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June 1992

Alice's misadventures in SAB 51's dirty pool. (Staff Accounting Bulletin 51 of the Securities and Exchange Commission)

by Briloff, Abraham J.

    Abstract- Staff Accounting Bulletin (SAB) 51 of the SEC provides corporations with the opportunity to exercise liberal accounting for the purpose of manifesting gains in profits and the appreciation of capital in financial statements. This is made possible by the SAB 51 rule that facilitates a pooling of ownership interests between two or more companies through the exchange of securities. A fictitious waste management business is used to illustrate the absurdity of the SAB 51 and the need for the SEC to abolish this policy.

I was lying under my spreading beech, brooding over AT&T's tortured endeavors to pull NCR into a pooling-of-interest when I let out with an ecstatic "Eureka!' That cry of exultation was prompted by my recognition of the spectacular consequences which can result from the linkage between the pooling accounting phenomenon and my discourse on SEC Staff Accounting Bulletin (SAB) 51 in my "Waste Management: Recycled Accounting" article in Barron's, August 6, 1990. That article included the following:

"In 1989, net income included a nontaxable gain of $70.8 million, stemming from its Chemical Waste Management subsidiaries public offering that October of five million shares of common.

"Waste Management had owned approximately 81% of Chemical Waste Management's common immediately prior to the public offering. After the transaction, it held approximately 78%, but the book value of its stake was enhanced-to the tune of $70.8 million-- when Chemical Waste Management collected the proceeds of its offering.

"In fact, Waste Management's determination to book that $70.8 million imputed gain in 1989 was, in and of itself, a manifestation of liberal accounting. The company's authority for so doing is derived from the SEC's SAB 51, issued in 1983. In that instance, the SEC staff tackled the question of how a parent company might account for gains arising from a subsidiaries' sale of stock.

"The SEC had previously insisted that such appreciation be deemed part of capital and not an item to be passed through the income statement. But in 1983, the agency's staff grudgingly decided to go along with an earlier AICPA position paper that would permit inclusion of such gains in income in certain limited circumstances. Even so, the SEC stressed in its 1983 ruling that its dispensation was interim guidance only; its expectation was that the FASB would soon get its act together and conclude a long-standing project on consolidation and equity accounting that was to address this issue among many others.

It is noteworthy that seven years after SAB 51 was promulgated and 10 years after the AICPA spoke, the FASB has yet to address the issue on which SEC staff offered interim guidance."

The Magic of Pooling

As it happened, I had considered pooling-of-interests accounting most intimately in Barron's, October 8, 1990. That article, entitled "Muddying the Waters: Accounting's Magic Wand," dealt with the pooling proclivities of Allwaste, Inc., thus:

"What really makes Allwaste remarkable is its acquisitive bent--and the way that the company's galloping growth is reflected in its published financials. According to its 10K 'During fiscal 1989, the company acquired nine companies in transactions accounted for as poolings-of-interest .... Aggregate consideration consisted of 8.6 million shares of the company's stock. Yet it is via the accounting for its acquisitions that Allwaste works its magic--with tricks, moreover, that are all perfectly okay by the good book of GAAP.

"At then-prevailing market prices, the shares Allwaste exchanged for companies it acquired during fiscal 1989 were worth over $70 million. Yet--under pooling-of-interests accounting rules--Allwaste recorded only a tiny fraction of that cost on its balance sheet. And, thanks to those same accounting rules, its reported earnings doubled.

"The critical rule regarding pooling-of-interests is APBO 16: The pooling-of-interest method accounts for a business combination as the uniting of the ownership interest of two or more companies by exchange of equity securities. Ownership interests continue and the former bases of accounting are retained. Income of the combined corporation includes income of the constituents for the entire fiscal period in which the combination occurs. The reported income of constituents for prior periods is combined and restated as income of the combined corporations.

"What that means in practice is that, because its acquisitions were accounted for as poolings, the company's revised balance sheets and income statements reflect the pooled companies as though they were part and parcel of Allwaste at all times during their respective lives. And the existence of that revised data permits a nosy analyst to extract a summary balance sheet, as of August 31, 1988, for the nine companies acquired and pooled by Allwaste during its subsequent fiscal year.

"Two audited balance sheets, both as of the same date, can then be placed side-by-side. In this instance, the first is the one that was certified by Allwaste's auditors and appeared in the 10K it filed for the year ended August 1988. The second is the balance sheet for the same date that was included for comparative purposes--in the 10K Allwaste filed for the succeeding year. According to the accountants' book of rules on poolings, the second balance sheet was made to reflect the assets, liabilities and shareholders' equity, as of the fiscal 1988 year-end, of the nine companies pooled during the subsequent year.

"The difference between the two balance sheets derived from this exercise indicates that the combined shareholders' equity of those nine acquisitions was only $4.3 million. For which Allwaste, as noted, issued shares worth over $70 million, but following the dictates of poolings- of-interest accounting-- the only cost entered onto Allwaste's books was the $4.3 million increase in its shareholders' equity. In other words, well over 90% of the cost of Allwaste's fiscal 1989 acquisitions got lost--and will remain so to eternity."

Stepping Through the Looking Glass

With that apperceptive base, I turn to a most exhilarating game plan, one which integrated the two distorting practices permitted by our profession's Good Book of GAAP--a combination that provides a distortion potential multiplied exponentially.

Now hold onto your hats, you're heading for a rough ride, thus:

Assume that Hypothetical Waste Management ("HWM") has 500 million shares outstanding, and earns $500 million (EPS $1). Its shares sell at $30, hence, a P/E of 30.

HWM identifies an entity dubbed Accounting Waste Management ("AWM") which owns dump sites with certified values aggregating $1 billion. AWM's historical earnings are about $50 million annually, with 10 million shares outstanding.

HWM proceeds to acquire AWM for 33.3 million of its shares (i.e., $1 billion worth of its shares) and accounts for the acquisition by applying pooling'of interests accounting.

Now, since AWM's book value is but $100 million, that is the number entered into HWM's books as its cost. Further, under the pooling rules, HWM restates its EPS at $1.03 ($550 million of consolidated earnings divided by 533.3 million shares now outstanding). For completeness, it should be noted that the market price is correspondingly boasted to $31.

In order to obtain operating resources, AWM proceeds to a public offering of two million newly-created shares at $100 each, i.e., equivalent to the same per-share price paid by HWM. AWM's balance sheet would now sport an aggregate equity of $300 million, i.e., the original $100 million plus the $200 million of newly-garnered equity; this $300 million is represented by 12 million shares--the 10 million in HWM's hands and two million with the public.

Now, HWM's proportional stake in the $300 million amounts to $250 million. Since this amount is $150 million greater than the $100 million on its books, it follows like night follows SAB 51 that HWM's income statement scoops up a plus of $150 million. Its income now zooms to $692 million, i.e., the historical $500 million plus the SAB 51 $150 million plus $42 million (5/6 of AWM's $50 million). When that $692 million is divided by its 533.3 million shares outstanding, the EPS escalates to $1.30 per share.

But Wait, You Haven't Seen Anything Yet

Moving along, HWM finds that its subsidiary has more dump sites than might reasonably be required for their operations, whereupon AWM sells off 10% of its sites for $100 million, precisely one-tenth of the "certified" billion dollar value. Then AWM's accounting may then calculate the gain on that sale, ordinary income, of course, to be $90 million, i.e., the $100 million proceeds less $10 million, representing one-tenth of the entire cost shown by the company's books. But then that $90 million had to be scaled down by the income tax, reckoned at $30 million; the net was but $60 million.

Assuming nothing further, AWM's income would be stated at $105 million, representing $45 million (9/10 of the historic $50 million plus the $60 million booked on the sale). But wait, we have forgotten something; thus, the $200 million garnered on the public offering was invested to yield $12 million net after tax--so that its income for the fiscal period is really $117 million; since there are 12 million shares outstanding, AWM's EPS is now $9.75. Wall Street's Gnomes remember AWM's P/E of 20 and therefore put a price of $195 on the company's shares.

Let us now shift our focus to HWM's consolidated income statement for the year, factoring in the foregoing. Thus, its income would be $747.5 million determined as follows (in $ millions):

That $1.40 is a dramatic increase over the $1 per share earned historically; but even if the P/E is not revised a single iota, the market price for HWM's shares would escalate to $42.

With that kind of coin available for circulation, why HWM could repeat the foregoing cycle time and time again. In addition, since the share price of its AWM lode is also on an upward trajectory, that subsidiary can proceed with further public offerings all to the added glory of HWM's bottom line--thanks to SAB 51.

Before concluding this glorious entertainment, let us go back to AWM's sale of the tenth of its dumpsites, the transaction which induced a $60 million profit-of which $50 million floated upward into HWM's income statement. A moment's reflection would inform us that there was, in fact, an economic loss. Note that the portion sold generated $70 million in net proceeds, i.e., the $100 million minus the $30 million tax. This means that the entire property had a net cash flow value of $700 million--something for which HWM paid with its own stock worth $1 billion. Clearly, HWM either ignored or overlooked the fact that its billion dollar outlay notwithstanding, the tax basis of the property acquired remained $100 million. As a consequence, the $60 million AWM gain, but even more so, the $50 million portion which was consolidated into HWM's bottom line, were most incongruous and were nought but distortions of logic.

Intentional Absurdity ! This SAB 51 pooling parable, is of course, absurd. This was intentional! It is hoped that by this reductio ad absurdum, the SEC staff will see fit to abort its misbegotten SAB 51 and, even more hopefully, that the solons at the FASB will consign the pooling-of-interests accounting ploy to one of the March Hare's holes.







Abraham J. Briloff, PhD, CPA, is Emanuel Saxe Distinguished Professor Emeritus of Accountancy at the Bernard M. Baruch College of the City University of New York He is a well known author and commentator on accounting matters.

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