Academic journal article Review of Business

Setting New Standards for Business Combinations and Intangible Assets

Academic journal article Review of Business

Setting New Standards for Business Combinations and Intangible Assets

Article excerpt

The business combination project undertaken by the Financial Accounting Standards Board evoked a lot of controversy. This article overviews an extensive due process and political struggle which lead to Statement No. 141, Business Combinations, and Statement No. 142, Goodwill and Other Intangible Assets, issued in June 2001. International repercussions of the new standards are also discussed.


In 1973, the Financial Accounting Standards Board (FASB) issued a "Request for Views Concerning Certain APB Opinions and Accounting Research Bulletins." As a result of the responses received from this open letter, the Board placed on its agenda a project on accounting for business combinations and purchased intangibles. In August 1976, the Board issued a Discussion Memorandum on the subject, but later deferred pursuing the matter due to issues of higher priority. Twenty years later, the Board once again placed this subject on the table in an effort to reconsider the requirements of APB Opinions No. 16, Business Combinations, and No. 17, Intangible Assets (1).

The need to reconsider the business combinations issues resulted from the flurry of merger and acquisition (M&A) activity in the late 1990's. The Securities and Exchange Commission (SEC), the FASB, and the audit profession had all witnessed an increase in the volume of inquiries on the application of APB Opinion Nos. 16 and 17. Any time accounting pronouncements in a particular area are put to the test in such a pervasive manner, it brings to the forefront of the profession flaws and deficiencies in those pronouncements. Companies with very similar merger and acquisition transactions could (if the criteria were met) account for these transactions using different methods, resulting in different financial statement impacts. The FASB's concern that representational faithfulness and comparability would be compromised was quite justifiable (2).

Business combinations were accounted for using one of two methods, the pooling of interest method or the purchase method. Use of the pooling method was required whenever 12 criteria were met; otherwise, the purchase method was to b used. Many companies contemplating an acquisition preferred the pooling of interests method. This was because the pooling treatment had a more favorable impact on the financial statements than the treatment of an acquisition as a purchase. Under purchase accounting, assets and liabilities of the acquired company are booked at fair value, which in most cases is greater than their carrying values. Since depreciable assets such as plant, property, and equipment now are being restated using a higher depreciable base, the result is higher depreciation charges and an unfavorable impact on the income statement. Another undesirable effect occurs because the purchase price paid over fair value of assets acquired is recognized as goodwill. The resulting amortization has a similar adverse im pact on the income statement Financial ratios also suffer as a result of the purchase method of accounting. Return on Investment, for example, is calculated by taking net income in the numerator and total assets in the denominator. The lower earnings in the numerator resulting from purchase accounting, coupled with the higher assets in the denominator, cause this ratio to be less favorable than if the pooling method were employed. Pooling treatment does not have the same adverse effect on the financial statements. When en the companies combine, the book values of the companies are carried forward. As a bonus, the acquired company's retained earnings is carried forward under pooling, providing management with more flexibility with regard to dividends (3).

The FASB was cognizant of the fact that the use of the pooling method had moved away significantly from its original intent Pooling treatment was originally intended for combinations in which a strong degree of affiliation existed between the combining companies prior to the combination. …

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