First Place Massachusetts Society of CPAs
Student Manuscript!

Getting Out of the Pool
By Patricia Mochen
Bridgewater State College

Business combinations have swamped the headlines of papers across the nation in recent years. In the early nineties the number of consolidations increased at a rate of 14% per year and the value of the deals increased at a rate of 31% per year. Companies combine for a multitude of reasons, among them cost savings, tax advantages, as well as earnings management. Investors need to know how such transactions are affecting their investments. Until now there have been two methods of accounting for business combinations, ‘purchase' accounting and ‘pooling of interests' accounting. The underlying issue in the controversy in accounting for consolidations is how to account for the intangible assets of goodwill and In Process Research and Development(IPR&D). A consistent and reliable rule must dictate how to account for these assets or else the financial statement of consolidating companies will continue to mislead and confuse investors.

For years purchase accounting was used by any company which bought another company and assumed control. Pooling accounting was used by companies which shared equal control and therefore pooled their interests. With time the line between control and sharing has become blurred, resulting in two completely different methods of accounting for essentially the same transaction. This discrepancy allows many companies to take unfair advantage of the accounting rules to better their financial earnings on the income statement.

The Financial Accounting Standards Board (FASB) has been for years studying issues dealing with merger accounting. The battle over merger accounting focuses on two issues: the In Process Research and Development(IPR&D) write-off and pooling of interests accounting for acquisitions. On April 22, 1999 the FASB took a major step towards the elimination of pooling accounting for consolidations by voting unanimously for purchase accounting as the only acceptable method for mergers and acquisitions. The board is expected to make an official draft early in June of 1999. Recently however even companies which have used purchase accounting to account for acquisitions have allocated large sums of the purchase price to IPR&D costs and therefore taken a large one time reduction of earnings instead of allocating the extra price differential to goodwill. Companies would rather take a one time "big bath" than have a constant yearly expense of the goodwill allocation. The Securities and Exchange Commission(SEC) has spoken out strongly against this practice. SEC Chairman Arthur Levitt states: "There are too many games being played in purchase accounting"(Stickel). He warns companies against the gimmicks. On February 25, 1999 the FASB proposed to end this one time write-off and have companies recognize the research and development costs over a period of years. The FASB and the SEC are seeking more consistency and comparability in order to protect the investors and creditors. The accounting should reflect the substance of the transaction over the form. The FASB is expected to address three issues in its June draft concerning consolidations, first purchase versus pooling accounting, the allocation of IPR&D costs and acceptable amortization period for goodwill.

Purchase accounting identifies one company as the buyer and records the company being acquired at the price actually paid. Accounting Principle Board opinion No. 16, "Business combinations", published in 1970, has provided the basic principles for accounting for business combinations up until now. In theory, purchase accounting should be used when one company achieves control over another company, or in other words when one company purchases the assets and liabilities of another company. When this happens, the purchasing company should record the assets and liabilities bought at their fair-market values. The excess of the purchase price over the fair market value is goodwill. Most companies amortize goodwill on a straight-line basis over the maximum allowed period of 40 years. Goodwill should never be written off immediately because it would lead to the conclusion that goodwill would have no future service potential. Goodwill is an intangible asset. An asset is defined in FASB's conceptual framework as "probable future economic benefits obtained or controlled by a particular entity as a result of past transactions or event "(Kieso & Weygandt, 40). Some accountants contend that intangibles should not be carried as assets on the balance sheet under any circumstances. According to this point of view they should be written off directly to retained earnings or to additional paid in capital because the useful life of goodwill is impossible to determine. This would be the ideal solution to accounting for goodwill because companies would be able to consolidate without the excess price over the assets effecting earnings. This practice would make the financial statements more relevant to the users. "In order to be recognized in the main body of financial statements, an item should meet the definition of a basic element, be measurable with sufficient certainty and be relevant and reliable"(Kieso, 47). It is very difficult to measure goodwill. That is why the only time goodwill appears a balance sheet is when one company purchases another. This is an inconsistency in Generally Accepted Accounting Principles (GAAP).

Other theorists suggest that goodwill as an asset does not last forever and that it should be charged to expense in the periods in which it helps to earn revenues. This would provide better matching of expenses to revenues. They argue that if the goodwill is not accounted for in future periods, the true cost of the acquisition is not accounted for. Currently GAAP calls for the amortization of goodwill. The FASB has recently been considering a reduction in the maximum of years for allocation from 40 to 20. Reducing the number of years would increase the burden to companies because the reduction of earnings would be larger for a shorter period of time. What would this change accomplish? The change would not improve the user's understanding of the transaction. Many companies are screaming fowl play. The chairman of the FASB recently stated: "The Board intends to reconsider its prior tentative decisions about goodwill before issuing its proposal on business combination issues"("FASB to Eliminate"). This could be a concession by the FASB because it seems determined to do away with pooling accounting. It is unsure exactly what the FASB will decide about accounting for goodwill. The FASB could either preserve the current 40-year write-off period, shorten it, or create a one time goodwill charge.

Why do companies want to avoid having goodwill on their balance sheets? In 1995, the 19 billion dollar Walt Disney Co.- Capital City ABC merger used purchase accounting. The merger resulted in goodwill of 16 billion dollars or 84% of the purchase price. Disney will have a 400 million dollar charge to goodwill each year(McGoldrick, 147). Joseph H. Wender, a partner at Goldman Sachs, explains how goodwill can affect a bank. "The huge amounts of goodwill banks have started to take on is unhealthy and it puts extra pressure on performing assets to boost bank earnings"(Elstein, "FASB" 2). The management of banks is always under tremendous pressure to have positive earnings and a charge to an intangible asset can be especially difficult in hard years.

Pooling accounting began in the 1940's for business combinations of entities which had the same economic substance. As time passed many types of consolidating companies qualified for pooling accounting. By using pooling accounting, companies pooled their balance sheets at book value and avoided creating the intangible asset of goodwill. This is the reason why most companies try to use pooling accounting to account for consolidations. In order to qualify for pooling accounting the two consolidating companies must pass 12 pooling of interest criteria. If one of the criteria is not met, purchase accounting becomes mandatory. The major barrier is that the transaction must be a stock for stock transaction. The SEC added an additional hurdle by issuing the Staff Accounting Bulletin 96. It ruled that repurchasing stock for up to 24 months after a stock-leveraged deal prohibits use of the pooling method. "Pooling accounting does require the acquisition be made by issuing common stock and this in turn means more shares of stock outstanding with all of its potential dilutive effects an earning per common share."(Schroeder, 757). If a company can not repurchase the stock, some control and profit per share are lost. David Berry, the director of research at Keefe, Bruyette&Woods Inc., explains: "Poolings are on their way down and I'd expect to see that continue. The main reason is purchase accounting permits investors to have their merger and buy back stock too" (Elstein, 24). Although pooling accounting has this drawback it is presently the most popular method of accounting for business combinations. Robert Willens, a Lehman Brothers managing director who specializes in tax and accounting issues, speaks of his experience in dealing with companies contemplating acquisitions. "I must spend 50 percent of my time fielding questions from clients who wish to avoid goodwill and who want to know how to qualify for pooling treatment. Clients will often say to us, ‘If I can't do this deal as a pooling, then I won't do it at all.'"(McGoldrick ,146). Similarly Arthur Wyatt, a member of the new US Financial Accounting Standards Board task force on this subject and a retired chairman of Arthur Andersen, comments: "If we were to assess the amount of time spent on questions of pooling versus purchase, we'd find that this is the most costly accounting issue we've ever had in the US"(McGoldrick, 146).

When a company uses the purchase method to account for a merger or acquisition it will want to keep the goodwill to a minimum. A recent trend in the high tech industry has been to allocate a large sum of the purchase price to IPR&D costs instead of goodwill. FASB Statement No. 2 requires that all R&D expenses be charged to expense when incurred. In purchase accounting all IPR&D is required to be written-off as acquired, although the R&D may not actually produce a usable product. The immediate charge is created solely on a theoretical basis. IPR&D costs are the result of an appraisal and do not necessarily result in the amount a company actually invests in research and development. The more of the appraised value a buyer can attribute to IPR&D, the less value is attributed to goodwill. This is better for the buyer's financial position because the write-off will only affect the initial year's earnings, while the capitalization of goodwill will affect earnings to come for many years. The SEC is playing police with regard to this abuse of IPR&D costs. The SEC has been watching companies which have high IPR&D costs in regard to acquisitions. Barite Lye, an Associate Professor at New York University Stern School of Business, recently conducted a study of acquisitions. He found that the existing accounting treatment has encouraged acquiring companies to overpay for R&D that may not deliver long-term value to shareholders. His study found that about 400 companies have written off part of their acquisitions as IPR&D in the 1990's as compared with only three in the 1980's. (MacDonald, "FASB," A2). For example, Cadence Design Systems Inc. of San Jose makes software. It took total IPR&D charges of $339 million on four acquisitions worth only $400 million in 1998. The FASB wants to stop this abuse and has issued a statement proposing the elimination of IPR&D charges. Dan Scheinman, the vice president for legal and government affairs at Crisco System Inc., says: "If this were to go through(the FASB proposal to amortize IPR&D), it has the potential for stunting economic innovation and growth. Part of Silicon Valley is about taking intelligent risk, and this proposal, I think, is something that threatens people away from taking intelligent risk"(Herhold). Similarly Mark Nebergall, an official at Software & Information Industry Ass., states "The high-tech industry is poised to fight the FASB's moves. We would oppose the change, because it would make it harder for companies to justify from an accounting standpoint whether to make an acquisition if they can't immediately write off a portion of the purchase price as R&D"(MacDonald, "FASB,"A2).

The FASB has had enough of the inconsistency in the accounting for mergers. Chairman Edmund L. Jerkins explains :

We have been addressing business combinations issues for several years. The Board decided that it is hard for investors to make sound decisions about combining companies when two different accounting treatments exist for what is essentially the same transaction. We believe that the purchase method of accounting gives investors a better idea of the initial cost of a transaction and the investment's performance over time than does the pooling of interests method ("FASB to Eliminate Pooling").

When the dual accounting for consolidations is eliminated, not only will the financial statement be more consistent and comparable, but the playing field of actual competition for bids will be equalized. "Companies that can pool are at a huge advantage to pay a lot more money in the form of stock instead of cash" said Robert Her, director of Smith Barney Inc. Clay Whiten, PMT Services Inc. Chief Financial Officer, comments: "It's a matter of battling for market share. We have been employing pooling in the last year because our competitors couldn't do it. There were strategic alliances we wanted to draw"(Quittner,14). Why should one company have an advantage in the exact same business transaction only because it can qualify for pooling accounting? Steven Goldstein, Chief Financial Officer at Centaur comments: "The elimination of pooling is good for banks and banking because it levels the playing field. During the merger wars, we lost out because we used cash earnings measure while other companies used GAAP, which artificially inflates earnings. With the end of pollings, now everybody has to use the same yardstick"(Padgett,22).

The FASB is also trying to conform with International standards. The United States is the only country which allows pooling in such a broad sense. Most other countries prohibit pooling except in rare circumstances. Many industrialized countries use only purchase accounting but allow goodwill to be written off in the first year of an acquisition. The position of the FASB on IPR&D would make it appear that they do not want to write-off goodwill in the first year of acquisition. However, they have left the door open for the discussion of goodwill. "The International Accounting Standard Committee has been very influential on the FASB's thinking on the goodwill issue"(MacDonald, "FASB Weighs Tighter,"A2) said Daniel J. Donoghue, a partner at Piper Jaffaray Inc., an investment firm in Chicago and a member of the FASB's executive advisory council. FASB chairman Edmund L. Jenkins emphatically states: "Promoting international comparability is part of the board's mission and is a specific goal in the board's strategic plan"(Lashinsky). It is hard for American companies to compete internationally if they do not have the same accounting practices. Although there are many gaps in the accounting practices this area is one in which the FASB would like to close.

The FASB has started the process of eliminating pooling accounting and the immediate write-off of IPR&D expenses. A key part of the process will be a decision on how to account for the intangible assets of goodwill and IPR&D. This will provide consistency and comparability to the financial statements making it possible for investors to focus on the true substance of the transaction. Purchase accounting better reflects the actual cost of the business combinations. By requiring the use of purchase accounting the FASB will bring United States into step with international norm.

 

 

 

 

Works Cited

Elstein, Aaron. "FASB Targets Pooling of Interest in Bank Deals." American Banker. 1 Jan 99: 2.

Elstein, Aaron. "Purchase Accounting Now Holds Sway in M&A." American Banker. 21 Feb. 1997: 24.

"FASB to Eliminate Pooling of Interests Accounting." (21 May 1999). http://raw.rutgers.edu/raw/fasb/news/nr42199.html. (26 May 1999).

Herhold, Scott. "Accounting Board Wants End to ‘Research and Development' Write-off." San Jose Mercury News, California. 25 Feb. 1999: http://www.epnet.com/cgi-bin/epwsa(26 may 1999).

Lashinsky, Adam. "FASB Ruling Ends Numbers Game." San Jose Mercury News, Calif. 1 Mar,1999: Http://www.epnet.com/cgi-bin/epwda(26 may 1999).

Kieso, Donald E, and Jerry J. Weygandt. Intermediate Accounting, eighth ed. New York: Wiley, 1995.

MacDonald Elizabeth. "FASB Weigh Killing Merger Write-Off." The Wall Street Journal. 23 Feb. 1999. : A2(E).

MacDonald Elizabeth. "FASB Weighs Tighter Acquisition Rules." The Wall Street Journal. 23 Oct. 1998: A2(E).

McGoldrick, Beth. "Goodwill Games." Institutional Investor, March 1997 : 145-148.

Padgett, Tania. "FASB Votes to End Pooling of Interest." American Banker,

22 April 1999: 22.

Quittner, Jeremy. "Power to Pool Gives Edge to Some Acquirer." American Banker. 23 April, 1997: 14.

Schroeder, Richard G. and Myrtle W. Clark. Accounting Theory. sixth ed. New York: Wiley, 1998.

Stickel, Amy. "SEC Ups Scrutiny of R&D Write-offs." Mergers Acquisitions Report. Securities Data Pub. Inc., 26 Oct. 1998.

 

Last Modified: April 6, 2004