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Chapter 3
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Pooling of Interests vs. Purchase
Accounting
©2001 Prentice Hall
Takeovers, Restructuring, and Corporate Governance, 3/e
Weston - 1
Accounting Standards for
Recording M&As
• Pooling and purchase accounting
guidelines of 1970
• Current role of FASB
©2001 Prentice Hall
Takeovers, Restructuring, and Corporate Governance, 3/e
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Pooling of Interests
Accounting
• 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
©2001 Prentice Hall
Takeovers, Restructuring, and Corporate Governance, 3/e
Weston - 3
• 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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Takeovers, Restructuring, and Corporate Governance, 3/e
Weston - 4
Purchase Accounting
• 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
©2001 Prentice Hall
Takeovers, Restructuring, and Corporate Governance, 3/e
Weston - 5
• 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
©2001 Prentice Hall
Takeovers, Restructuring, and Corporate Governance, 3/e
Weston - 6
• "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
©2001 Prentice Hall
Takeovers, Restructuring, and Corporate Governance, 3/e
Weston - 7
Effects on Net Income
• 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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Takeovers, Restructuring, and Corporate Governance, 3/e
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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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Takeovers, Restructuring, and Corporate Governance, 3/e
Weston - 9
Effects on Cash Flows
• 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
©2001 Prentice Hall
Takeovers, Restructuring, and Corporate Governance, 3/e
Weston - 10
• 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
©2001 Prentice Hall
Takeovers, Restructuring, and Corporate Governance, 3/e
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Effects on Leverage
• 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
©2001 Prentice Hall
Takeovers, Restructuring, and Corporate Governance, 3/e
Weston - 12
Empirical Studies
• 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
©2001 Prentice Hall
Takeovers, Restructuring, and Corporate Governance, 3/e
Weston - 13
FASB Proposal to Eliminate
Pooling
• 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
©2001 Prentice Hall
Takeovers, Restructuring, and Corporate Governance, 3/e
Weston - 14