A student in my Mergers and Acquisitions class asked a question that took me back two decades:
I had a question about how pre 2001 consolidation was preferred due to accounting rules allowing pooling rather than purchase. I was taught last year and working this past summer that the form of an M&A deal was heavily influenced by tax considerations. I intuitively assumed purchase was the far superior option; doesn’t purchase accounting create an massive taxation benefit by allowing the surviving corporation deductions for goodwill even though I am ignorant as to the marked up value of assets on other considerations such as basis? I get that there are appearances to consider, but is that the only reason pooling was the preferable method of accounting?
Let's start with basics.
Acme Co., Inc., buys Omega, Inc., with Acme as the surviving entity. If pooling accounting was used, Acme's financial statements would be combined—“pooled”—with those of Omega, so that both companies’ assets and liabilities would be included on Acme’s balance sheet at their existing book value.[1]
If the deal is structured so as to use purchase accounting, however, the transaction is treated for accounting purposes as a purchase by Acme of Omega. In that case, Omega's assets would be marked up or down, as the case might be, to their fair market value on Acme's post-acquisition financial statements.
In addition, in purchase accounting, any control premium—defined for this purpose as the difference between the fair market value of Omega's assets and the price Acme paid to acquire Omega—would be included on Acme’s balance sheet as “goodwill.” In pooling accounting, there is no goodwill, because both companies' items are simply combined—the control premium is ignored.
Goodwill is amortized over time, which during the amortization period generates an annual expense on the company’s income statement. This reduces the company’s earnings and, as such, earnings per share.
Because the amortization period does not depend on the amount of goodwill in question, the more goodwill created in the acquisition, the greater the amount the company will recognize each year as an expense and, hence, the greater the reduction in the company’s annual earnings. Purchase accounting thus typically resulted in lower reported earnings.
Why would a company care? After all, we’re talking about a technical accounting treatment. The company’s actual cash flows are not affected. Yet, because reported earnings get so much attention from analysts and investors, falling accounting earnings are generally disfavored.
In addition, as we’ll see below, the purchase method makes it easier to assess the total purchase price paid to acquire the target, which in turn allows for more meaningful evaluation of the subsequent performance of that investment than is the case with the pooling method. Managers who would prefer that their shareholders not be able to accurately assess their performance might opt for pooling.
Given the option between purchase and pooling, companies thus would often pick pooling because management believed it made their earnings look better.
The SEC and the FASB thus worried that companies would choose between pooling and purchase based purely on how they wanted their accounting earnings to look rather than their actual financial condition.
Did the choice between purchase and pooling actually affect the stock price of the surviving entity? The answer appears to be no. Empirical studies found no statistically significant abnormal returns from one choice versus the other. Analysts and investors appear to have focused on cash earnings rather than accounting earnings. Perhaps as a result, the corporate preference for pooling was marginal. Most years, the split between purchase and pooling leaned only slightly to the latter. Still, there was a perception that companies wasted a lot of money trying to structure deals so that their preferred accounting treatment could be available and that some deals didn’t happen simply because they couldn’t get the preferred treatment.
Turning to the tax consequences, it is true that purchase accounting generates significant tax benefits. The goodwill accrued generates amortization tax deductions. The stepped-up basis means that if the surviving company sells some of the acquired assets, the company will recognize less gain and, accordingly, pay less tax.
In 2001, the FASB ruled that all acquisitions should be taxed as purchases:
The single-method approach … reflects the conclusion that virtually all business combinations are acquisitions and, thus, all business combinations should be accounted for in the same way that other asset acquisitions are accounted for-based on the values exchanged.
The FASB argued that the change would aid investors by ensuring that financial statements would:
Better reflect the investment made in an acquired entity—the purchase method records a business combination based on the values exchanged, thus users are provided information about the total purchase price paid to acquire another entity, which allows for more meaningful evaluation of the subsequent performance of that investment. Similar information is not provided when the pooling method is used.
Improve the comparability of reported financial information—all business combinations are accounted for using a single method, thus, users are able to compare the financial results of entities that engage in business combinations on an apples-to-apples basis. That is because the assets acquired and liabilities assumed in all business combinations are recognized and measured in the same way regardless of the nature of the consideration exchanged for them.
Provide more complete financial information—the explicit criteria for recognition of intangible assets apart from goodwill and the expanded disclosure requirements of this Statement provide more information about the assets acquired and liabilities assumed in business combinations. That additional information should, among other things, provide users with a better understanding of the resources acquired and improve their ability to assess future profitability and cash flows.
In addition, the FASB argued it would lower transaction costs:
Requiring one method of accounting reduces the costs of accounting for business combinations. For example, it eliminates the costs incurred by entities in positioning themselves to meet the criteria for using the pooling method, such as the monetary and nonmonetary costs of taking actions they might not otherwise have taken or refraining from actions they might otherwise have taken.
In sum, both forms had perceived advantages—but only if you assumed analysts and investors focused solely on headline earnings rather than digging into the income statement and balance sheet.
[1] Claire Hill explained:
In poolings, the consideration paid in the merger must be shares of stock. Pooling rules have long restricted share repurchases following mergers accounted for as poolings. If a newly-merged entity can freely repurchase its stock, the difference between pooling and purchase all but evaporates. And, left to their own devices, companies would have ample incentive to make liberal repurchases. In the pooling, they issued new shares of stock: they can effectively reverse that issuance, amplifying pooling's earnings-increasing benefit, by repurchasing some number of shares. Thus, with a pooling and stock repurchase, a newly merged company could get the best of all worlds: earnings from the two companies, no reductions for goodwill, and a minimum number of shares among which to “divide” the earnings for purposes of the earnings per share computation. Before the rule, companies had interpreted the prohibition against post-merger share repurchases quite liberally. In March of 1996, the SEC adopted a rule significantly restricting post-merger repurchases; too many repurchases will preclude pooling treatment.
Claire A. Hill, Why Financial Appearances Might Matter: An Explanation for "Dirty Pooling" and Some Other Types of Financial Cosmetics, 22 Del. J. Corp. L. 141, 162 n.66 (1997)
