On September 14, 1998, WorldCom merged with MCI to form MCI WorldCom, a global telecommunications giant. On September 30, NationsBank of Charlotte, North Carolina, and BankAmerica of San Francisco merged to form BankAmerica, one of the largest banks in the United States. While each case involved the combination of two firms, each used a different accounting method. MCI WorldCom's merger announcement noted that the combination would be accounted for as a "purchase"; on the other hand, BankAmerica's merger used a method called "pooling of interests" accounting.
In May 1991, American Telephone and Telegraph (AT&T) acquired computer manufacturer NCR Corporation (formerly National Cash Register) for $110 per share, in what was to that date the largest-ever computer industry merger. Press reports indicated that during negotiations AT&T upped its offer by $5 per share, an increase of about $325 million, to secure NCR's cooperation in accounting for the acquisition as a pooling of interests.1
Here is the mystery. AT&T paid the additional $325 million to use pooling accounting rather than the alternative-purchase accounting-a choice that affected accounting numbers but neither added assets, reduced liabilities, nor changed tax treatment. Why then was AT&T willing to expend an additional $325 million? Both anecdotal and empirical evidence indicate that AT&T's preference for pooling is not unusual. Corporate managers frequently go to some expense to employ pooling, though there are no obvious benefits.
These cases raise questions for those not acquainted with the features of merger and acquisition procedure. What are the differences between purchase and pooling of interests accounting? Should the choice of accounting method be of concern to analysts, investors, or others interested in business activity? Why are two different forms of accounting-purchase and pooling-used for otherwise similar acquisitions? What drives the choice between the two methods, and why are acquirers willing to take expensive steps that have only cosmetic consequences? This article addresses these questions.
Despite firms' express preference for pooling, the body responsible for setting U.S. accounting standards, the Financial Accounting Standards Board (FASB), recently proposed eliminating pooling, even though the accounting treatment has been used for years. While the change would bring U.S. merger and acquisition accounting standards more in line with standards used in other countries, acquisitive corporations are likely to oppose it. The change might offer some benefits, but the benefits could be offset by efficiency losses.
1. POOLING AND PURCHASE: THE NUTS AND BOLTS
Accountants attempt to report in balance sheets an accurate valuation of a firm's assets, liabilities, and equity. But how should accountants value a firm arising from the combination of two separate businesses? One approach is to simply sum the dollar amounts of assets, liabilities, and equity of the two firms as they stood before the combination. This is pooling of interests accounting. Or, since business combinations are typically one firm's purchase of another firm, another valid method would value the purchased firm at its purchase price, and add the purchase price to the assets of the acquiring firm, as one would if the acquisition were of a piece of equipment. In broad terms, the latter approach is purchase accounting. The financial statements of a combined firm will vary with the choice between pooling or purchase accounting. While accounting methods for business combinations have changed over time, under today's accounting rules both pooling and purchase are acceptable means of valuing combinations in the United States.
The terms merger, acquisition, consolidation, reorganization, and combination are often used interchangeably (none is particularly associated with either pooling or purchase accounting). While no single term predominates, throughout this article the term business combination will be employed to indicate the uniting of two firms, regardless of the features of the unification. …