The value of international cross-border merger and acquisition activity rose by 47 percent from 1998 to 1999, up from US $541 billion to a record US $798 billion. United States' Generally Accepted Accounting Principles currently permit two mutually exclusive alternatives in accounting for business combinations. The first is purchase accounting. The second, pooling of interests, is the subject of proposed elimination. In this manuscript, the purchase and pooling methods are illustrated. Further, the potential impacts of the likely elimination of the pooling alternative are discussed, both in terms of standard setting implications and in terms of potential impacts on merger and acquisition activity.
Many corporate executives, financial analysts and investment brokers speculate that the elimination of the pooling of interests alternative to record mergers and acquisitions will severely reduce the number of such mergers and acquisitions. Why would the elimination of the accounting alternative cause a reduction in mergers and acquisitions? The purpose of this article is to explain the accounting alternative proposed to be eliminated and to link its elimination to the impact on mergers and acquisitions.
The Rationale Behind Current U.S. Accounting Rules
The booming world economy of the last few years has been accompanied by an increase in mergers and acquisitions. KMPG Peat Marwick reports that the value of international crossborder merger and acquisition activity rose by 47 percent from 1998 to 1999, up from US$541 billion to US $798 billion (KPMG, 2000). The ease of formation of new business structures through mergers and acquisition has generally been viewed as a positive factor for the economy. Thus, the reduction of the number of mergers and acquisitions could have negative consequences for the business economy, both in the United States and worldwide.
The use of an accounting alternative for recording mergers and acquisitions entitled "pooling of interests" has been widely used in business combinations for the last decade because of its favorable impact on earnings subsequent to the business combination. The standard setting body for accounting standards in the U. S., the Financial Accounting Standards Board (FASB), is proposing the elimination of the pooling of interests method as an alternative for recording business combinations. The elimination of this alternative thus might provide a negative incentive for the combination of business organizations.
United States' Generally Accepted Accounting Principles (GAAP) currently permits two mutually exclusive alternatives in the accounting for business combinations. These accounting methods are referred to as the pooling of interests method and the purchase method respectively. To better understand the effect of these methods on business combinations (mergers and acquisitions), a brief explanation of each method follows. The advantages and disadvantages of each method are also indicated.
The pooling method is based on the notion that two companies merge as equals. Either a new company is created or one company remains with the other becoming part of the remaining company. The concept underlying pooling is both previous entities retain their operating activities and identities in the same manner as before the combination. A recent example of such a combination is the merger of Daimler-Benz and Chrysler Corporation to form Daimler Chrysler. Under present United States' accounting standards recognized by the Financial Accounting Standards Board (FASB) as adopted from Accounting Principles Board (APB) 16 (APB, 1970), potential pooling candidates must meet requirements set forth by FASB (APB 16: Business Combinations) (see Figure 1). The staff of the Chief Accountant's office of the SEC reviews these criteria for business combinations that involve corporations under SEC jurisdiction. If the requirements are not met, the new entity must report under the purchase method (described below). Theoretically, only mergers of companies of similar size and type may qualify as poolings. In reality, deals can influence the accounting treatment by carefully structuring the combination to meet the criteria of pooling, often at additional initial cost (Walter, 1999). Under the pooling method, the values for the assets and liabilities that are the values currently recorded on the books of each company are carried forward to the remaining company existing after the business combination. There are no new assets or liabilities created by the business combination. The income statement of the remaining company includes all revenues and expenses from the beginning of each of the prior company's fiscal year.
The purchase method presumes that one company acquires another company. Under the purchase method, the surviving company recognizes assets and liabilities acquired from the liquidated company in the business combination at their fair market values. Any excess of purchase price paid for acquiring these assets and liabilities over the net fair market value of assets and liabilities is recognized as goodwill. Thus the assets and liabilities of the acquired company take on new values as they are transferred to the acquiring company and goodwill may be created. The differences in fair market values and the recorded or book value of the assets acquired must be depreciated or amortized against expense for their useful lives. Also goodwill must be amortized against expense, under current accounting standards, for its useful life or a period not to exceed 40 years. The income statement of the existing company after the business combination does not include the results of operations of the acquired company prior to the acquisition date.
Thus under the purchase method, in most current business combinations, large amounts of fair market values differences may be charged to expense each year plus possibly a good chunk of the goodwill. Thus the purchase method for a business combination can result in material charges to expense each year from depreciating and amortizing fair market values differences and goodwill. For example, the Securities and Exchange Commission recently determined that 12 acquisitions by Zions Bancorp accounted for as pooling of interests should have been treated as purchases (Cahill, 1999). Zions had not recognized $500 million in goodwill because of the pooling of interest treatment. Zions will now have to charge $12.5 million annually against earnings thus lowering its earnings per share significantly.
Purchase versus Pooling: An Illustration
A simple illustration of the treatment of business combinations under the pooling of interests vs. purchase methods is shown in Figures 2 & 3. The assumption is that Beta and Zeta companies merge with Beta the surviving company. In consummating the merger, Beta Co. issues shares with a fair market value of $90 million in exchange for all the shares of Zeta. The fair market value of the Beta's shares is not considered in a pooling but is considered in the purchase method as shown below. Note that cash flow is not affected by choosing one method over the other.
The purchase method determines goodwill by initially considering the fair market value of Zeta's net assets. The fair market value of Zeta's assets was assumed to be $100 million or $15 million above the recorded or book value of $85 million. The fair market value of liabilities was assumed the same as book value, $30 million. Since net fair market value of the assets was $70 million (100 minus 30), then the difference between the purchase price and fair market value of shares issued, $90 million, and $70 million is goodwill of $20 million. After the merger, Beta Co. will have to depreciate or amortize each year the fair market value difference in assets of $15 million and the goodwill of $20. Under the pooling method, no depreciation or amortization is required.
Since 1996, 730 acquisitions with a total value of $419 billion have been consummated using the pooling of interests method (Cahill, 1999). The advantages of the pooling method, most notably, the lack of recognition and amortization of goodwill, have made it a popular alternative to the purchase method. At a time when mergers and acquisitions are a primary vehicle for high-tech companies to gain quick access to complementary technologies and markets, mergers and acquisitions have come to the forefront of business news. In 1998, in New England alone, 1294 mergers and acquisitions involving regional high-tech companies valued at $220.6 billion were reported to the Securities and Exchange Commission. According to the SEC, most of these deals were accounted for as pooling of interest (Ewing, 1999).
The FASB Proposal
The FASB has proposed (FASB, 1999) to eliminate the pooling method for several reasons. Theoretically the pooling method is to be applied only when the business combination results in a business entity that continues with same proportion of ownership. Additionally the companies should be roughly equal in size and would continue with the same nature of operations as prior to the combination. Apparently, this is not the case in many instances where pooling has been applied. Thus the use of the pooling method to record business combinations has not resulted in the financial reporting that was intended. Also, the SEC has indicated that more than 40% of the time of the staff of the Chief Accountant's office of the SEC is devoted to reviewing business combinations to determine if these combinations meet the criteria for a pooling of interests (Ewing, 1999). Elimination of the pooling of interests method will reduce the SEC's staff workload devoted to monitoring business combinations.
In addition to the proposed elimination of the pooling method, the he FASB also seeks to refine the surviving purchase method. Specifically, the FASB proposes a reduction in the maximum amortization period for goodwill from 40 to 20 years. Since this reduction in goodwill life will result in even higher charges for amortization of goodwill, the FASB has also proposed that the amortization expense of goodwill could be presented on the income statement on a separate line after "income before goodwill charges" (FASB,1999). Thus readers could view the net income as a separate amount before goodwill amortization. Since there is no effect on the cash balance from the choice of pooling vs. purchase, this income presentation would help offset the negative influence on earnings of increased goodwill amortization.
Standard Setting Implications
The FASB proposal for elimination of pooling constitutes a step toward international harmony; nevertheless, international uniformity is not in the hands of the FASB. "The changes that the FASB proposes would still fall short of creating a uniform global standard "(Merrill Lynch, 1998). For example, the IASC allows pooling in limited circumstances. While very few U. S. business combinations would meet these circumstances as described in the IASC standard entitled a "uniting of interests", the option would remain. Furthermore, United States' standard setters do not dictate rules the world over. The practices of other developed nations vary in relation to the use of the pooling of interests. In the United Kingdom, Canada, Sweden, France, Italy, the Netherlands, Spain and Switzerland pooling is an option. Even where pooling of interests is not utilized, the treatment of goodwill introduces variation in income and balance sheet effects of business combinations. For example, in Germany, once goodwill is recognized as part of a stock-based merger, it is written off immediately against equity. In effect, while the purchase approach is used, no reduction to net income is realized, as would be the case under U.S. accounting rules.
Research Findings Regarding Purchase versus Pooling
Because business combinations contribute to their business, Wall Street Brokerage houses have invested time and money in applied research on the topic of purchase and pooling. Meanwhile, academics have applied traditional research techniques to evaluate the impacts of purchase versus pooling on corporate earnings and stock prices.
Brokerage firms such as Salomon Smith Barney and Merrill Lynch have sponsored research studies of their own to ascertain whether or not the market distinguishes between business combinations accounted for under the pooling of interests versus those accounting for as purchases. Salomon Smith Barney's Financial Strategy Group sought to answer the question: Is, in a purchase transaction, the price earnings multiple adjusted to negate the goodwill charge (which has no effect on cash flow)? The evidence from stock market valuations and price reactions to transaction announcements are consistent with the notion that purchase accounting does not adversely affect firm valuations (CPA Journal, 1999).
A recent Merrill Lynch study notes, "In 1998, 55% of the dollar volume of U.S. mergers employed the pooling method. Many of these mergers-and the (financial) efficiencies they produced, would not have occurred had the companies been forced to comply with the new (mandatory purchase) accounting standards now being contemplated" (Bloomberg News, 1999).
While Wall Street firms have paid increasing attention to the likely loss of the pooling of interests option, Chief Financial Officers are also concerned. A recent survey conducted as part of the Institutional Investor's CFO Forum reveals that nearly 90% of CFO's surveyed expected the ban on pooling to slow the pace of merger activity. Nearly 25% of those surveyed expect the slowdown in merger activity to be dramatic (Institutional Investor, 1999).
Academics have long been interested in the tactical and financial impacts of accounting options for business combinations. In an indepth study of the valuation attributes of AT&T's acquisition of NCR, Lys and Vincent concluded that AT&T paid a premium for the use of the pooling-of interests method to avoid a sustained decrease in earnings per share. In the AT&T/NCR case, AT&T paid a confirmed $50 million for the reissuance of existing NCR treasury stock to make the deal work. . Why spend $50 million to ensure the deal could be accounted for as a pooling? As described by the authors,
"AT&T's management believed that the reduction in EPS under purchase accounting by roughly $0.45 per share in each of the next ten years would be detrimental to its share price as well as to its ability to raise capital." Perhaps even more importantly, Lys and Vincent make the point that the "window dressing" afforded by the pooling choice was worth the price to be paid.
No one can be certain what effect the elimination of the pooling of interests accounting option will have on mergers and acquisitions. If pooling is discarded, U.S. companies will learn to play by only one set of rules - those prescribed by purchase accounting. One thing is likely. If left with only purchasing as an option, the debaters are likely to focus on the crux of the purchase accounting issue goodwill. It is goodwill amortization that reduces net income and earnings per share, so those concerned with its effects are likely to discuss its classification (on the income statement and balance sheet) and the proper period for goodwill amortization, if any.
Meanwhile, is the U.S. any closer to achieving worldwide harmonization with respect to accounting alternatives? Of course, the U.S. can lead, but there is no guarantee that others, including the IASC will follow. Nevertheless, some are happy with FASB's move to eliminate pooling, no matter what the international community says or does. Mike McNamee of
Business Week put it this way: "While regulators, including the SEC should tread carefully, they do need to wipe out this accounting gimmick that allows managers to hide overpriced deals and other blunders from investors forever."
Accounting Principles Board. 1970. Business Combinations. August.
Bloomberg News. 1999. 'Pooling of Interests' Accounting Rule Due'. Los Angeles Times. Los Angeles, CA. Sep 8:2.
Cahill, Joseph B. 1999. Zions Sides Over Its Plan to Restate Net. Wall Street Journal. New York, New York. December 29: A3,A6.
CPA Journal. 1999. Salomon Smith Barney Survey Says Losing Pooling of Interests Will Be OK. New York, New York: September: 11.
Ewing Eileen Smith. 1999. Pooling Ruling Could Dampen Economy. Boston Globe. Boston, Massachusetts. August 24: D4.
Financial Accounting Standards Board (FASB). 1999. Proposed Statement of Financial Accounting Standards, "Business Combinations and Intangible Assets". New Jersey.
Institutional Investor. 1999. "Alas, Poor Pooling," New York, New York. June: 37-- 38.
Johnson, Todd. 1999. " No More Pooling," Accountancy. London, UK. June. Pp. 80 KPMG. Cross-borer M&A Reaching All-Time High.
Leander, Tom. Will FASB Derail the M&A Express? Global Finance. New York, New
York. December: 60-62.
Lys, T and L,. Vincent. 1995. "An Analysis of Value Destruction in AT&T's Acquisition of NCR" Journal of Financial Economics. 29: 353-378.
Walter, John R. 1999. "Pooling or Purchase: A Merger Mystery." Economic Quarterly: Federal Reserve Bank of Richmond. Richmond, Virginia: Winter 2746.
Russell F. Briner (Email: email@example.com)
University of Texas at San Antonio
Cheryl Linthicum Fulkerson
University of Texas at San Antonio