Everyone Out of the Pool

he United States is perhaps one of the last countries in the world to still permit pooling-of-interests accounting. FASB is now debating whether to eliminate pooling as a method of accounting for mergers and acquisitions. Following a September 1999 exposure draft, Business Combinations and Intangible Assets, FASB held public hearings in February and March. If a final proposal passes by the end of 2000, it could take effect on January 1, 2001. All U.S. companies initiating business combinations after that date would have to use the purchase method to account for the transaction. Experts expect a flurry of poolings in advance of the elimination of this popular accounting alternative as companies hurry to complete acquisitions while they still can do so without recording a large goodwill balance. Should companies race to beat the deadline? We believe the answer to this question is no.

America Online (AOL) and Time Warner will account for their recently announced merger as a purchase. That these companies will not structure the deal as a pooling is surprising to many observers, since the transaction will require the new company to recognize goodwill totaling about $150 billion. Deals of this size frequently are accounted for as poolings and often are contingent on the acquirer receiving pooling accounting treatment.

AOL and Time Warner executives say purchase accounting will enable the new company, AOL Time Warner, to dispose of unproductive assets and conduct stock buybacks. This is not permitted if the company applies pooling accounting. Further, they believe most analysts will ignore the annual goodwill amortization “drag” and instead focus on the new company’s cash earnings disclosure. Following the merger, the new company will have to reduce net income by $7.5 billion each year for the next 20 years. AOL and Time Warner are confident analysts will disregard this charge against income and look at the new company’s reported cash earnings, which will not have to be reduced by the $7.5 billion expense. Our research supports AOL Time Warner’s decision and suggests companies should not race the clock to complete pooling-of-interests transactions. This is especially true for companies that are currently buying back shares or planning to do so in the near future.

POOL RULES

Under the current rules, a company can account for a business combination using either the pooling-of-interests or the purchase method. Under the pooling method, the parent company obtains a controlling interest in the stock of the target company by exchanging shares of stock without making significant cash disbursements. If the transaction satisfies all conditions for pooling, the book values of the two companies are simply combined without recognizing market values or goodwill.

In contrast, the purchase method requires the acquiring company to capitalize the fair market value of the target company’s net assets. In addition, the purchase price in excess of identifiable assets is capitalized as goodwill on the books of the combined company. The new company amortizes recorded goodwill over a period not to exceed 40 years. (FASB’s ED reduces the amortization period for goodwill to 20 years.) For many companies the absence of this earnings reduction is the appeal of pooling accounting.

In March 1996 the SEC issued Staff Accounting Bulletin no. 96, Treasury Stock Acquisitions Following Consummation of a Business Combination Accounted for as a Pooling of Interests. SAB no. 96 requires pooling companies to rescind or forgo stock repurchase plans to remain eligible for pooling treatment. The SEC issued this rule to prohibit companies from issuing stock in a merger and then subsequently buying back the shares for cash, violating the spirit of pooling transactions. This ruling led many companies to rescind their stock repurchase plans following the completion of a pooling. For example, Ameritech, Texas Instruments, Pharmacia and Upjohn, as well as several banks, recently rescinded stock buyback programs so they would be eligible for pooling accounting treatment in an acquisition. Other companies eliminated buyback plans so they would remain eligible to pool in the future.

THE COSTS AND BENEFITS OF POOLING

Using a sample of 39 companies that rescinded their stock repurchase plans between November 1995 and June 1998 to preserve pooling treatment, we compared the costs and benefits of pooling vs. purchase accounting after the SEC issued SAB no. 96. We compared the rescinding companies with other companies that completed mergers using purchase accounting. To do this, we used company-specific data, survey information from the CFOs of pooling and purchasing companies and interviews with those CFOs. In addition, we used the MergerStat database (a commercially available database of corporate merger information) to determine merger announcement dates and the premiums acquiring companies paid.

A premium is the amount a company pays to acquire a target company’s stock in excess of the closing market price of the seller’s stock just before it announces the acquisition. A 1-day premium is the acquisition price divided by the closing price one day before the merger announcement. For example, assume company A reaches an agreement to acquire the outstanding shares of company B for $100 per share. The day before the announcement, the closing price of company B was $75 per share. The 1-day premium company A paid to acquire company B’s stock would be $25 or 33% of the $75 stock price.

Exhibit 1: Average Acquisition Premiums

Here are our findings:

• On average, companies paid a premium to pool rather than purchase. Past studies have shown this, and we found it to be true with our sample of companies as well. We used the premium amount 1 business day (1-day premium) and 5 business days (5-day premium) before a merger was announced. We calculated 1-day and 5-day average and median acquisition premiums for both pooling and purchasing companies. The 1-day and 5-day a verage acquisition premiums were, respectively, 43% and 49% for pooling companies compared with 27% and 32% for purchasing companies (see exhibit 1, above). The 1-day and 5-day median acquisition premiums were, respectively, 34% and 36% for pooling companies and 25% and 28% for purchasing companies (see exhibit 2, below). Thus, on average, the eventual share price target-company shareholders accepted was higher when the acquisition was structured as a pooling, requiring the purchaser to pay more.

In Pfizer’s recent acquisition of Warner Lambert, the pooling of the companies involved an acquisition premium approximately 34% above Warner Lambert’s stock price just before Pfizer announced its first bid. Warner Lambert’s stock price was already trading higher to reflect existing merger talks with American Home Products.

Exhibit 2: Median Acquisition Premiums

• Stock buybacks are generally valuable to shareholders for a number of reasons. For example, buybacks increase the overall ownership percentage for remaining shareholders, send a potentially positive message to investors about the company’s prospects and offer tax advantages to the company and its stockholders. As a result, companies often trumpet the initiation of buyback plans. Among our sample 39 companies, we found that shareholder wealth increased following the announcement of share buybacks. Because the SEC does not permit such buybacks when companies use pooling accounting, the lost opportunity to buy back shares is a cost for companies that engage in poolings.
• The market generally adjusts for the cosmetic earnings decrease associated with purchase accounting when purchasing companies include amortization of goodwill in their net income by placing more value on those earnings. We found this to be the case with our sample companies as well.

For example, consider two identical companies. Company A uses purchase accounting and reports goodwill amortization of 50 cents per share aftertax and earnings per share (EPS) of $1.00. The company’s cash earnings (cash earnings ignore noncash goodwill amortization) are $1.50. Company B uses pooling accounting and reports no goodwill amortization, EPS of $1.50 and cash earnings of $1.50. The market adjusts for the accounting difference by valuing the purchasing company (company A) at 15 times the cosmetically low $1.00 EPS. In turn, it values the pooling company (company B) at only 10 times the inflated $1.50 EPS. In each case the companys’ stock price is $15 (10 times cash earnings). Since the market appears to make the appropriate adjustment, company B does not enjoy a stock price benefit from the higher reported net income associated with pooling.

POOLING FOR BANKS

Certain circumstances may create economic incentives for companies to use pooling. Banks, for example, are subject to minimum regulatory capital requirements. This regulatory calculation reduces the banks’ stockholders’ equity balance by the amount of recorded intangible assets, such as the goodwill that purchase accounting creates. As a result, banks generally favor pooling to reduce the likelihood they will fall out of regulatory compliance. The American Bankers Association estimates that two-thirds of recent bank mergers used the pooling method. Every merger is not a purchase, the ABA says, and pooling better represents many business combinations. In testimony before FASB in February, the banking trade association said eliminating pooling could have an adverse impact on future bank consolidations. However, such constraints are not relevant to most companies.

What will banks do if FASB drops pooling? First, they are likely to report their cash earnings very prominently to make sure nobody misses the impact of goodwill amortization. Long term, the industry also has the option of lobbying regulators for changes in how regulatory capital is determined to compensate for the constraints imposed by purchase accounting.

WALK, DON’T RUN

Companies generally pay more to pool. In many instances, they also forgo valuable share repurchase plans so they can report the cosmetically higher net income that results from pooling accounting treatment. The costs of this action appear to outweigh the benefits—if in fact there are any true economic benefits to poolings. The results of our research support the decision AOL and Time Warner made not to pool.

There are several reasons why CPAs and financial managers should carefully consider whether rushing to complete a pooling before FASB pulls the plug on this option is in the best interests of their companies’ shareholders.

• Market participants—analysts, brokers, investors—appear to focus on cash earnings disclosures that exclude noncash charges for goodwill amortization.
• If a company completes a pooling of interests, it must rescind existing stock repurchase plans and forgo stock repurchases for up to two years.
• As the possible December 31, 2000, deadline draws nearer, companies may inappropriately rush to consummate a pooling. Rushing to complete any deal may cause mistakes and create additional costs for the company.