Accounting for Acquisitions and Firm Value

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ABSTRACT

The accounting of an acquisition is based on either the pooling or the purchase method. Pooling (or pooling of interests) treats the combined companies (acquirer and acquired) as though they had always operated as one company. The purpose of this study is to investigate the extent to which the accounting method used affects the value of the acquiring firm. One argument is that the accounting method used should not affect this value inasmuch as the accounting method does not directly affect cash flow. Our sample consists of 146 pooling and 46 purchase announcements from 1981 to 1995. Results indicate that valuation effects are more favorable for acquisitions using the purchase method in the eleven-day period surrounding the announcement and for at least six months following the announcements. These results stand even after conducting a cross-sectional analysis that controls for the firms' price/earnings ratio, size, market parameter estimates, earnings surprises, and leverage. These results suggest that market participants value the added flexibility and indirect tax benefits that are provided by the purchase method of accounting as opposed to the higher reported future earnings associated with the pooling method.

INTRODUCTION

The accounting of an acquisition is based on either the pooling or the purchase method. Pooling (or pooling of interests) treats the combined companies (acquirer and acquired) as though they had always operated as one company. Consequently, the financial statements of the new company merely reflect the consolidation of statements of the two previously separate entities. In contrast, purchase accounting revalues the assets and liabilities of the acquired company at their current fair market values with the possible difference between the acquisition price and the market value of the acquired company's net identifiable asset (i.e. goodwill) being amortized over a period not to exceed 40 years. This amortization creates an expense that reduces reported earnings of the acquiring firm.

The purpose of this study is to investigate the extent to which the accounting method used affects the value of the acquiring firm. One argument is that the accounting method used should not affect this value inasmuch as the accounting method does not directly affect cash flow. However, there are other arguments relating to valuation effects from future cash flows and/or indirect cash flows that provide a rationale for how and why the choice of accounting method can impact value.

ADVANTAGES OF POOLING

Research by Ball & Brown (1968), Gonedes (1975), Hoskins, Hughes & Ricks (1986), and others has shown that reported earnings can partially drive stock prices. To the extent that the accounting method affects future earnings, the valuation effects may be more favorable for acquirers using the pooling method.

Earnings for pooling firms are generally higher for a number of reasons. The first is due to the way in which the acquired firm's earnings are folded into the new entity's reported earnings. Under pooling, the net earnings for the entire year of acquisition are carried into the merged firm's income statement; under purchase accounting, only the income earned by the acquired firm after the acquisition date are reported by the acquiring firm. Depending on when during the year the acquisition takes place, this difference may be more (late in the year) or less (early in the year) significant in the reported earnings for the first year.

Pooling would also result in higher earnings reporting for reason related to the treatment of the acquired firm's assets and liabilities after acquisition. The tax aspects of mergers and acquisitions are extraordinarily complex but can be roughly divided between tax-free reorganizations and taxable acquisitions. In general, tax-free reorganizations under IRC Section 368 will be accounted for under the "pooling of interest" method. Taxable acquisitions, with re-valuation of assets to their fair market value (an election under IRC Section 338 is available for stock acquisitions), are usually reported using the "purchase" method of accounting. The discussion of the reporting aspects of pooling vs. purchase accounting assumes a parallel to the tax consequences of tax-free reorganizations vs. taxable acquisitions. It further assumes that market participants implicitly understand the relevant tax consequences related to the method of accounting disclosed in the acquisition announcement. Under pooling, the valuation of these assets and liabilities remains unchanged from how they appeared on the pre-acquisition balance sheet of the acquired firm. Under purchase accounting, the assets and liabilities of the acquired firm are restated at their current market values. Because there is no re-valuation (i.e., "write-up") of the acquired firm's assets under pooling, depreciation expenses after the acquisition are generally lower (with the resultant reported earnings being generally higher) than the depreciation that would taken for the same acquisition under purchase accounting.

Related to this non-revaluation of assets is the fact that there is no possibility for the recognition of "goodwill" (i.e. the difference between the purchase price and the market value of the acquired firm's net identifiable assets) from an acquisition under pooling. Had a firm recognized goodwill upon acquisition (as would have been the case under purchase accounting), it would be required to amortize (i.e., expense) this intangible asset, which, in turn, would negatively impact reported earnings. In fact, under the Exposure Draft on a proposed Statement, Business Combinations and Intangible Assets, issued by the FASB in September, 1999, not only would the purchase method be required for all business combinations but any goodwill that is recognized as a result of the acquisition would not be subject to amortization. Instead, goodwill would be reviewed for impairment (i.e., its fair value is less than its carrying amount) on a regular basis (FASB, 1999). As a final consequence of non-revaluation of assets, pooling firms will generally report higher gains (or lower losses) upon the disposal of the assets of the acquired firm due to the lower basis of these assets. In contrast, because of the revaluation to current market values at the time of acquisition, the acquired firm's assets lose whatever pre-acquisition gains which are inherent in them.

As a result of these accounting differences, a company using pooling would be expected to report higher earnings after the acquisition than a company using the purchase method. (Also see Herz & Abahoonie (1990) for a more detailed discussion of earnings differentials between the purchase and pooling methods.)

If market participants do indeed use reported earnings in assessing a firm's value, one would expect abnormal returns associated with the pooling method to be larger than those associated with the purchase method of accounting for acquisitions. This leads to the following null hypothesis:

   HO: Abnormal returns surrounding the announcement of a pooling
       acquisition are larger than those associated with a purchase
       acquisition.

ADVANTAGES OF THE PURCHASE METHOD

While its use will generally result in lower reported earnings, the purchase method of accounting does offer some advantages over pooling. As shown in Appendix A, firms must …