Currently, when one company buys the stock of another with its own shares, the transaction can be accounted for as a pooling-of-interests under GAAP (Generally Accepted Accounting Principles). This stock-for-stock deal is treated as a merger and the financial statements are restated as if the two companies had always been together.

There are tax advantages to the selling stockholders, who do not have to pay capital gains taxes until the shares of the acquiring company are sold. There are also accounting "benefits" to the acquiring company, which doesn't need to recognize goodwill.

Goodwill is created in a purchase transaction where one company acquires another, with cash or stock, not as a merger but as a takeover. Goodwill represents the amount by which the purchase price exceeds the book value (the shareholders' equity from the balance sheet) of the acquired company. Not surprisingly, this "excess" amount is defined as the good will built up with customers; less obvious is the fact that the accounting treatment of this item is illogical and irrelevant.

Goodwill is created in purchase transactions, and the accounting fashions of the GAAP currently require that this goodwill be expensed in an item called goodwill amortization. But where is the sense here? Goodwill grows in value over time — why would you treat it as a depreciating asset?

Simply put, goodwill should be ignored. When analyzing a company, add back the goodwill amortization to the net income in determining true reported earnings (this will also improve the free cash flow).

Another consequence of acquisitions is the recent proliferation of in-process R&D write-offs. These occur, particularly in technology buyouts, when the buying company decides that some portion of the seller's research and development is worthless. Accordingly, it takes a large one-time write-off to expense this "worthless" R&D.

Effectively, what the company is doing is getting around the goodwill problem. Goodwill amortization is an annual expense which investors should ignore but, by and large, do not. In-process R&D is a one-time write-off, and Wall Street tends to ignore expenses which are non-recurring. This, of course, creates a temptation for public companies to bunch together some ongoing operating expenses and write them off in a single year as a "non-recurring" charge. If necessity is the mother of invention, trying to please Wall Street is the mother of necessity.

The Securities and Exchange Commission (SEC) which regulates public companies and the Financial Accounting Standards Board (FASB) which sets the accounting rules have lately been taking a more active role. The SEC is cracking down on which in-process R&D write-offs are permissible. The irony here is that the abuse of these R&D write-offs wouldn't take place if goodwill were treated correctly in the first place.

Beginning in 2002, the accounting rules for goodwill will finally reflect economic reality (SFAS 142). Goodwill need no longer be amortized — instead, it will be ignored on the income statement (unless it is determined that the goodwill value listed on the books has declined).

Companies will begin reporting their earnings without the deduction for goodwill amortization. Wise investors have always ignored this amortization, but now, everyone else will do the same. The impact on the reported earnings will be far more dramatic for some companies than the average. For example, in the WealthEffect Portfolio, Media General and Belo deduct significant amortization (reducing reported earnings by >50%); for Disney, the deduction is meaningful (>20%); for Reader's Digest and Wells Fargo, the impact is above-average (10-20%).

Concurrent with its ruling on goodwill amortization, the FASB has eliminated pooling transactions (SFAS 141), sensibly requiring that all acquisitions be accounted for as purchases. In addition, the FASB is moving towards a more accurate accounting for the true costs of company stock options, which is long overdue.

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