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. …