the pooling method will reduce the likelihood that some desirable combinations will occur. This would be an unfortunate outcome for the biotechnology industry, where mergers of complementary technologies are often necessary to enable

the development of innovative new drugs and diagnostic products for the benefit of

patients and families around the world.

The problems of comparability, relevance, reliability, and neutrality that the

Board says drives its proposed change are recreated in purchase accounting by the

need to confront the many problems inherent in the treatment of intangible assets,

in general, and goodwill in particular. With so much of the value of biotechnology

companies lying in these intangibles, the financial presentation under the mandated

use of purchase accounting will be significantly more problematic than under pooling.

One of the foundations of financial accounting is comparability across time as well

as between companies. Users of financial statements should be able to look across

periods and evaluate a company’s performance over time, to see and be able to

evaluate trends and significant new developments in its financial situation. The

strength of accounting for business acquisitions by pooling is that it allows for just

such a comparison. The merger of two entities by their owners, the shareholders,

is undertaken with the expectation that the new, combined entity will allow for

greater value to be generated going forward. By preserving the historical values of

assets carried on the books of the predecessor companies, such a comparison can be

made easily. The assets, income flow, and other financial elements of the two companies are simply combined and not altered, and so any change in the future, good

or bad, is readily apparent.

Purchase accounting departs from this model of combination and thus undermines

the users of financial statements’ ability to compare performance over time easily.

Under purchase accounting, the historical valuation of assets of one of the predecessor companies is preserved, while the assets of the other company are revalued

according to the fair market value at the time of the business combination. Thus,

going forward there is an amalgam of valuation of assets, some at historical cost

and some at this new, fair market valuation.

The Board’s proposed rule does not adequately take into account the true worth

of a biotechnology company’s intangible assets and would slow their growth, which

is more important than detailed accounting. Investors do not care about accountants’ estimates of a company’s various hard-to-measure intangible assets. What they

really want to know is, does this merger contribute to the bottom line.

I do not pretend that there are any easy answers to the problem of dealing with

intangible assets and their role in biotechnology companies. The rapid changes in

the biotechnology industry have created new situations where traditional accounting

principles no longer can be relied upon to provide accurate, transparent, public disclosure. The worth of biotechnology companies is increasingly related to intangible

assets that traditional accounting fails to measure. It is a difficult problem, and I

applaud the Board for continuing to grapple with it. However, in the face of this

recognized difficulty, the elimination of pooling alone means not that problems with

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accounting reliability, comparability and neutrality will be eliminated, but instead

will be exacerbated.

The magnitude of this proposed rule change requires a careful weighing of the

possible costs of change against the conviction that the public will enjoy significant

benefits.

The risk of adverse impact to the biotechnology industry due to the elimination

of pooling is significant enough to require an equally significant showing of the benefits to be realized. In fact, none of the benefits claimed on behalf of the proposed

rule change meet such a standard either separately or collectively.

NATIONAL ASSOCIATION OF MANUFACTURERS

May 3, 2000

The Honorable MICHAEL OXLEY

Chairman, Subcommittee on Finance and Hazardous Materials

House Commerce Committee

2233 Rayburn House Office Building

Washington, DC 20515

DEAR MR. CHAIRMAN: I am writing on behalf of the National Association of Manufacturers (NAM) regarding the subcommittee hearing on business combinations

scheduled for Thursday, May 4. The NAM—‘‘18 million people who make things in

America’’—is the nation’s largest and oldest multi-industry trade association. The

NAM represents 14,000 members (including 10,000 small and mid-sized companies)

and 350 member associations serving manufacturers and employees in every industrial sector and all 50 states. As many of our members are current or frequent participants in mergers and acquisitions (M&As), we have a vested interest in this

issue and have, in fact, testified before the Financial Accounting Standards Board

(FASB) and the Senate Banking Committee in February and March of this year, respectively.

While the NAM fully supports the independence of the FASB and strongly believes that setting of accounting standards should be left to the private sector, we

are also very concerned about some of the changes the FASB has suggested in its

proposal on Business Combinations and Intangible Assets. Most notably, the FASB

has proposed to eliminate the pooling-of-interests method of accounting and to halve

the maximum amortization period for goodwill (currently 40 years, would be 20

years under the proposal). The NAM opposes both of these changes for the reasons

set forth in our enclosed statement for the record.

Our primary purpose for writing to you today is to clarify the scope of those who

would be harmed by these proposals, should the project move forward unmodified.

In much of what has been written and said about this issue, it has been characterized as a ‘‘high tech’’ issue. (The NAM insists that modern manufacturing and ‘‘high

tech’’ are increasingly synonymous but, for the sake of this discussion, will accept

the distinction.) And the FASB has correctly asserted that accounting rules should

be equally applicable to all sectors of the economy and not favor one sector over another. However, while it is certainly true that much of the incredible growth of the

high tech sector has been achieved through mergers relying on pooling, pooling has

also played, and continues to play, a very significant role for more traditional manufacturers. It is important to note that the NAM’s very active involvement in this

issue is not due solely—or even most significantly—to the interests of our many

high tech members. We are consistently hearing, primarily from more traditional

manufacturers, that this merger or that merger would not have occurred had it not

been for the applicability of pooling. This is not to say that all mergers are inherently good, but that is up to the market to decide—not the FASB.

The FASB has made it quite clear that it is not its mission to take into account

economic consequences when promulgating new accounting standards. But there is

no ‘‘abuse’’ being addressed in this case that would require drastic or expedited action, and the potential risks far outweigh the potential benefits. Consequently, we

are heartened that this subcommittee has seen fit to fill the gap by considering the

potential economic consequences of the FASB’s Business Combinations and Intangible Assets proposal. Please feel free to call me or the NAM’s director of corporate

finance and tax, Kimberly Pinter (202-637-3071) if you have further questions.

Sincerely,

MICHAEL E. BAROODY, Senior Vice President

Policy, Communications and Public Affairs,

National Association of Manufacturers

Enclosure

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PREPARED STATEMENT OF KIMBERLY J. PINTER, DIRECTOR, CORPORATE FINANCE AND

TAX, NATIONAL ASSOCIATION OF MANUFACTURERS ON BEHALF OF THE NATIONAL

ASSOCIATION OF MANUFACTURERS

I. INTRODUCTION

The National Association of Manufacturers (NAM) appreciates this opportunity to

present its views on the Financial Accounting Standards Board’s (FASB) Business

Combinations and Intangible Assets proposal. The NAM is the nation’s largest and

oldest multi-industry trade association, representing 14,000 members in every industrial sector and in all 50 states. A significant number of our members are frequent or current participants in merger and acquisition (M&A) activity and have a

vested interest in the outcome of this project.

II. POOLING

The centerpiece of this project is the proposed disallowance of the pooling-of-interests method of accounting. The NAM finds this proposal objectionable based on a

number of different factors.

First of all, the NAM disagrees with the FASB’s underlying premise that all business combinations are substantively the same. My personal observation as a nonaccountant is that it seems very odd that the term ‘‘M&A’’ would be standard jargon

if ‘‘M’s’’ and ‘‘A’s’’ were really exactly the same thing.

Substantively, a transaction in which a shareholder remains a shareholder fundamentally differs from one in which the shareholder cashes out. The pooling method respects this continuity. The criteria for using the pooling method are already

quite strict and reflect the primary factors of such continuity. The FASB contends

that by eliminating pooling they will be aiding comparability of financial statements—making like things look alike. It is the NAM’s position that not all transactions are alike, and that while like things should look alike, dissimilar things

should look different.

Additionally, there are substantive problems with the purchase method that

should be addressed, particularly before the elimination of pooling, should its elimination ultimately be determined to be an appropriate goal. These problems center

around the valuation of intangibles.

The NAM’s first concern in this area is the proposed halving of the maximum allowable period over which to amortize goodwill charges. The FASB has taken the

position that goodwill is a diminishing asset. The NAM disagrees with this premise.

In the case of a successful merger, goodwill should actually increase. Goodwill results because the value of a company is greater than the sum of its parts. Following

from that, every merger participant is hopeful that a successful merger will yield

more than the sum of its parts.

Furthermore, even if we were to accept the idea of goodwill as a wasting asset,

it has been conceded that goodwill cannot be reliably measured nor its actual useful

life determined. Therefore, the arbitrary limit of 40 years was set some time ago.

Companies and markets have acclimated to this standard. Now, with no more accurate or useful way to account for goodwill, the FASB is proposing to replace one arbitrary limit with another—in a way that would significantly and adversely affect

our members’ financial statements.

The problems inherent in the valuation of goodwill are not unique to goodwill.

Technological advance has fueled a whole host of new intangibles, many of which

are equally difficult to characterize and value. They are, if you will, a by-product

of the ‘‘new economy.’’ But let me explain for a moment what I mean by the ‘‘new

economy.’’ It is not a place or a specific industry segment. It is a pervasive concept

affecting all industries to varying degrees. The NAM has done several reports, in

fact, on ‘‘Technology on the Factory Floor.’’ Traditional manufacturers are huge consumers and producers of technology, whether it’s to improve methods of cutting steel

using laser-like streams of super-cooled chemicals; to locate oil, gas, or other natural

resources; to automate an assembly line; or even to provide all of their employees

with home computers. Such a dramatic evolution in the way our companies do business seems to warrant at least an examination of whether traditional accounting

principles are still accurate and appropriate.

I have personally discussed the proposed elimination of pooling with many of our

member companies, and I have been truly surprised by the number of times I have

heard that this merger or that merger would not have happened had it not been

for the applicability of pooling. And I have heard these comments across the board

from all kinds of manufacturers. Even those that don’t use pooling are very concerned about its possible unavailability for future transactions.

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1Letter of the Association for Investment Management and Research, to Mr. Timothy Lucas,

Director of Research and Technical Activities, Financial Accounting Standards Board, December

7, 1999 (Letter of Comment No.: 56A).

Manufacturing is the largest contributor to economic growth, and the recent surge

in M&A activity has coincided with a surge in productivity growth. By mentioning

these facts, I don’t mean to suggest that pooling should be retained because it somehow ‘‘encourages’’ business combinations; rather, it appears that the existence of

only the purchase method to account for a diverse array of transactions would discourage such activity—and that result could well have a negative effect on the economy.

III. PROCESS

Finally, the NAM is concerned that the FASB is not hearing from all parties who

may be critical of the project. Too often we have found that companies are very reluctant to too visibly criticize the merits of a FASB proposal due to concern that

such activity might invite increased SEC scrutiny. Regardless of whether such concerns are founded, as they say, perception is reality, and it does have a chilling effect on full participation in the process. That said, the NAM appreciates the FASB’s

extensive efforts to thoroughly evaluate these issues with significant outside input

and participation, and we do fully support the FASB’s independence and privatesector setting of accounting standards.

AMERICAN BUSINESS CONFERENCE

May 3, 2000

The Honorable MICHAEL G. OXLEY

United States House of Representatives

Washington, DC 20510

DEAR CONGRESSMAN OXLEY: I write in regard to the upcoming hearings in the

Subcommittee on Finance and Hazardous Materials on the efforts of the Financial

Accounting Standards Board (FASB) to change substantially accounting rules for

business combinations.

The American Business Conference (ABC), a coalition of CEOs of fast-growing,

midsize companies, is very concerned about FASB’s proposal. We hope that the Subcommittee’s hearing will illuminate the many important issues put into play by the

FASB initiative—issues we regard as far from settled. As background, I have enclosed with this letter a memorandum I wrote on FASB’s business combinations

project. I hope it may prove of use to you and your colleagues.

In the view of ABC members, the single greatest service your hearing can perform

is to underscore the comprehensive nature of FASB’s business combinations project.

The project is not, as some have suggested, merely an effort to eliminate poolingof-interests with a few extra details thrown in. FASB’s project seeks to change all

business combinations—accounting—the pooling-of-interests method, used in about

5 percent of merger and acquisition deals, and the purchase method, used in the

vast majority of merger and acquisition transactions.

Because the FASB business combinations project is a comprehensive agenda for

change, it carries critical implications for every business enterprise in the country,

regardless of industry and regardless of which method of accounting—pooling or

purchase—they have used in the past or may plan to employ in the future. Interest

in and concern about various aspects of FASB’s proposal accordingly can be found

in all segments of the American business community, among accounting firms, and

among investors.

This is the essential point for understanding the controversy swirling around

FASB’s project. The fact is, as a reading of comment letters to the FASB demonstrates, there is no meaningful consensus in the private sector in support of the

business combinations project.

For example, defenders of FASB’s plan to abolish pooling-of-interests accounting

point to the Association for Investment Management and Research (AIMR), for support of their position. And it is certainly true that AIMR, the leading association

of investment professionals, on balance advocates the elimination of pooling. However, the AIMR ‘‘disagrees strongly’’ with another crucial aspect of FASB’s proposal,

namely the display under the purchase method of goodwill amortization charges net

of tax and after operating earnings.1 (The enclosed memorandum discusses the latter issue in greater detail.)

A review of the positions of the major accounting firms also displays misgivings

about the FASB proposal. PricewaterhouseCoopers, as an instance, disagrees with

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2Letter of PricewaterhouseCoopers LLP to Mr. Timothy Lucas, Director of Research and Technical Activities, Financial Accounting Standards Board, December 7, 1999, (Letter of Comment

No: 1A) and Letter of KPMG to Timothy Lucas, December 7, 1999, (Letter of Comment No: 35A).

Most of the other accounting firms submitting comment letters to FASB cite similar problems

in the exposure draft. These misgivings are mirrored in letters from leading investment banks,

commercial banks, and money management firms. 3Letter of Ford Motor Company to Timothy Lucas, Director of Research and Technical Activities, Financial Accounting Standards Board, December 3, 1999 (Letter of Comment No.: 92).

FASB’s position regarding the elimination of pooling and with some of the Board’s

proposed changes to purchase accounting, including the display of goodwill amortization. For its part, KPMG does not support the total elimination of pooling or the

separate treatment of goodwill amortization from other intangible assets under purchase accounting.2

The comment letters to the FASB from corporations constitute a litany of dissent.

Thus Ford Motor Company, although it does not use the pooling-of-interests method,

is nonetheless ‘‘not in favor of its elimination.’’ As for FASB’s proposed reform of

purchase accounting, Ford does not agree with the Board on goodwill recoverability,

disclosure requirements for acquisitions, the new twenty-year period for goodwill

amortization, or the separate line-item disclosure of goodwill amortization. Ford’s

dissent is more or less typical of the response of other corporations, big and small,

‘‘old’’ economy and ‘‘new’’ economy.3

Although the Board’s rulemaking process. is not complete, FASB members thus

far have shown little inclination to rethink their proposal. In spite of the considerable criticism that the Exposure Draft has attracted, the Board seems determined

to move forward on the elimination of pooling accounting and the alteration of purchase accounting. Undoubtedly the Board will have to ‘‘tweak’’ aspects of its proposal, but it seems unlikely that those marginal changes will speak to the broader

objections of the private sector.

If I am correct about the Board’s attitude, the result will be unfortunate. It will

be unfortunate first because FASB will force on the business, accounting, and investment communities a ‘‘reform’’ of business combinations accounting that I believe

is deeply flawed and that will almost surely have to be revisited, sooner rather than

later.

It will be unfortunate, too, because a decision by the Board to press ahead with

a rule that has met with so much resistance during the comment period threatens

the Board’s long-term capacity to exert leadership on a host of other cutting-edge

accounting issues. The Board very well may have its way in this matter, but at

what price? ABC strongly supports the FASB and respects the Board’s independence. We believe, however, that FASB’s ability to maintain that independence is directly proportionate to its constituents’ faith in the Board’s capacity to respond to

constructive criticism. Fairly or not, many of our colleagues in the business community harbor serious doubts on this point.

We at ABC believe that a responsible, intellectually tenable compromise is possible in regard to business combinations accounting. We also believe the FASB process itself is sufficiently flexible to allow for that compromise to happen, provided

that all the interested parties are willing to take the time to do the job correctly. I

do not pretend to know the exact lineaments of a workable compromise but I suspect it would, as a first step, entail a satisfactory, mutually agreeable recasting of

purchase accounting, particularly as it pertains to intangible assets including goodwill.

In closing, let me state a view that I suspect you share: Congress ideally ought

not to have a legislative role in the setting of accounting standards. What Congress

can do, and indeed, what I hope it will do through the Finance. Subcommittee’s

hearing, is to exert its traditional oversight function in such a way as to inform citizens of the issues at stake while encouraging intelligent compromise within the private standard-setting process. To that end, ABC stands ready to assist you and your

colleagues on the Subcommittee.

Sincerely,

BARRY K. ROGSTAD

President

cc: The Honorable Edolphus Towns

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