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Pooling of Interests vs. Purchase
Accounting
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• Pooling and purchase accounting guidelines of 1970
• Current role of FASB
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• Acquisitions are mainly by stock and nontaxable
• Acquiring firm and target firm approximately the same size
• Twelve tests must be met to qualify for pooling
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• Accounting treatment
– Add individual asset and liability amounts of the two companies
– Additional shares of common stock issued by acquiring firm offset in the paid-in capital account
– Retained earnings are simply added
– Any remaining offset to paid-in capital account made to retained earnings
– Consolidated income statement is a summation of each account
– Accounting treatment reflected in prior year financial data
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• Combinations usually for cash and taxable; or fail to meet some tests for pooling
• Operations of target firm are absorbed into acquiring firm
• Excess of price paid over acquired book net worth assigned either to
– Tangible depreciable assets up to fair market value
– Goodwill
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• Net worth accounts of target are eliminated
• Combined common stock account is total shares times par value
• Total debits less any credit to the common stock account is a "plug" credit to the paid-in capital account
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• "Combined" retained earnings is the retained earnings of the acquiring firm
• Reported net income is lower
• Goodwill amortization
– Financial reporting: write-off period no longer than 40 years
– Tax reporting: for taxable purchases, 1993 tax law change allows tax deductible goodwill amortization over 15 years
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• When purchase price exceeds the book net worth of target, accounting net income of the combined firm will be lower under purchase accounting than under pooling
• When the excess is assigned to depreciable assets, the depreciation expense item will be increased
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• When the excess is assigned to goodwill, the annual amortization of goodwill will be increased whether tax deductible or not
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• If the excess is assigned to nontax deductible goodwill, cash flows are unaffected
• When the excess is assigned to depreciable assets, cash flows under purchase accounting will be increased by the amount of depreciation tax shelter
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• When the excess is assigned to goodwill whose amortization is deductible under the tax law change of
1993, cash flows under purchase accounting will be increased
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• Pooling — leverage is unchanged
• Purchase
– When payment is by stock, leverage is decreased
– When payment is from excess cash or increased debt, leverage is increased
• See the text and diskette for use with
Weston, Johnson, Siu (2000) for Tables
3.1 through 3.6 for analysis of above relationships
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• Acquiring firms prefer pooling method to avoid negative impact of goodwill amortization on reported earnings
• Stock prices of acquiring firms are not penalized when purchase method accounting is used
• No statistical significant difference in stock price reactions to accounting method used in nontaxable transactions
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• Effective late 2000 or early 2001
• Reasons to eliminate pooling
– Provides less information
– Ignores the values exchanged
– Financial statements do not provide enough information on the transaction
– Difficult to compare companies
– Artificially boosts earnings
– Transaction should be recorded based on value that is given up in exchange
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