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9-109-002 JULY1,2008 KARTHIKRAMANNA The Politics and Economics of Accounting for Goodwill at Cisco Systems (A) On March 2, 2000, Dennis Powell, vice president and corporate controller for Cisco Systems, appeared before the Senate Committee on Banking, Housing, and Urban Affairs. Powell was testifying on a recent proposal by the Financial Accounting Standards Board (FASB) to abolish the pooling-of-interests method of accounting for mergers. Powell expressed his opposition to the FASB proposal, arguing that the accounting method firms would be required to use in lieu of pooling (i.e., the purchase method) would “stifle technology 1 development, impede capital formation and slow job creation . . . .” The Senate heard from eight other expert witnesses that day; all but one—Ed Jenkins, chairman of the FASB—argued against the proposal to abolish pooling. 2 Six months later, by September 2000, Powell had abandoned his support for the pooling method. In leading a group of industry representatives at a meeting with members of the FASB, Powell argued for a regime that permitted only the purchase method, provided goodwill recognized under that method be solely subject to impairment testing (rather than amortization as the FASB had proposed). 3 Accounting for Mergers: Purchase and Pooling Methods Until 2001, U.S. generally accepted accounting principles (GAAP) had two methods to account for mergers: the purchase method and the pooling-of-interests method. Under the purchase method, acquired tangible assets, certain acquired intangible assets (e.g., contracts, patents, franchises, customer and supplier lists, and favorable leases), and all acquired liabilities were revalued to their 1 Prepared statement of Dennis Powell before the Senate Committee on Banking, Housing, and Urban Affairs (Washington: U.S. Government Printing Office, 2000). 2 Karthik Ramanna, The implications of unverifiable fair-value accounting: Evidence from the political economy of goodwill accounting, Journal of Accounting and Economics (forthcoming). 3 Dennis Powell, Business Combination Purchase Accounting: Goodwill Impairment Test, appendix to the minutes of the September 29, 2000 FASB Board meeting (Norwalk, CT: FASB, 2000). ________________________________________________________________________________________________________________ Professor Karthik Ramanna prepared the original version of this case, “The Politics and Economics of Accounting for Goodwill at Cisco Systems,” HBS No. 108-021. This version was prepared by the same author. This case was developed from published sources. HBS cases are developed solely as the basis for class discussion. Cases are not intended to serve as endorsements, sources of primary data, or illustrations of effective or ineffective management. Copyright © 2008 President and Fellows of Harvard College. To order copies or request permission to reproduce materials, call 1-800-545-7685, write Harvard Business School Publishing, Boston, MA 02163, or go to This publication may not be digitized, photocopied, or otherwise reproduced, posted, or transmitted, without the permission of Harvard Business School. 109-002 The Politics and Economics of Accounting for Goodwill at Cisco Systems (A) current fair values before being added to the acquiring firm’s books. Any excess of the total price paid for the acquisition over the sum of the revalued net assets was added to acquirer’s books as goodwill. In the years following the acquisition, goodwill was amortized in the acquirer’s income statement. Further, under the purchase method, the acquiring firm only recognized the acquired firm’s income from the date of the acquisition. Under the pooling method, the surviving firm in an acquisition simply added the book value of all acquired assets and liabilities to its own assets and liabilities. There were no asset and liability revaluations and no goodwill was recorded. Accordingly, there was no goodwill expense associated with pooling transactions. Further, under the pooling method, the acquiring firm recognized the acquired firm’s income for the entire fiscal year in which the acquisition occurred. Thus, the balance sheets and income statements of firms doing pooling method acquisitions looked very different from those of firms doing purchase method acquisitions. Firms were required to use the purchase method unless they met certain criteria to qualify for pooling accounting. The most important of these criteria were (1) that each of the companies in an acquisition was independent of the other and (2) that the acquiring firm issued only common stock (with rights identical to its own outstanding common stock) in consideration for the acquired firm. 4 Cisco and the Making of Mergers Accounting In September 1999, the FASB proposed abolishing the pooling method of accounting for mergers; all firms 5 were asked to use purchase method accounting with amortization required for any goodwill. The vast differences between pooling and purchase method accounting, the FASB argued, had led to situations whereby “two transactions that [were] not significantly different [could] be accounted for by methods that produce[d] 6 dramatically different financial statement results.” The FASB solicited public comments on its proposal; about 7 60% of corporate respondents opposed the idea. Cisco was among these opponents, and Powell took a lead role in expressing Cisco’s concerns. At Cisco, Powell oversaw global financial reporting, international tax strategies and implementation, 8 corporate procurement, and internal auditing. In a December 1999 letter to the FASB, Powell wrote expressing “serious concerns” with the proposed elimination of pooling accounting in favor of the purchase method with goodwill amortization. “While we understand that pooling accounting has its critics,” he wrote, “we believe on balance, for equity funded transactions, it is less problematic than the purchase accounting model in representing the economic reality of operating results of the combined entity.” 4 5 6 7 8 9 2 9 Accounting Principles Board Opinion No. 16: Business Combinations, (New York: AICPA, 1970). Exposure Draft 201-A: Business Combinations and Intangible Assets, (Norwalk, CT: FASB, 1999). Ibid., p. 34. See footnote 2. Dennis Powell’s biography,, accessed July 19, 2007. Dennis Powell, Letter of Comment No.: 25A, FASB file reference: 1033-201 (Norwalk, CT: FASB, 1999), p. 2. The Politics and Economics of Accounting for Goodwill at Cisco Systems (A) 109-002 10 Powell’s opposition to the purchase method was based on the idea that goodwill was not an asset. “[G]oodwill is simply the amount of purchase price that is left over after allocating value to identifiable assets . . .,” he noted. “It has no value on its own; it can’t be borrowed against, sold separately or generate any cash 11 flow.” Powell also expressed doubts about the purchase method in general and about goodwill amortization in particular: The purchase method of accounting was designed for accounting for tangible assets that have reliable measurable fair values. However, in the acquisitions of New Economy technology companies, an overwhelming portion of the purchase price is attributable to intangibles. It is this situation that makes the purchase method inadequate. Identifying intangibles is difficult, but determining the fair value of identified intangible assets with some level of consistency or reliability is impossible. . . . 12 While Cisco continues to grow our business by combining with similar companies with the same long term strategic goals, our operating results would decrease because of the amortization of goodwill. This decrease in operating results would continue even if the acquisitions we complete were successful resulting in an increase to our market capitalization . . . . Our operating results would not be comparable to companies who develop technology internally. 13 Powell concluded his letter to the FASB with a passionate defense of pooling accounting: “We believe the retention of pooling of interests accounting is particularly critical considering the adverse impact its elimination will have on the merger activity in the United States, which in turn will negatively impact the ecosystem that is driving technology development in this country today.” 14 Concerns from corporations like Cisco over the FASB proposal to abolish pooling quickly reached Congress. In March and May of 2000, the Senate Banking Committee and the House Finance Subcommittee, respectively, held hearings on the issue. Several of the corporate respondents who had already expressed their 15 opposition to the FASB testified at these hearings. Cisco was among them: Powell appeared before both the Senate and House on Cisco’s behalf, reiterating his arguments above. In comments to the House, he added that extant accounting rules for mergers accounting had “for the past 50 years, generated and supported the strongest capital markets in the world.” 16 10 FASB Concept Statement No. 6 defines “assets” as “probable future economic benefits obtained or controlled by a particular entity as a result of past transactions or events.” 11 See footnote 9, p. 2. 12 Ibid., p. 3. Note that when Powell was speaking of “identified intangibles,” he was referring to their definition at the time, that is, “intangible assets that can be identified and named.” APB Opinion 16, paragraph 88e, p. 319. The current definition of “identified intangibles” includes any asset that arises from legal rights (regardless of whether those rights are transferable or separable) or any asset that is capable of being separated or divided for sale, rent, and so on (regardless of whether there is intent to do so). SFAS 141, paragraph 39, p. 17. 13 14 15 Ibid., pp. 4–5. Ibid., p. 5. See footnote 2. 16 Prepared statement of Dennis Powell before the House Subcommittee on Finance and Hazardous Materials (Washington: U.S. Government Printing Office, 2000). 3 109-002 The Politics and Economics of Accounting for Goodwill at Cisco Systems (A) Sometime after the hearings in Congress, two separate groups of opponents to the FASB proposal met with 17 members of the FASB Board. Powell led the second group. This meeting, held in September of 2000, included experts from the American Business Conference, Merrill Lynch, the Technology Network, and United Parcel Service, besides Powell on Cisco’s behalf. Both Powell’s group and the group before it did not discuss retaining pooling accounting at their respective meetings. Instead, they proposed an alternative to goodwill amortization under a regime that permitted only the purchase method. In the years after an acquisition, they argued for goodwill to be periodically tested for impairment. The impairment test, they proposed, would be based on a comparison of goodwill’s recorded book value and an estimate of the current fair value of goodwill. 18 The FASB, after some field testing and an additional round of comment solicitation, accepted the goodwill impairment alternative. In June 2001, the FASB formally promulgated new accounting standards that abolished pooling accounting, requiring all firms to use the purchase method, with impairment testing for any acquired goodwill. 19 According to the 2001 standards, an acquiring firm must—upon completing the acquisition— allocate any acquired goodwill among its reporting units (a reporting unit is a segment within the acquiring firm with discrete financial information that is regularly reviewed by management). If the acquired goodwill represents synergies from a merger, managers are required to disaggregate and allocate those synergies to reporting units based on estimates of how they are expected to be realized. In the years after an acquisition, goodwill must be tested for impairment within the reporting unit to which it was allocated. The goodwill impairment test in a reporting unit is a two-step procedure. In the first step, managers must estimate the current fair value of the reporting unit (as a whole) and compare it to the unit’s total book value. If the unit’s fair value is greater than the unit’s book value, step two is ignored and no goodwill impairment is recognized. If the unit’s fair value is less than its book value, step two is conducted as follows. Managers calculate the current fair value of the unit’s goodwill as the difference between the estimate of the unit’s total fair value (as calculated in step one) and an estimate of the current fair value of the unit’s net assets (excluding goodwill). The current fair value of goodwill is then compared to the goodwill’s book value. The excess (if any) of the goodwill’s book value over its current fair value is the unit’s goodwill impairment. Managers are not required to disclose the assumptions that underlie their estimates of goodwill’s fair value (both at the initial stage of allocating goodwill to reporting units and at the subsequent stage of testing for goodwill impairment within units). The goodwill impairment of reporting units (if any) are aggregated and reported at the firm level. 17 See footnote 2. 18 Trevor Harris, Accounting for Business Combination: A Workable Solution, appendix to the minutes of the May 31, 2000 FASB Board meeting (Norwalk, CT: FASB, 2000); see also footnote 3. 19 See Statement of Financial Accounting Standards No. 141, Business Combinations (Norwalk, CT: FASB, 2001) and Statement of Financial Accounting Standards No. 142, Goodwill and Other Intangible Assets (Norwalk, CT: FASB, 2001). The FASB, in collaboration with the International Accounting Standards Board, is in the process of revising the current rules of purchase method accounting in order to harmonize them with international accounting practices. Under the new rules, expected to be released in the third quarter of 2007, the purchase method will be known as the “acquisition method.” See FASB Project Updates: Business Combinations,, accessed August 20, 2007. 4 The Politics and Economics of Accounting for Goodwill at Cisco Systems (A) 109-002 Cisco Systems in the 1990s Cisco Systems was founded in 1984 by two computer scientists from Stanford University. The company developed technologies that enabled computer networks to communicate with one another. Cisco went public in February 1990 with a market capitalization of about $224 million. By the close of the 1990 fiscal year, Cisco had 251 employees and $69 million in revenues. The 1990s were a period of extraordinary growth for Cisco (see Exhibit 2). As it was a key supplier of computer networking technologies, the company’s fortunes grew with the rise of the Internet. By 1999, Cisco employed nearly 21,000 people, had sales of about $12.2 billion, and had a market capitalization of over $235 billion. On March 27, 2000, Cisco briefly became the world’s most valuable company, with a market capitalization of $569 billion. 20 Cisco’s growth was fuelled in large part by an acquisitions strategy. This strategy was laid out in a 1993 21 plan put forth by then Chief Technology Officer John Chambers (Chambers became CEO in 1995). Cisco made its first acquisition in September 1993. From then through the end of 2000, Cisco acquired 75 other companies at a combined price of over $36 billion. Most of these deals were to acquire key intangibles. As Chambers noted, “Most people forget that in a high-tech acquisition, you really are acquiring only people. . . . At what we pay, $500,000 to $2 million an employee, we are not acquiring current market share. We are 22 acquiring futures.” Of the combined purchase price of Cisco’s acquisitions through February 2000, Powell attributed 95% to goodwill and other intangible assets. history from 1993 through 2000. 23 See Exhibit 3 for a summary of Cisco’s acquisition Cisco operations for the quarter ending April 29, 2000 were classified into four broad areas: routers, switches, access, and “other.” Routers and switches each accounted for about $2 billion of the quarter-ending sales, while access and “other” accounted for about $0.6 billion and $0.8 billion, respectively. Unallocated negative sales adjustments were about $0.5 billion. 24 Cisco Systems’ Acquisition of ArrowPoint Communications On May 5, 2000, one day after Powell testified before the U.S. House, Cisco Systems announced its acquisition of ArrowPoint Communications. ArrowPoint was a Boston-based provider of Internet content 25 switches that help Web hosts optimize and track their website performance. The switches allow Web hosts to direct their preferred customers through priority routes and to limit access to their websites based on security or 26 privacy concerns. ArrowPoint had only just completed its IPO (April 5, 2000) when the Cisco deal was announced. 3, 2000, ArrowPoint’s stock opened at $102, giving it a market capitalization of over $3.6 20 27 On May Cisco Systems Corporate Timeline,, accessed July 19, 2007. 21 “Cisco Systems, Inc.: Acquisition Integration for Manufacturing (A),” HBS Case No. 600-015 (Boston: Harvard Business School Publishing, 2000). 22 23 24 25 26 27 John Byrne, “The Corporation of the Future,” BusinessWeek, August 31, 1998, quoted from HBS Case No. 600-015. See footnote 1. Cisco Systems Form 10-Q, filed June 13, 2000. “Cisco Systems to Acquire ArrowPoint Communications,” press release,, accessed July 19, 2007. ArrowPoint Corporate Profile,, accessed July 19, 2007. ArrowPoint Communications Form 10-Q, filed May 2, 2000. 5 109-002 The Politics and Economics of Accounting for Goodwill at Cisco Systems (A) billion; by May 5, ArrowPoint stock closed at $140. In a press release dated May 5, Cisco announced that it would exchange for every outstanding share and option in ArrowPoint 2.1218 shares in Cisco. Based on Cisco’s closing price of $63.625 on May 4, the deal was worth over $5.7 billion (including nearly $1 billion for converted ArrowPoint options). Cisco announced that it was acquiring ArrowPoint “to provide its customers with a feature-rich, flexible content switching platform.” 28 A press release announcing the merger added: Coupled with Cisco’s Internet infrastructure, ArrowPoint’s products will provide a new level of intelligence that will enable ISPs, Web hosting companies and other customers to create a faster, more reliable Web experience. In addition, ArrowPoint’s solutions strengthen Cisco’s presence in emerging markets that include ASPs (Application Service Provider), AIPs (Application Infrastructure Provider) and “dot com” companies. 29 Cisco stated that after the acquisition the 337-person ArrowPoint group would continue to be led by its CEO, Cheng Wu. ArrowPoint employees would join Cisco’s Public Carrier IP Group, and Wu would report to a senior vice president at Cisco. Exhibits 4 and 5 detail Cisco’s and ArrowPoint’s most recent balance sheets and income statements before the acquisition announcement. 28 29 30 6 30 See footnote 25. Ibid. Note: Quarterly income statements are presented because ArrowPoint never released an annual report. The Politics and Economics of Accounting for Goodwill at Cisco Systems (A) Exhibit 1 109-002 Accounting Standard-Setting in the United States Accounting standards for public companies in the United States were unregulated until the early 1930s. The Securities Acts of 1933 and 1934, promulgated in the wake of the stock market crash of 1929, created the Securities and Exchange Commission (SEC) and charged it with the responsibility to set accounting standards. Since the late 1930s, the SEC has relied on private standard-setting bodies to establish accounting rule ...
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Companies merge and acquire other firms for various reasons. Some companies acquire
firms so that they can control the supply of raw material. Companies merge with other
companies so that they can gain a large market base. Companies also merge so that they can
increase their operations and service delivery. A merger occurs both in the physical and in the
accounts. The firms can physically merge their offices, production plants and other amenities.
The firms are also required to merge their accounts. The acquiring firm merges its financial
accounts with those of the acquired company to produce a single financial statement. The
government and accounting boards regulate how accounts in mergers and acquisition happen.
The article discusses the different methods of accounting used by companies after they
acquire and merge with other firms. In the United States, the Financial Accounting Standard
Board is responsible for setting the accounting methods that apply to companies (Pratt, 2011).
The board regularly evaluates the accounting methods and proposes changes to the relevant
stakeholders. The board through the Senate Committee on Banking, Housing, and Urban Affairs
requests for the public input on the proposals. Companies in the United States used two methods
of accounting after a merger or acquisition. The pooling of interest method was the predominant
method of accounting. A minority of companies used the purchase method because it had
qualifying conditions.
The main distinction between the two metho...

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