The prevailing opinion is that FASB in the United States will follow its counterparts in the international arena and severely restrict, if not eliminate, pooling as an acceptable method of accounting for business combinations. Why is pooling experiencing such significant popularity when standards setters are thought to be on the verge of radically changing it? Is there a rush to structure mergers that qualify for pooling before the accounting rules change? What is it that combining companies prefer in the pooling method, and what about the method seems to concern accounting rule-makers?

Existing accounting standards for business combinations are set forth in APB No. 16, Business Combinations, issued in 1970. APB No. 16 establishes two methods of accounting for mergers, but the two are not alternatives. Business combinations are accounted for as purchases unless the 12 conditions outlined for qualification as a pooling are achieved (see Exhibit 2). Under purchase accounting, the excess of the amount paid for the acquired company over the sum of the fair values of the identifiable net assets is recorded as goodwill; the goodwill must be amortized to expense over its estimated life, not to exceed 40 years. In a pooling, the historical costs (existing book values) of the combining companies are merely combined; no goodwill is recognized and, therefore, no amortization expense is charged against future earnings.

Merging Companies Prefer Pooling

At a time when U.S. companies are grappling for competitive positions in a globalizing economy, pooling seems to be the preferred method of accounting for mega-mergers. Companies once thought too large to combine are coming together to form enormously large organizations designed to serve global markets and doing so at prices that represent huge premiums over existing book value. As indicated in Exhibit 1, implied goodwill in these recent large mergers could approach $20 to $60 billion if each were accounted for as a purchase under APB No. 16. The effect would be to reduce future earnings of the combined companies by significant proportions.

Daimler-Benz AG announced on October 27 that about 97% of its shares were exchanged for the Daimler-Chrysler shares. Because more than 90% were exchanged, the criteria to treat the combination as a pooling were met.

Many mergers are nontaxable transactions, such that goodwill amortization is without any tax benefit and essentially worsens future earnings. A company's earnings are one of the important determinants of its stock price. Furthermore, many managers have large stock holdings, stock options, or bonus programs tied to the company's earnings. So managers often have personal motivations to avoid any unnecessary charges that will reduce future earnings.

Many companies consider purchase accounting, with the resultant amortization of goodwill, to be a competitive disadvantage for U.S. companies in comparison to foreign companies that have no such accounting rule. With no future earnings reduction, foreign companies may be willing to pay more than a U.S. company to acquire a U.S.-based company. However, with many international accounting standards changing to require amortization, this may no longer be a real disadvantage.

Some accountants agree that pooling facilitates the comparison of financial information year-to-year and thereby provides more usable information to financial statement users than does the purchase method. Purchase accounting allows a combined company to report growth in operations and earnings even if no actual growth occurs. Companies in the business of health care delivery, with income dependent on rates paid by state agencies, often have difficulty in reporting growth without the benefit of acquisitions. Pooling accounting requires the restatement of prior financial statements, and therefore enables comparisons to be more meaningful to users. The restatement of financial statements required by pooling also allows financial statement users to ascertain whether the proposed benefits of a merger are actually reflected in improved operating performance.

Elimination or serious curtailment of pooling accounting might significantly reduce U.S. merger activity. Nonetheless, FASB is currently examining accounting for business combinations in a project that could potentially change merger accounting drastically.

Concerns of Standards Setters

Critics of pooling have long held that the method ignores economic reality and fails to present financial information fairly, because future earnings are overstated and financial position is understated. They believe pooling fails to recognize the historical cost principle, with cost determined by the fair value of stock issued. They also believe pooling using historical cost values distorts important investment and performance measures.

FASB initiated its project to reexamine accounting for business combinations at the encouragement of the former chief accountant of the SEC. The staffs of the SEC and FASB typically spend enormous amounts of time interpreting the requirements of ABP No. 16 in terms of whether a combination qualifies for pooling accounting. The 12 conditions often require identification of management intent with respect to the transaction, and the terms of a deal are often not clear as to whether the conditions are satisfied. The time investment by the SEC and FASB staffs occurs in spite of the myriad interpretations, technical bulletins, SEC releases, and Emerging Issues Task Force (EITF) consensuses that have been written to provide guidance on accounting for business combinations.

FASB also has a desire to develop comparability in accounting requirements with other countries as the economy becomes increasingly global. The accounting standards of Australia, Canada, New Zealand, the United Kingdom, and the International Accounting Standards Committee (IASC) essentially do not allow pooling, except in rare circumstances in which the acquirer cannot be identified. U.K. and Canadian companies complain about the ability to use pooling by U.S. companies. This inconsistency often results in an unleveled playing field in the competition for business combinations in an international arena.

At the outset of its business combination project, FASB issued a special report, "Issues Associated with the FASB Project on Business Combinations," to solicit feedback on the topics and concerns it intends to address. Essentially, the project will address 1) whether there is a need for two methods of accounting for business combinations, and 2) how purchased goodwill should be accounted for. The majority of respondents to the special report agreed these issues were the appropriate ones to be examined.

A Brief History of Pooling

Arthur Wyatt, George Catlett, and Norman Olson set forth the early history of pooling accounting for business combinations in Accounting Research Studies No. 5 and No. 10. Both studies express opposition to the acceptability of pooling, although Study No. 5 contains a supporting view of pooling by Robert Holsen. The first mention of the term pooling by the AICPA was in a letter from the Committee on Public Utility Accounting to AICPA Council in 1945. Pooling was defined as a combining of interests of two or more entities of similar size. The letter generally concluded that no new cost basis was established in a pooling. This was important in the utilities industry, since cost formed the basis for rate-setting.

Accounting Research Bulletin (ARB) No. 40 was issued in 1950 prescribing the accounting for business combinations. Poolings were defined as combinations in which ownership interests were continued; new ownership interests were described as purchases. Poolings also involved companies of comparable size, continuity of management, and similar or complementary business activities. ARB No. 43, which restated and revised existing pronouncements, basically incorporated the guidance of ARB No. 40.

In 1957, the AICPA Committee on Accounting Procedure issued ARB No. 48, changing the relative size criterion so that combinations of interests of as much as 95% and 5% could qualify as poolings. ARB No. 48 also deleted mention of similar or complementary business activities as a factor. This new pronouncement gave even wider latitude to selection of an accounting method, so that the combining parties' intentions basically decided the pooling versus purchase question. By the late 1950s, business combinations were being accounted for as poolings even if one of the established criteria was absent. Many felt the absence of one criterion should not preclude use of pooling.

In 1970, the Accounting Principles Board issued Opinion No. 16 to provide guidance for business combinations. The board originally planned to abolish poolings to prevent abuses that were occurring in which business combinations were, in effect, one entity acquiring another. However, the board decided poolings should be retained if the 12 conditions set forth in the opinion were met; the conditions were designed to curb some of the abuses and reduce the number of poolings. The opinion was passed by the affirmative vote of 12 of the 18 members and required significant compromise. Three of the dissenters believed pooling should only be permitted for combinations of companies of relatively equal size. Three others believed pooling should be eliminated as an acceptable accounting method altogether; they felt the opinion only prevented some of the abuses seen under pooling at that time.

In 1976, FASB issued a discussion memorandum on business combinations, intending to again take up the issues associated with accounting for mergers. However, enmeshed in a project to develop a conceptual framework at the time, the board postponed the project due to more pressing concerns.

So, Opinion No. 16 continues to set forth the 12 conditions for pooling that represent guidance today. Questions related to business combinations have spawned 39 AICPA Interpretations, three FASB Interpretations, one FASB Technical Bulletin, more than 50 issues of the EITF, 13 SEC Staff Accounting Bulletins, and four SEC Accounting Series Releases.

Status of FASB Project

FASB projects typically span a period of three years or more due to the nature of the issues involved and the extensive time required for FASB's due diligence process. For much of 1998, FASB has addressed various issues associated with purchased goodwill. The board has reached preliminary conclusions regarding the qualification of purchased goodwill as an asset, measurement of purchased goodwill, conditions for impairment of goodwill, amortization requirements, and reporting of amortization and impairment charges resulting from goodwill. The board has not yet addressed the need for two methods of accounting for business combinations, but plans to do so (see Sidebar).

Meanwhile, international accounting standards setters have finalized or are completing their deliberations on accounting for business combinations. None of these bodies (Australia, Canada, New Zealand, the United Kingdom, or IASC) anticipate allowing pooling (uniting of interests) unless no acquirer can be identified from the parties involved in the combination.

What is the Fate of Pooling?

The outcome of the FASB project on business combinations is impossible to predict, but many observers believe one result will be the elimination or significant curtailment of pooling. FASB's special report on the issues involved in the project indicates the board is not inclined to redefine the conditions required for pooling, but more likely will consider whether a need exists for separate methods at all.

The board also may examine ways to narrow the differences between pooling and purchase accounting such as 1) a requirement to fair value all assets and liabilities of combining companies, 2) a requirement to perform periodic impairment tests of purchased goodwill instead of amortization, or 3) a change in reporting goodwill write-offs and amortization in a separate income statement line item or in comprehensive income. The latter two changes could make the elimination of pooling more palatable for merging companies. Whatever the outcome, FASB proposals to curtail pooling accounting may face strong opposition from business and others based upon the popularity of the method today.

Recent FASB proposals on accounting for stock options and derivatives have faced strong opposition from private companies and from Congress. In the case of stock options, the opposition came from nearly every sector; ultimately, a warning from Congress resulted in FASB making optional its preference that stock options be accounted for by charges against earnings. The opposition has not been as strong or effective in the case of derivatives, but still has resulted in challenges from members of Congress that threaten the very nature of the accounting standard-setting process. Further attempts to reduce earnings of companies are not likely to be taken lightly by those who believe accounting standards setters overstep their bounds when earnings reduction is involved.

Purchase accounting is not a panacea for all the issues associated with business combinations. If FASB decides to allow purchase accounting almost exclusively, limiting pooling to only a few transactions, many issues will need to be addressed, including--

* how should purchased in-process research and development "assets" be treated?

* should restructuring reserves be allowed to be created and included in goodwill?

* how should the allocation of purchase price to specific assets be made?

* what are the appropriate amortizable lives for goodwill and purchased intangibles? and

* how should impairment of goodwill be measured?

The popularity in the United States of utilizing pooling accounting for mergers seems to be accelerating at a time when significant questions have been formally raised as to whether the method produces results that are comparable on an international basis and presents adequate information to users of financial statements. Whatever the outcome, accounting for business combinations is an issue that deserves reexamination. *

James R. Duncan, PhD, CPA, is an assistant professor of accounting at Ball State University. Robert L. Carleton, CPA, is Senior Vice President and Controller of Tricon Global Restaurants, Inc., and is a member of the FASB Task Force on Business Combinations.