Full Text of Testimony

Summary

On July 20, 2001, the Financial Accounting Standards Board ("FASB" or "Board") issued two final Statements-No. 141, Business Combinations, and No. 142, Goodwill and Other Intangible Assets. 

Statement 141 will significantly improve the transparency of the accounting and reporting for business combinations by requiring that all business combinations be accounted for under a single method-the purchase method.  Use of the pooling-of-interests method ("pooling method") is no longer permitted.  The purchase method provides investors with the information necessary to determine the true cost of one company buying another and, as a result, provides a basis for investors to track future returns on the investment.  Statement 141 requires that the purchase method of accounting be used for all business combinations initiated after June 30, 2001.

Statement 142 will improve the purchase method in a number of ways.  Most significantly, the Statement requires that goodwill no longer be amortized to earnings, but instead be tested for impairment.  That improvement will provide investors with greater transparency with respect to the economic value of goodwill and the amount and timing of its impact on companies' earnings.  Statement 142 requires that amortization of goodwill cease upon initial application of the Statement, which, for most companies, will be January 1, 2002.

 

Mr. Chairman, Members of the Subcommittee, I am Edmund Jenkins, chairman of the Financial Accounting Standards Board.  I am pleased to be here today.  I understand the important oversight role of this Subcommittee.

This morning I plan to discuss the mission and due process of the FASB and our two recently issued final Statements to improve the transparency of the accounting and reporting for business combinations.  In addition, I will provide an overview of the FASB's involvement in the area of international accounting standard setting.  I have brief prepared remarks, and I would respectfully request that the full text of my statement and all 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 February 2000 letter from the Financial Accounting Policy Committee of the Association for Investment Management and Research, the leading organization of investment professionals in the US 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. 

More recently, in an October 1997 speech, former SEC Chairman Arthur Levitt stated:

It is compellingly clear to me that the objectivity and fairness of standards-setting can only be guaranteed if the process is insulated from political agendas, special interests, and bureaucratic convenience.  If that independence is compromised, or perceived to be compromised, we would pay a heavy price in declining investor confidence in the markets.

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 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 former SEC Chairman 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 Does the FASB Follow in Developing Accounting Standards?

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-consumers, 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 Statements 141 and 142:

• Following the Board's extensive agenda decision process, we decided to add the project on business combinations to the Board's technical agenda in 1996. (Attachment 2 includes a detailed description of how topics are added to the FASB's technical agenda.)

• 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 13 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 a 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 consisting of representatives from the accounting-standard-setting bodies of Australia, Canada, New Zealand, the United Kingdom, and the International Accounting Standards Committee ("IASC") (collectively the "G4+1"), 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 G4+1 Position Paper. 

• From 1996 through 1999 we held over 40 public meetings 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 summary of all of the Board's decisions.  The updated summary was available on the FASB website 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.)

• In September 1999, we published for public comment an Exposure Draft that contained proposed changes to the existing standards of accounting for business combinations and intangible assets.  We received approximately 200 comment letters in response to the 1999 Exposure Draft.

• In connection with the issuance of the 1999 Exposure Draft, we prepared and issued a number of explanatory documents to assist constituents in understanding the Board's proposed decisions including a FASB Viewpoints, Why Eliminate the Pooling Method? (Attachment 6).  All of the documents were available on the FASB website 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 1999 Exposure Draft with interested parties.  More than 40 individuals and organizations testified. 

• In March 2000, we held a third public business combinations task force meeting to discuss issues raised by constituents in the comment letters and public hearings.   

• In October and November 2000, we conducted field visits with 14 companies in a variety of industries to discuss a goodwill impairment approach developed by the FASB staff in response to constituent input.

• In November 2000, we held a fourth public business combinations task force meeting to discuss the results of the field visits and the potential need for issuance of a revised Exposure Draft proposing changes to the 1999 Exposure Draft's provisions for accounting for goodwill.

• We held over 15 public meetings during 2000 to consider constituent input received in response to the 1999 Exposure Draft. 

• In February 2001, we published for public comment a revised Exposure Draft that contained proposed changes to the 1999 Exposure Draft's provisions for accounting for goodwill.  We received approximately 200 comment letters in response to the 2001 revised Exposure Draft.

• In connection with the issuance of the 2001 revised Exposure Draft, we prepared and issued to the public a FASB Viewpoints, Why Did the Board Change Its Mind on Goodwill Amortization? (Attachment 9).  The document was available on the FASB website and was sent by mail to anyone who requested it.  

• We held over 10 public meetings during 2001 to address the issues raised by constituents in response to the 2001 revised Exposure Draft and to continue to address issues raised by constituents in response to the 1999 Exposure Draft.

• In May 2001, the Board completed its public deliberations of all the substantive issues raised by constituents in response to both the 1999 Exposure Draft and the 2001 revised Exposure Draft.  The Board reviewed the entire package of decisions made in connection with its public deliberations and unanimously supported the issuance of two final Statements--Statements 141 and 142, replacing Accounting Principles Board ("APB") Opinion No. 16, Business Combinations ("Opinion 16"), and APB Opinion No. 17, Intangible Assets ("Opinion 17"), respectively. 

• In June 2001, we issued the FASB's monthly newsletter, Status Report, which included an article entitled Conversations with Constituents.  The purpose of the article was to provide constituent perspectives on the impact of Statements 141 and 142.  In addition, the FASB website contained up-to-date details of all of the Board's significant decisions to be contained in the two Statements.  

• In July 2001, the Board issued Statements 141 and 142 to the public.

What Was Wrong with the Accounting for Business Combinations?

Prior to the issuance of Statements 141 and 142, the accounting for business combinations was governed by the requirements of Opinions 16 and 17, which were issued in 1970 by the APB, a former standard-setting group of the American Institute of Certified Public Accountants. 

Under Opinion 16, business combinations were accounted for using one of two methods, the pooling method or the purchase method.  Use of the pooling method was required whenever 12 criteria were met; otherwise, the purchase method was to be used.  Because those 12 criteria did not distinguish economically dissimilar transactions, business combinations that were similar were accounted for using different methods that produced dramatically different financial statement results.  Consequently:

• Analysts and other consumers of financial statements indicated that it was difficult to compare the financial results of companies because different methods of accounting for business combinations were used.

• Because intangible assets are an increasingly important economic resource for many companies and are an increasing proportion of the assets acquired in many business combinations, consumers of financial statements also indicated a need for better information about those assets.  While the purchase method recognizes all intangible assets acquired in a business combination (either separately or as goodwill), only those intangible assets previously recorded by the acquired entity are recognized when the pooling method is used. 

• Company managements indicated that the differences between the pooling and purchase methods of accounting for business combinations affected competition in markets for mergers and acquisitions.

Under Opinion 17, all intangible assets acquired in a business combination, including goodwill, were required to be amortized or charged to earnings over the useful economic life of the asset.  Consumers, including analysts and other users of financial statements, as well as company managements, noted that intangible assets, including goodwill, are an increasing proportion of the assets acquired in many transactions.  As a result, better information about those assets was needed.  Consumers of financial statements also indicated that they did not regard goodwill amortization expense as being useful information in analyzing investments. 

 

What Do Statements 141 and 142 Require?

The provisions of Statements 141 and 142 reflect a significantly different approach to the accounting for business combinations than was taken in Opinions 16 and 17.  The most significant of those changes are:

• Statement 141 requires that all business combinations be accounted for by a single method-the purchase method.  Thus all business combinations will be accounted for in the same way that other asset acquisitions are accounted for-based on the values exchanged.

• In contrast to Opinion 16, which required separate recognition of intangible assets that can be identified and named, Statement 141 requires that intangible assets be recognized as assets apart from goodwill if they meet one of two criteria-the contractual-legal criterion or the separability criterion.  To assist in identifying acquired intangible assets, Statement 141 also provides an illustrative list of intangible assets that meet either of those criteria.

• In addition to the disclosure requirements in Opinion 16, Statement 141 requires disclosure of the primary reasons for a business combination and the allocation of the purchase price paid to the assets acquired and liabilities assumed by major balance sheet caption.  When the amounts of goodwill and intangible assets acquired are significant in relation to the purchase price paid, disclosure of other information about those assets is required, such as the amount of goodwill by reportable segment and the amount of the purchase price assigned to each major intangible asset class.

• Acquiring companies usually integrate acquired companies into their operations, and thus the acquirers' expectations of benefits from the resulting synergies usually are reflected in the premium that they pay to acquire those companies.  However, the transaction-based approach to accounting for goodwill under Opinion 17 treated the acquired entity as if it remained a stand-alone entity rather than being integrated with the acquiring entity; as a result, the portion of the premium related to expected synergies (goodwill) was not accounted for appropriately.  Statement 142 adopts a more aggregate view of goodwill and bases the accounting for goodwill on the units of the combined entity into which an acquired entity is integrated (those units are referred to as reporting units). 

• Opinion 17 presumed that goodwill and all other intangible assets were wasting assets (that is, finite lived), and thus the amounts assigned to them should be amortized in determining net income; Opinion 17 also mandated an arbitrary ceiling of 40 years for that amortization.  Statement 142 does not presume that those assets are wasting assets.  Instead, goodwill and intangible assets that have indefinite useful lives will not be amortized but rather will be tested at least annually for impairment.  Intangible assets that have finite useful lives will continue to be amortized over their useful lives, but without the constraint of an arbitrary ceiling.

• Previous standards, including Opinion 17, provided little guidance about how to determine and measure goodwill impairment; as a result, the accounting for goodwill impairments was not consistent and not comparable and yielded information of questionable usefulness.  Statement 142 provides specific guidance for testing goodwill for impairment.  Goodwill will be tested for impairment at least annually using a two-step process that begins with an estimation of the fair value of a reporting unit.  The first step is a screen for potential impairment, and the second step measures the amount of impairment, if any.  However, if certain criteria are met, the requirement to test goodwill for impairment annually can be satisfied without a remeasurement of the fair value of a reporting unit.

• In addition, Statement 142 provides specific guidance on testing intangible assets that will not be amortized for impairment and thus removes those intangible assets from the scope of other impairment guidance.  Intangible assets that are not amortized will be tested for impairment at least annually by comparing the fair value of those assets with their recorded amounts.

• Statement 142 requires disclosure of information about goodwill and other intangible assets in the years subsequent to their acquisition that was not previously required.  Required disclosures include information about the changes in the carrying amount of goodwill from period to period (in the aggregate and by reportable segment), the carrying amount of intangible assets by major intangible asset class for those assets subject to amortization and for those not subject to amortization, and the estimated intangible asset amortization expense for the next five years.  

How Will Statements 141 and 142 Improve Financial Reporting?

The changes to accounting for business combinations required by Statements 141 and 142 will significantly improve financial reporting for the benefit of the public-investors, creditors, and other consumers of financial statements-as well as companies that prepare and audit those reports.  More specifically, application of Statements 141 and 142 will result in financial statements that:

• Better reflect the investment made in an acquired entity-the purchase method records a business combination based on the values exchanged, thus, consumers are provided information about the total purchase price paid to acquire another company, which allows for more meaningful evaluation of the subsequent performance of that investment.  Similar information is not provided when the pooling method is used.

• Improve the comparability of reported financial information-all business combinations are accounted for using a single method, thus, consumers are able to compare the financial results of companies that engage in business combinations on an apples-to-apples basis.  That is because the assets acquired and liabilities assumed in all business combinations are recognized and measured in the same way regardless of the nature of the consideration exchanged for them. 

• Provide more complete financial information-the explicit criteria for recognition of intangible assets apart from goodwill, the required nonamortization and impairment testing for goodwill and certain intangible assets, and the expanded disclosure requirements provide consumers with more information about the assets acquired in business combinations.  That additional information should, among other things, provide consumers with a better understanding of the resources acquired and the expectations about and changes in those resources over time, and improve their ability to assess future profitability and cash flows.

• Reduce certain transaction costs-requiring the purchase method of accounting for all business combinations reduces the costs incurred by companies in positioning themselves to meet the criteria for using the pooling method, such as the monetary and nonmonetary costs of taking actions they might not otherwise have taken or refraining from actions they might otherwise have taken.

When Do Companies Have to Begin Following the Requirements of Statements 141 and 142?

The provisions of Statement 141 apply to all business combinations initiated after June 30, 2001.  Statement 141 also applies to all business combinations accounted for using the purchase method for which the date of acquisition is July 1, 2001, or later.

Statement 141 does not apply, however, to combinations of two or more not-for-profit organizations, the acquisition of a for-profit company by a not-for-profit organization, and combinations of two or more mutual enterprises.  All of those combinations are being considered in a separate Board project.

The provisions of Statement 142 are required to be applied starting with fiscal years beginning after December 15, 2001.  Early adoption is permitted for companies with fiscal years beginning after March 15, 2001, provided that the first interim financial statements have not previously been issued.  Statement 142 is required to be applied at the beginning of a company's fiscal year and to be applied to all goodwill and other intangible assets recorded in its financial statements at that date. 

There is one exception to the date at which Statement 142 becomes effective:  Goodwill and intangible assets acquired by companies after June 30, 2001, will be subject immediately to the nonamortization and amortization provisions of Statement 142.

What Is the FASB's Involvement in International Accounting Standard Setting?

Among the significant developments affecting the FASB over the past several years has been the increased attention to the globalization of the financial markets.  This has placed heightened interest and emphasis on the quality of international accounting standards and the process for developing those standards.  In order for companies from around the globe to share equal access to the capital markets, financial reporting must provide greater comparability and credibility.  These issues have underscored the need for a single set of high-quality accounting standards.

In 1999, the FASB and our parent entity the Financial Accounting Foundation ("FAF") published a report, International Accounting Standard Setting:  A Vision for the Future (the "FAF-FASB Vision") (Attachment 14).  The FAF-FASB Vision identified the establishment of a high quality global standard-setting structure as essential to the future success of a truly international financial reporting system in which a single set of accounting standards could be used world-wide.  Without such a structure, the continued independent processes of the various national and international standard setters would only result in increasing divergences among national financial reporting regimes and between national and international accounting standards.  That would increase the difficulties of meeting market demands for international comparability.  Continued differences would augment the risks and uncertainties surrounding cross-border investment opportunities and would raise questions about the relative quality of one set of standards compared to another. 

In its vision, the FASB identified the restructuring of the existing London-based international accounting standard setter, the IASC, as one way in which a quality global standard setter might be established.  The IASC had begun the process of reorganizing itself to create a new global standard-setting structure in 1997.  It appointed a Strategy Working Party ("SWP") to develop the IASC's strategy and structure.  That SWP included a FASB member and an FAF trustee.  In November 1999, the SWP published a report, Recommendations on Shaping IASC for the Future, which was unanimously supported by the IASC board.  The recommendations describe a private sector structure with many of the characteristics of the existing FAF-FASB structure and in many ways consistent with the ideal structure described in the FAF-FASB Vision. 

In December 1999, the IASC began implementing the SWP's recommendations.  In May 2000, the IASC established a group of trustees responsible for overseeing a new standard-setting body, named the International Accounting Standards Board ("IASB").  In January 2001, the IASC trustees selected the initial members of the IASB.  Two members of the IASC trustees are or were members of the FAF trustees, and two members of the IASB are former members of the FASB.  One of those members will be responsible for maintaining liaison between the FASB and the IASB.

While the FASB's primary focus has always been and will continue to be on US accounting standards, it has for many years been an important contributor to the convergence of international accounting standards.  The business combinations project resulting in the issuance of Statements 141 and 142 is the most recent example of our continued support of that effort.  The Accounting Standards Board ("AcSB") of the Canadian Institute of Chartered Accountants has been conducting a project on business combinations concurrently with the FASB project with the goal of converging North American accounting standards related to business combinations.  The AcSB will soon issue final standards that prohibit the use of the pooling method and are similar in most other material respects with Statements 141 and 142. 

During the past year, the FASB also continued to support the convergence effort through our participation in the G4+1.  Carrying on its mission of encouraging dialogue and collaboration among participating nations, the G4+1 published two reports last year.  The first was on a new approach to lease accounting and the second focused on share-based payments.  Following the recent formation of the IASB, the G4+1 disbanded in anticipation that much of its past work will be addressed in the future through the IASB.

Yet another example of FASB participation in the global accounting arena over the past year was the December 2000 publication of a Special Report on the fair value of financial instruments.   The Special Report was published in collaboration with several national standard setters from around the globe and the IASC that were brought together through a Joint Working Group of standard setters.  The Special Report recommends far-reaching changes to accounting practices for financial instruments and similar items, including measurement of virtually all financial instruments at fair value and the elimination of special accounting for instruments used in hedging relationships.

As the FASB participates in the critical task of developing sound and consistent global standards, we look forward to a close, constructive and active relationship with the IASB and other national standard setters in achieving convergence of high quality financial reporting standards around the world.  We are particularly pleased that two former FASB members are members of the IASB. (Attachment 15 is an interview with the two former FASB members discussing their perspectives on the IASB).  We plan on continuing to work in partnership with the IASB and contributing to projects that are international in scope and have important implications for our US constituents. 

In closing, I believe the improved transparency that will result from Statements 141 and 142, and the thorough and open due process that the Board followed in developing those Statements, illustrates the benefits and the strengths of independent private sector accounting standard setting.  Those benefits and strengths will well serve the FASB and the IASB as we work in partnership to develop sound and consistent global standards for the world's capital markets.  For over 28 years the FASB has proven, and will continue to prove, invaluable to the efficiency of the capital markets and to the continued confidence of investors-the consumers of financial information. 

Thank you, Mr. Chairman.  I very much appreciate this opportunity and would be pleased to respond to any questions.