©2001 Prentice Hall Takeovers, Restructuring, and Corporate Governance, 3/e Weston Chapter Pooling of Interests vs. Purchase Accounting

©2001 Prentice Hall Takeovers, Restructuring, and Corporate Governance, 3/e Weston - 2 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 Weston - 3 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 - 4 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

©2001 Prentice Hall Takeovers, Restructuring, and Corporate Governance, 3/e Weston - 5 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 - 6 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 - 7 "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 - 8 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

©2001 Prentice Hall Takeovers, Restructuring, and Corporate Governance, 3/e Weston - 9 When the excess is assigned to goodwill, the annual amortization of goodwill will be increased whether tax deductible or not

©2001 Prentice Hall Takeovers, Restructuring, and Corporate Governance, 3/e Weston - 10 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 - 11 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 Weston - 12 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 - 13 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 - 14 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