In accounting for mergers and acquisitions, the pooling of interests method of accounting has always been a poor cousin to the more popular purchase method. (See Table 1.) A recent Securities and Exchange Commission (SEC) ruling could make the use of pooling even less frequent. The SEC rule, which restricts post-merger repurchases of stock, closes what was a major loophole in the use of pooling accounting.
When one company acquires another company, there are two methods of accounting for the transaction, the purchase method or the pooling of interests method. These are mutually exclusive methods unlike areas such as inventory accounting where a firm can choose for example, between LIFO and FIFO. In order for a company to use the pooling method, it must comply, in advance of an acquisition, with 12 conditions listed in Accounting Principles Board Opinion No. 16 Business Combinations (APB 16) as well as with additional SEC criteria. Failure to follow any of these detailed rules precludes the use of pooling accounting.
For many companies, however, structuring an acquisition to meet all of the pooling criteria is well worth the effort. The use of pooling accounting will normally produce higher reported earnings than the use of purchase accounting. Purchase accounting requires that the investment be recorded at the fair market value of the transaction.
Many times, fair market value of the transaction will include a payment for goodwill or, what is sometimes called "unspecified intangible value." Any recorded goodwill must be amortized to expense in future accounting periods. In addition, higher market values for other recorded assets, for example inventory and fixed assets, in the transaction will result in more cost-of-goods-sold expense and depreciation expense respectively in future periods. Pooling, on the other hand, requires the combining of book values of recorded assets on the books of the two merging firms resulting in no goodwill and no fair market values, hence lower expenses and higher profits.
Despite the income effects advantage mentioned above in favor of pooling accounting, there is one major disadvantage to pooling which sometimes scares potential merger candidates away from this accounting method. Pooling accounting does require that the acquisition be made by issuing common stock and this means more shares of stock outstanding with all of its potential dilutive effects on earnings per common share. The profit pie may be larger with the use of pooling accounting versus purchase accounting but the pie may have to be sliced into a greater number of pieces.
The problem of dilution caused by the issuance of common shares in a pooling of interests would appear to have a simple solution. Why not have the issuing firm repurchase common stock and then use these shares to effect the pooling, and thereby neutralize the potential dilution? For example, company A wants to buy Company B for $10 million at a time when its stock is selling for $10 a share. Instead of paying cash for Company B and being required to use purchase accounting, Company A could take the $10 million of cash, repurchase one million shares of its common stock, and then reissue these shares to shareholders of Company B. Since common stock was used for the acquisition, Company A could account for the transaction as a pooling without any dilution of equity. It would appear that this is an example of"having your cake and eating it too."
The Accounting Principles Board (APB) anticipated some of this maneuvering and closed it down in APB 16 (Paragraph 47) which states that no changes in the equity interests of the voting common stock of any combining company may be made in contemplation of a pooling of interests. This restriction is for a period beginning two years prior to the initiation date of the plan of combination.
In the example above, if the firm repurchased the $10 million in stock into treasury within two years prior to the acquisition, the shares issued in the pooling would be deemed to have come from these "tainted" treasury shares and thereby preclude the pooling accounting treatment thus closing a potential loophole. But, what about the opposite case? Issue out clean common stock for the merger, meet all of the pooling criteria, and account for the business combination as a pooling of interests. Then, sometime later, go out and repurchase the one million shares issued in the business combination, thereby winding up with no new net shares issued and the acquisition financed, in effect, through the payment of $10 million in cash. Did the APB speak to this "after the pooling" repurchase of common stock? The answer is yes and no. In APB 16 (Paragraph 48) the APB states "some transactions, after a business combination is consummated, are inconsistent with the combining of entire existing interests of common stockholders. Including those transactions in the negotiations and terms of the combination, either explicitly or by intent, counteracts the effect of combining stockholder interests." One prohibited transaction specifically mentioned in Paragraph 48 is "the combined corporation does not agree directly or indirectly to retire or reacquire all or part of the common stock issued to effect the combination."
This rule prohibits a firm from buying back shares specifically issued to the stockholders of a combining company. If the rule is violated, the transaction loses its status as a pooling of interests and must be accounted for using the purchase method of accounting.
This prohibition against the post-acquisition repurchase of shares in APB 16 appears to be directed only at the specific shares issued to effect the business combination. What this rule does is to close down one potential loophole but to leave open another one. The acquiring firm cannot in any way negotiate to buy back the common shares issued to a member of the combining group (i.e. the company being acquired). But what about leaving those shareholders alone and going into the open market in the months following the business combination and buying back your own stock from other shareholders? The issue is not addressed in APB 16. This appears to give companies the opportunity to issue common shares in a business combination, get advantageous pooling of interests accounting treatment for the combination, and then use cash to eliminate any potential dilution from the shares issued by buying back other common shares in the open market.
New SEC accounting release
In Staff Accounting Bulletin No. 96, Treasury Stock Acquisitions Following Consumation of a Business Combination Accounted for as a Pooling-of-Interests, (SAB 96), issued on March 19, 1996, the SEC moved to close this remaining loophole. In SAB 96, the SEC poses a hypothetical example of a company which, concurrently with the development of a plan for a business combination, formulates a plan to reacquire treasury stock after the consummation date of the business combination. The treasury stock will not be reacquired directly from the former owners of the combining company. SAB 96 makes clear that this is a "planned transaction" as discussed in APB 16 and thereby would preclude the use of pooling accounting for the business combination. This interpretation extends not only to transactions explicitly agreed to but also to intended transactions.In addition, the fact that the intention to reacquire treasury stock is not announced until after consummation of the business combination does not change matters. It is the formulation of an intention to repurchase shares that is the defining action which precludes pooling accounting treatment. Again, the repurchase of shares need not be from a former shareholder in the combining company. Open market transactions will be considered as part of an intentional plan.
If the repurchase of shares subsequent to a business combination is considered to be a planned transaction, it will be prohibited under SAB 96 for a maximum of two years. If, however, the repurchase of shares in not considered to be a planned transaction at the date of the business combination, it would not be prohibited if it occurs more than six months after the business combination is consumated. In determining whether a repurchase of shares is a planned transaction at the date of the business combination, all management actions before and after the business combination will be considered evidence of a plan. Evidence of a planned transaction would include: (1) a share repurchase shortly after a merger (within six months), (2) earnings projections or forecasts issued by the company which reflect postconsummation acquisitions of treasury stock, and (3) statements of intent issued by the company shortly after the merger. (SAB 96, p. 6)
Based on an analysis of SAB 96, it appears that the remaining loophole that has been used by companies to, in effect, pay cash for an acquired company and yet use pooling accounting has now been closed. What will be the impact of this ruling on the use of pooling accounting?
The future of pooling accounting
What happens now? Given the new SEC regulation, what are the accounting strategies available to companies who are considering a business combination? Can firms still "have their cake and eat it too?" Can they still use pooling accounting and avoid the dilution of having issued additional common shares or must companies accept the fact that pooling accounting treatment comes at a cost of having additional common shares outstanding?The following suggestions can be followed by firms interested in pooling accounting treatment for business combinations.
- Accept the new rule and live with it. This is not a totally satisfactory solution but it suggests to companies that they not abandon pooling accounting as a preferred approach. Pooling accounting does bring with it the important advantage of higher profits through lower asset values and no recorded goodwill. The additional dilution due to the issuance of additional common shares may still be worth it. Also, the firm can still go into; the open market and repurchase common shares, but they cannot have a planned transaction to do so and they must wait at least six months before doing so.
- Lobby for additional changes in accounting rules. Roger Lowenstein writing in the Wall Street Journal (May 9, 1996, p. C1) has an interesting suggestion. He calls for the abandonment of pooling as an acceptable method of accounting with the important proviso that goodwill created under the purchase method of accounting does not have to be amortized against earnings as long as the acquired company continues to be worth a premium. The simple logic of his proposal is that much of the attractiveness of pooling accounting lies in the unattractiveness of purchase accounting. If an acquiring company was not faced with the huge amortizations that goodwill brings with it, then the purchase accounting treatment would not be so distasteful. (Note: This does not eliminate the revaluations of other assets such as inventories and plant assets which would cause higher cost of goods sold expense and depreciation expense, respectively.)
Another possible compromise might be the initial recording of goodwill in a purchase transaction with the immediate write-off of the recorded value to stockholders' equity. This approach is acceptable under United Kingdom accounting standards and has been advocated in the past under United States accounting standards. (Catlett and Olson)
Summary and conclusions
As stated earlier in the article, the pooling of interests method of accounting for business combinations has never been as popular as the purchase method though permitted by APB 16 under certain parameters. Given the higher earnings that would normally be reported under pooling accounting, the major reason for this lack of popularity has been the potential dilution of earnings due to the increase in the number of common shares outstanding needed to effect the business combination. A loophole in accounting rules was found which allowed companies to use pooling accounting treatment and then buy back shares into treasury. The end result was the acquiring company winds up buying a targeted company for cash dollars but recording the transaction at low historical book values. THE BEST OF BOTH WORLDS!The SEC has now stepped in with SAB 96 which closes this loophole. Ira planned transaction exists at the date of the business combination, a two-year waiting period must be met before the acquisition of treasury shares. If there is no evidence of a planned transaction, then at least six months must pass before the repurchase of treasury shares takes place.
The authors have tided this article with a question mark--POOLING: ... GOING ... GOING ... GONE? At first reading, SAB 96 would indicate that the tide should be followed with an exclamation mark (!). After SAB 96, pooling would appear to be gone. Chances are that the small number of companies which have used pooling accounting in business combinations will dwindle now that the opportunity to buy back shares in a quick fashion has been closed to them. A careful reading of SAB 96, however, still makes the question mark (?) the correct punctuation at this time. Companies which have aggressively used the buy-back strategy in the past need only to adjust their timing and be a little more indefinite in their plans. Companies which have not considered pooling accounting in the past may want to do so now as they examine a longer-term treasury stock repurchase strategy. Pooling: ... Going ... Going ... but perhaps, not gone!
Table 1. Business Combinations
Accounting Treatment 1994 1993 1992 1991Pooling of Interest 19 21 17 16
Purchase of Interests 215 200 182 160
Total 234 221 199 176
Source: 1995 Accounting Trends & Techniques, Forty-Ninth Edition, American Institute of Certified Public Accountants, 1995, p.61.
References
APB Opinion No. 16, Business Combinations. Accounting Principles Board, August 1970.Berton, Lee, "Rule May Alter Accounting in Mergers," Wall Street Journal, May 15, 1996, p. A3.
Catlett, G. R. and Olson, N. 0., "Accounting for Goodwill," Accounting Research Study No. 10, American Institute of Certified Public Accountants, 1968.
Lowenstein, Roger, "A Modest Proposal to Stop 'Pooling'," (Intrinsic Value), Wall Street Journal, May 9, 1996, p. C1.
Staff Accounting Bulletin No. 96, Topic 2-F: Treasury Stock Acquisitions Following Consumation of a Business Combination Accounted for as a Pooling-of-Interests. 17 CFR Part 211, Securities and Exchange Commission, March 19, 1996.
1995 Accounting Trends & Techniques. Forty-Ninth Edition, American Institute of Certified Public Accountants, 1995.
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By Abba Spero, Ph.D., CPA and Larry Kreiser, Ph.D., CPA
Abba Spero and Larry Kreiser are professors in the Department of Accounting at ClevelandStateUniversity, Cleveland, Ohio44115. Dr. Spero can be reached at 216/687-4725, FAX: 216/ 687-9212. Dr. Kreiser can be reached at 216/687-2081, FAX: 216/687-9212.
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Source: Ohio CPA Journal, Feb97, Vol. 56 Issue 1, p28, 5p
Item: 9704115531