Medical Device Link.

Originally Published MX November/December 2001

FINANCE

Goodbye, Goodwill

New accounting rules could have a significant effect on reported earnings and company valuations for medical device manufacturers.

E.W. (Sandy) Purcell

The 1990s witnessed quite a sharp rise in mergers-and-acquisitions (M&A) activity in the healthcare equipment and supplies market. Moreover, the pace of deal-making has remained robust over the past year. In the 12 months ending July 31, 2001, deal-makers in healthcare announced 120 transactions, a 58% increase over prior-year activity and a new high in deal volume (see Figure 1). As a result, many medical device manufacturers today carry large legacies of goodwill on their balance sheets.

The Financial Accounting Standards Board (FASB; Norwalk, CT) recently enacted a sweeping reform of the treatment of goodwill and other intangible assets. FASB’s new rules apply to all companies reporting on a generally accepted accounting principles basis. These changes will directly affect the reported bottom line for many companies, especially in the medical device industry.
Goodwill can be defined as an intangible asset that provides a competitive advantage. Examples include a strong reputation and high employee morale. When a business is purchased, accounting principles require that the purchase price be assigned to the fair value of the identifiable assets that are acquired. The sum of the fair values placed on the assets (after the deduction of liabilities) is often less than the total purchase price of the business. The difference is assigned to an asset account called goodwill. In an acquisition, goodwill appears on the balance sheet of the acquirer in the amount by which the purchase price exceeds the net tangible assets of the acquired company.

Figure 1. M&A activity among manufacturers of healthcare equipment and supplies rose sharply throughout the 1990s. Deal count includes all transactions announced and not subsequently canceled. Source: Houlihan Lokey Howard & Zukin (Chicago). (Click to enlarge)

Accounting rules previously required goodwill to be amortized over a period not to exceed 40 years through charges of equal amount every year to the earnings account. This annual charge to earnings was not allowed as a tax deduction, and thus had an effect on after-tax income that was roughly double that of most other expenses.

But these rules no longer apply. FASB has recently completed a five-year overhaul of its rules for booking mergers and acquisitions. New rules adopted by FASB do away with pooling-of-interests accounting for M&A transactions taking place after June 30, 2001, and eliminate amortization of goodwill for all companies reporting after December 15, 2001. Instead, companies will test goodwill for impairment and write down impaired goodwill to implied fair value. In other words, companies will leave goodwill unchanged on their books until its value falls, or becomes impaired, rather than writing off the goodwill according to a preset amortization schedule each year.

Some companies have the option of adopting the new goodwill standard in the current year rather than the following one. Such companies must not have issued their financial statements for the first quarter, and must have a fiscal year ending after March 31, 2001, and before December 15, 2001. Companies that have this choice should consider prompt adoption of the new standard. Doing so will enable companies laden with goodwill from past M&A deals to discontinue amortization and avoid a significant charge to reported net income in the coming year. Since a number of medical device manufacturers carry significant goodwill levels—that is, well above 15% of total assets—this article examines the effect of FASB’s new rules on the medical device industry.

The Growth of Intangible Assets

The great consolidation wave of the past decade raised the decibel level of long-standing grievances over accounting standards affecting business combinations. The shortcomings of those standards also grew more acute as a result of the changing industrial landscape of the United States. Throughout the 1980s and 1990s, the service and information technology (IT) sectors expanded their share of U.S. economic output, while heavy manufacturing continued to decline. The bulk of assets of service and IT companies consist of intangible assets such as the knowledge and expertise of employees, patents, trademarks, computer programs, and goodwill.

Goodwill often accounts for the lion’s share of an IT or service company’s market value. For example, PeopleSoft (Pleasanton, CA), an enterprise software provider, reported net assets—total assets minus total liabilities—of $1.3 billion as of June 30, 2001. That figure is dwarfed by the company’s market capitalization, which totaled more than $12 billion at the end of June.

Medical device and equipment manufacturers exhibit wide spreads between the reported value of their net assets and their market caps. Dentsply International (York, PA), a manufacturer of dental x-ray equipment and other dental products, reported $567 million in net assets as of June 30; its market cap as of the same date surpassed $2.2 billion. Stryker Corp. (Kalamazoo, MI), which makes orthopedic implants and other medical products, reported $943.6 million in net assets as of June 30, compared with more than $10 billion in market cap. Medical device giant Medtronic (Minneapolis) reported $5.5 billion in net assets as of the company’s April 27 fiscal-year close date, compared with more than $53.2 billion in market cap.

These figures came from public companies, which trade at a premium—typically 30%—compared to the value of minority ownership in their closely held counterparts. But the principle remains the same.

While goodwill is no longer amortized, most identifiable intangible assets will continue to be amortized over their expected useful lives. FASB wants recognition of more individual intangible assets. The agency’s statement, Goodwill and Other Intangible Assets, requires that an intangible asset be recognized separately from goodwill if it meets one of the following two asset-recognition criteria.

• Control over the future economic benefits of the asset results from contractual or other legal rights.
• The intangible asset is capable of being separated or divided and sold, transferred, rented, or exchanged.¹

To assist in identifying intangibles, FASB has developed an expanded list of assets that it believes meet the criteria for recognition separate from goodwill. The identification of such intangible assets should increase the amounts allocated to identifiable intangibles and reduce the amounts assigned to goodwill.

Settling a Controversy

Critics have long regarded goodwill amortization as a noncash expense that understates net income. As a result, deal-makers have often resorted to the pooling-of-interests method to book mergers and acquisitions, in which the balance sheets of the acquirer and the acquired company are combined line by line without a tax impact. Pooling requires the acquirer to record the acquired company’s net assets at historical book value. The acquirer consequently has no accounting acquisition premium (AAP; an expectation of benefits resulting from the synergies of a business combination) or goodwill to amortize because none was booked.

The question of whether to use purchase or pooling methods for reporting M&A transactions has stirred controversy for decades. The coexistence of two generally accepted accounting methods frustrates the ability to make ready comparisons between companies using different standards.

Recent research suggests that reporting the AAP under purchase accounting also depresses a company’s share price. In an efficient market, investors presumably discount goodwill amortization in their evaluation of cash flow and adjust price-to-earnings (P/E) ratios accordingly. However, a study conducted under the auspices of Indiana University (Bloomington, IN) in 1999 found otherwise.

In the study, 113 buy-side analysts were asked to estimate the price of a company’s publicly traded common stock after a stock-for-stock business acquisition. The combined company booked the merger under one of three approaches: recording the AAP and amortizing it under the purchase method, fully expensing the AAP in the year of the acquisition, or applying the pooling method and thereby not recording the AAP. The analysts reached their lowest stock-price judgments when the underlying company recorded the AAP and amortized goodwill under the purchase method.²

These problems grew in the 1990s as goodwill and other intangible assets made up an increasing share of assets acquired in M&A deals. To resolve the problems, FASB unanimously approved two new accounting standards in June 2001.

Business Combinations. This standard prohibits the pooling-of-interests method for booking mergers and acquisitions. Companies are required to use the purchase method for all business combinations initiated after June 30, 2001. Investors and other users of financial statements will now be able to compare results among companies, since purchase accounting will be the sole method used.³

Goodwill and Other Intangible Assets. This standard does away with goodwill amortization and the amortization of intangible assets where the useful life extends beyond the foreseeable horizon. Prior accounting standards had assumed that goodwill and other intangible assets were "wasting assets"—that is, finite-lived and subject to ratable amortization. FASB no longer presumes intangible assets are wasting assets. According to this statement, "goodwill and intangible assets that have indefinite useful lives will not be amortized but rather will be tested at least annually for impairment."⁴

Intangible assets that are being amortized should continue to be reviewed for impairment in accordance with FASB’s statement, Accounting for the Impairment or Disposal of Long-Lived Assets.⁵ However, the recognition of impairment losses on intangible assets with indefinite lives should be based on the fair market values of the assets. In either case—that is, involving a finite-lived intangible asset subject to amortization or an indefinite-lived asset subject to testing—the impairment loss would be measured as the excess of the book value over fair value.

The sections that follow address first the mechanics of goodwill impairment, then the treatment of other intangible assets under the new guidelines.

Goodwill Impairment Mechanics

Under Goodwill and Other Intangible Assets, companies will identify goodwill at the reporting-unit level and write off goodwill only when it is impaired. Companies that write down impaired goodwill will present the aggregate amount of goodwill impairment losses as a separate line item in the income statement before the "income from continuing operations" line. In applying FASB’s statement on goodwill to intangible assets acquired in a transaction prior to the effective date of June 30, 2001, the transitional intangible-asset impairment loss is recognized as the effect of a change in accounting principle, and is reported between the "extraordinary items" and the "net income" lines. After the transition year, goodwill impairment must be run through future income statements.

A fair value–based impairment test should estimate the implied fair value of goodwill, which is then compared with its book value to determine whether goodwill is impaired. The method to determine the fair value of goodwill is similar to the method of allocating the purchase price to the net assets obtained in an acquisition. The value of net assets of a reporting unit should be subtracted from its fair value to determine the implied fair value of the reporting unit’s goodwill.

An intangible asset (including goodwill) that is not subject to amortization must be tested for impairment annually, or more frequently if events or changes in circumstances indicate that the asset might be impaired. An example of such a trigger event would be a decline in company or unit market capitalization below the carrying amount of the entity’s net assets. Another trigger would be if the credit rating of an entity’s publicly traded debt falls below investment grade.

The first step used to identify potential impairment compares the fair value of the reporting unit with its book value, including goodwill. If the fair value of a reporting unit exceeds its book value, there is no impairment and the second step of the impairment test, which undertakes the allocation process as if the reporting unit had been acquired in an acquisition, is unnecessary.

Complicating the valuation issues for companies reporting to the Securities and Exchange Commission (SEC; Washington, DC) is the issue of independence in the assessment and determination of impairment amounts. The SEC is requiring a higher level of disclosure for those accounting firms that provide audit services together with other financial advisory services. The accounting firm that conducts the audit for the reporting company may have to obtain the impairment assessment from an independent valuation analyst.

The new rules will weigh unevenly across U.S. industries. In the technology sector, many companies already report earnings without goodwill amortization. However, effects will be significant in all hotbeds of M&A activity. That group includes the energy, financial services, and healthcare sectors. Medtronic, with goodwill weighing in at 16% of total assets, stands as the role model for the acquisitive company in the medical device industry. Many medical device companies have been formed from roll-ups of smaller units. In fact, a number of medical device manufacturers report substantial goodwill as a percentage of assets (see Table I).

The following example, which is drawn from the financial statements of Aetna (Hartford, CT), illustrates the negative impact that goodwill amortization can have on earnings. Aetna’s healthcare operations comprise three major acquisitions: the June 1996 merger with U.S. Health for a total consideration of $8.9 billion, the July 1998 acquisition of New York Life’s healthcare businesses for $1.1 billion, and the August 1999 acquisition of Prudential Health Care for $1 billion.

In the wake of these acquisitions, Aetna booked nearly $6.8 billion in goodwill, an extraordinary 91% of its enterprise value in 2000. However, an estimated fair value of Aetna’s goodwill as of April 2001 pegged the number at $827 million, a potential impairment of nearly $6 billion.

A write-down of this magnitude poses dramatic financial implications, at least insofar as standard fundamental metrics are concerned. In Aetna’s case, the results may adversely affect the company’s compliance with the regulatory requirements of its recent commercial paper offering. The company took direct hits to book value of equity, net earnings, net margin, and return on equity, as well as the expansion of leverage and price-to-book ratios.

Based on recent studies, the elimination of goodwill amortization is expected to increase net earnings by 10–20%, on average. In addition to the expected effect on P/E ratios, stock prices may increase for companies that had negative earnings under the prior method of amortizing goodwill but will now show positive earnings. The pricing behavior of securities analysts does not always track cash flow. Analysts also look to net earnings, earnings growth, and P/E multiples. Thus, shifts from negative to positive earnings as a result of the elimination of goodwill amortization may support increased stock prices. A mitigating factor may be the increased frequency of write-offs of goodwill as companies make their assessments of goodwill impairment. Stock prices of those companies taking repetitive impairment charges are likely to receive negative investor response, even though cash flows are unaffected.

Intangible Accounting

The new FASB rules encourage companies to make impairment assessments quickly. The assessment process should include whether intangible assets might have indefinite life and are therefore not subject to amortization. In addition, some acquired assets that were previously captured in goodwill may become identifiable, finite-lived intangibles that can be amortized.

At the time of acquisition, the economic life of an intangible asset is determined and used for purposes of accounting for the depreciation and amortization of the asset after acquisition. FASB’s Goodwill and Other Intangible Assets suggests that companies reassess the economic lives of intangible assets and make adjustments where appropriate. In some instances, the useful life of an intangible asset cannot be determined with reasonable accuracy. In its statement on goodwill, FASB defines the term indefinite as having a "life that extends beyond the foreseeable horizon." An intangible asset with indefinite life is treated like goodwill and is amortized until useful lives can be determined. Some examples of intangible assets having indefinite life might be Federal Communications Commission licenses, trademarks, brand names, and airport landing rights.

Conclusion

Theoretically, the proposed change in statement no. 142 should not affect a company’s value. Goodwill amortization is a noncash charge resulting from costs that are already embedded in the stock price. Its elimination should therefore not affect expected cash flow or value, and as a result, P/E ratios will adjust downward. However, due to a variety of factors, P/E ratios may not immediately and fully adjust downward. It will be important for medical device companies to work with their auditors and advisors on the effects of the new rules on reported earnings’ performance measures.

M&A activities should increase, especially in the medical device industry. The tough requirements of pooling and the earnings impact of purchase accounting previously deterred many buyers from bidding on companies. With the new rules, nonpoolable companies now are more attractive to potential buyers. In addition, buyers that could not previously suffer the earnings impact of purchase accounting are free to enter the bidding. All buyers may become more competitive in their bidding against foreign buyers because the new rules put them on a more-even playing field in terms of M&A accounting. Finally, companies that were historically unattractive acquisition candidates due to the size of their potential goodwill value may become more attractive to hostile bidders.

Overall, because the benefits of pooling have been eliminated and because a future impairment charge to earnings is not desirable, companies undergoing an M&A transaction will be valued on their ability to match pricing and execution with expected posttransaction synergies.

REFERENCES

1. Financial Accounting Standards Board, Goodwill and Other Intangible Assets, statement of financial accounting standards no. 142, June 2001.

2. PE Hopkins, RW Houston, and MF Peters, "Purchasing, Pooling, and Equity Analysts’ Valuation Judgments," The Accounting Review 75, no. 3 (2000): 257–281.

3. Financial Accounting Standards Board, Business Combinations, statement of financial accounting standards no. 141, June 2001.

4. Goodwill and Other Intangible Assets, no. 142.

5. Financial Accounting Standards Board, Accounting for the Impairment or Disposal of Long-Lived Assets, statement of financial accounting standards no. 144, October 2001.

E. W. (Sandy) Purcell is a director of Houlihan Lokey Howard & Zukin (Chicago and Los Angeles), an international investment banking firm. He also heads the financial advisory services practice for the firm’s Midwest region.

Illustration by Beata Szpura/Illustration Works

Copyright ©2001 MX