Purchase Versus Pooling

Prior to the issuance of FASB Statement No. 141, in 2001, there were two methods available to record the acquisition of a company. The primary method, applicable to most acquisitions, was the purchase method. Purchase accounting recorded all assets and liabilities at their estimated fair values. When the price exceeded the sum of the fair values for individual, identifiable assets, the excess was attributed to goodwill. Prior to July 2001, goodwill was amortized up to 40 years. With the issuance of FASB Statement No. 142, goodwill is no longer amortized. It is now tested for, and, if necessary, adjusted for impairment. Under the pooling method, all assets and liabilities were transferred to the acquiring company at existing book values, and no goodwill could be created. Purchase and pooling were not meant to be alternative methods available for any acquisition. It was intended that pooling would apply only to a “merger of equals.” Toward this objective, in 1970, APB Opinion No. 16 restricted the use of pooling to transactions that met a strict set of criteria, which are covered in detail in Appendix B at the end of this chapter. The most important of the criteria required that 90% of the acquired firm’s common stock shares be received in exchange for the acquiring company’s common stock. All shareholders had to be treated equally in the distribution of shares. Over time, many business combinations were “managed” so that they would meet the pooling criteria. This meant that the acquiring company would receive the more favorable accounting treatment. Several perceived advantages led firms to try to use the pooling method. Below is a summary of the major differences between pooling and purchases.

Difference in Accounting

Asset valuation: Under purchase accounting, assets are recorded at fair value, and goodwill may be recorded. Under pooling, assets were recorded at existing book value (which is generally lower than fair value), and no goodwill was created.

Current-year income: Under purchase accounting, the acquired firm’s income is added to the acquiring firm’s income statement starting on the purchase date. Under pooling, the acquired firm’s income was added as of the first day of the reporting period (no matter when the acquisition occurs).

Retained earnings: In a purchase, the acquired firm’s retained earnings cannot be added to that of the purchasing company. Under pooling, the retained earnings of the acquired firm were added to that of the acquiring firm (with some rare exceptions).

Direct acquisition costs: In a purchase, these costs are added to the cost of the company purchased. They are typically included in goodwill, which used to increase goodwill amortization in later periods. Now these costs could increase impairment losses in future periods. In a pooling, these costs were expensed in the period of the purchase.

Total equity: In a purchase, the fair value of the shares issued to pay for the purchase must be added to the equity of the acquiring firm. In a pooling, the book value of the acquired firm’s equity was assigned to the shares issued by the acquiring firm.


Pooling Advantage

• Reported income is higher because depreciation expense is lower and there was no new goodwill amortization. (Goodwill was amortized over 40 years or less prior to FASB Statement No. 142.)
• Return on assets is greater as a higher income is divided by a lower asset base.
• Assuming that the acquired firm is profitable, the acquiring firm was able to include the acquired firm’s income, along with its own, for the entire year even if the pooling occurred on the last day of the reporting period.
• There was an instant increase in retained earnings, which made prior periods look more profitable.
• Prior-year income statements were retroactively combined; thus, the acquiring firm “pulled in” the income of the acquired firm in its prior-year statements.
• Income could have been higher in later periods, since there was no amortization of these costs. However, pooling income was decreased in the period of the acquisition, since these costs were expensed in the period of acquisition.
• Total equity was usually lower. Return on equity was greater, since a higher income was divided by a lower equity amount.

The financial statement advantages incurred by the pooling method and the increased “gaming” to use the pooling method led to its elimination in July 2001 with the issuance of FASB Statement No. 141. The FASB held that fair values should be used in all combinations. The lack of comparability due to financial statement distortions, which resulted from companies using alternative methods, could no longer be tolerated. Even before the statement was issued, companies were reluctant to use pooling. In the fall of 1999, Tyco International was criticized for stimulating earnings growth through the use of the pooling method. This precipitated a significant decline in the value of Tyco’s shares. Tyco later announced that it would no longer acquire companies as a pooling of interests. Some foreign countries still allow the use of the pooling method when similar-size firms combine; it is difficult to determine the buyer versus the seller in such cases. There were, of course, many combinations in the United States, prior to July 2001, that used the pooling method. Additional information about pooling of interests is covered in Appendix B of this chapter. Those who desire a complete knowledge of former pooling procedures should obtain a copy of the 7th edition of this text.