Plan to Prohibit Pooling in M&A Accounting Causes Tidal Wave of Controversy

A proposal to purify accounting standards is roiling the usually calm waters of the accounting profession. At issue is the proposed revocation of a popular accounting method, called pooling of interests, that essentially lets businesses account for some big-ticket mergers and acquisitions for free.

The controversy, which pits the accounting profession’s rule-making Financial Accounting Standards Board (FASB) against takeover attorneys and investment bankers, has been cast as a battle between accounting purists and M&A specialists who racked up almost $1.4 trillion in activity during the year 2000, according to Mergerstat, which tracks merger and acquisition activity.

In fact though, the proposal may be driven as much by FASB’s desire to save its most important asset, independence, as by the organization’s pursuit of the Holy Grail of accounting theory.

At the heart of the matter is the question of how to account for the premium—or payment in excess of fair market value (or net book value in some cases)—that one company pays to acquire another. The excess, when it is recognized, is generally known as goodwill. But depending on the circumstances, that excess may never be explicitly recognized.

Assume, for example, that company “A” acquires company “N” for $10.2 billion in stock (cash deals are not eligible for the pooling of interests treatment), even though the net assets (assets less liabilities) of company “N” total only $700 million. The $9.5 billion premium paid by “A” for “N” would usually be explained away, if anyone asked, as the intangible value of the acquired company’s name, technology, patents or other intangible assets.

In fact, that is basically what happened in 1998 when America Online acquired Netscape Communications in a stock transaction. Even though the deal was for stock instead of cash, a disinterested observer might admire AOL’s management for being willing to take a $9 billion-plus hit – the premium paid to acquire Netscape – to the company’s income statement.

Except for one item—the charge never made it to AOL’s financials. This is because, having satisfied a number of qualifications (including the fact that the currency of the transaction was stock), AOL was required to account for the deal as a pooling of interests, where Netscape’s net assets were basically added to those of AOL’s on the balance sheet, while the multi-billion-dollar premium, or excess payment, never made it to AOL’s profit and loss statement. Some people might call it a disappearing act that Houdini would envy.

Is there an alternative that would grant greater transparency to investors and others? There would be, if the AOL-Netscape acquisition had been done in cash. Then the transaction would have been accounted for under the purchase method (instead of as a pooling of interests) with the premium (payment in excess of fair market valuation) being recorded on AOL’s books as goodwill—an intangible asset easily visible on the financial statements—that would be amortized over a period of time not to exceed 40 years.

“The problem with pooling is that you don’t account for the takeover premium, so you can’t really account for how well the takeover succeeded,” observes accounting professor Philip G. Berger. “If analysts see how much of a takeover premium was paid, they can determine whether the return on investment justified it. So pooling is a less desirable way to keep track of the takeover activity.”

Pooling of interests may do more than just confound analysts. Accounting professor Robert E. Verrecchia says the distortion associated with pooling affects both the balance sheet and the P&L statement. Under the pooling method, companies generally combine the values reflected on their balance sheets. The balance sheets, he says, “are based on historical costs, but accounting theory suggests when you buy an asset, the transaction should be based on either what you paid for the asset or the asset’s fair market value (FMV). Under the purchase method (where assets are revalued to current, or fair market value) the reference point is what you paid, and the difference between capture cost and net worth goes to goodwill, where it is amortized and the charges hit the P&L.”

It is easy to see why FASB and many accountants are crying foul over the fact that two different methods, which can yield dramatically different results, may be applied to essentially similar transactions. Why, they ask, should companies account for similar activity in different ways?

That’s a valid point, except the issue is not so cut and dry. That is because accounting theory and generally accepted accounting principles already let companies account for similar transactions in a variety of ways.

Consider one example—depreciation. Similar assets may be depreciated in a variety of ways, ranging from straight-line, where the charge is recognized equally over the life of the asset, to accelerated depreciation methods that may load greater charges in earlier years, with the amount of the annual charge sloping down in later periods.

Norm Strauss, national director of accounting standards and partner at Ernst & Young, agrees that accounting is filled with subjective applications, but notes depreciation methods are rooted in the useful lives of assets that can seen and touched. “So perhaps the time lines are not so arbitrary after all.” He also notes that while FASB is considering eliminating the pooling method, it may also skirt controversy by eliminating the requirement (under the purchase method) to amortize goodwill. Except, that is, in cases where the goodwill has been impaired, perhaps as signaled by recurring corporate losses.

“Under this model, you could compare goodwill to a wine that improves with each passing year,” says Strauss. “So you could have timeless goodwill, which is never amortized as long as it’s not impaired.”

In the end (which won’t be known at least until June of this year), the M&A community may still be able to avoid onerous charges associated with takeover premiums. But at least it may be easier to track down the fact that a premium was paid.

Given the fact that the bottom-line on the pooling controversy may not change much, even if pooling per se is eliminated, it might be fair to ask if FASB’s discomfort was due to more than impure accounting theory. Perhaps, in fact, it has a lot to do with the nature of FASB’s relationship with the SEC–a delicate game of cat-and-mouse, where FASB tries to maintain its independence and avoid government oversight.

When you consider the legal foundation upon which FASB bases its authority, it’s easy to see why the Board gets a bit skittish when the SEC gets upset. According to the FASB website, “the SEC has statutory authority to establish financial accounting and reporting standards for publicly held companies under the Securities Exchange Act of 1934. Throughout its history, however, the Commission’s policy has been to rely on the private sector for this function to the extent that the private sector demonstrates ability to fulfill the responsibility in the public interest.”

Pay particular attention to the last sentence, because it’s a safe bet that FASB does.

Did the pooling of interests method stir the ire of the SEC? It’s a touchy question. But Berger notes that the SEC has long complained that something like 50% of its staff’s time is eaten up simply reviewing proposals for pooling.

So far no one is pointing a finger at the SEC, accusing it of politicizing a business process. And perhaps, when the accounting history books are written, it will turn out that both the SEC and the FASB took the high road. Then again, as E&Y’s Strauss points out, “No matter what standard you pick, someone will be unhappy.”

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