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APB 16: time to reconsider; acquisitions disguised as poolings can lead to misleading improvements in earnings.

Consider this dilemma: A company entering its fourth quarter finds earnings have deteriorated significantly, the company's stock is out of favor with analysts and a long-expected recession is under way. The company already is using the most advantageous accounting methods. Executives have cut back, slimmed down, restructured, refocused and economized in every way they can think of, but it has not been enough. As an afterthought, management decides to call its auditors for suggestions. Almost without hesitation, the engagement partner suggests a transaction and accounting treatment to give the company's financial statements the facelift they need.

What was the engagement partner's suggestion? A merger using the pooling of interests method. When the 12 conditions of American Institute of CPAs Accounting Principles Board Opinion no. 16, Business Combinations, are met, a pooling of interests creates instant earnings on the company's income statement. In fact, no matter how late in the fiscal year a pooling is consummated, earnings of the acquired company for the entire year are included in consolidated net income. On top of that, there's no goodwill to be recorded and amortized over the next 40 years.

As good as this outcome sounds, the above scenario masks some problems the Financial Accounting Standards Board is going to have to address. The rules governing poolings are now over 20 years old, and today's business environment is far different, especially in terms of capital structure and financial instruments, than when APB Opinion no. 16 was passed. In addition, of all the major industrialized countries, only Great Britain allows anything resembling pooling, and its rule makers are modifying the rules to prevent most poolings. Finally, the International Accounting Standards Committee (IASC) has an exposure draft outstanding that blacklists poolings and would eliminate them in most circumstances.


Originating in the 1940s, the term "poolings" was coined to describe the final form of a union of similar-sized utilities combined via an exchange of securities. In response to the utility companies' attempts to justify higher rates by writing their assets up to fair market value at the time of the combination, the Federal Power Commission ruled valuation on this basis was improper and no new values should be assigned to properties because no change in substance had actually occurred.

In essence, by denying the utilities' requests, a new book-value-based combination called a "pooling of interests" was created. The AICPA formalized this merger concept in 1950 in Accounting Research Bulletin no. 40, Business Combinations, as a fusing of equity interests normally involving.

* Companies of relatively the same size.

* A continuity of combined management.

* Similar or complementary business activities.

No new basis of accountability arose and assets remained at book value.

What went wrong? Denial of fair-value-based accounting for utility poolings turned into a veritable gold mine for everybody else. Book-value-based depreciation often was far less than fair-value-based depreciation under the other merger accounting alternative, the purchase method. Additionally, goodwill was neither recorded nor amortized in a pooling. Moreover, ARB no. 40 and subsequent pronouncements allowed for diverse interpretation, so by the "go-go" years of the late 1960s, when earnings were everything, the substance of a merger became irrelevant--virtually any combination could be accounted for as a pooling and the resulting public outcry was unrelenting.

As exhibit 1, page 101, indicates, it took some fairly strong pressure from the Securities and Exchange Commission in February 1969 to finally prod the AICPA into action. Rather than incorporating the three conceptually sound guidelines of ARB no. 40, however, Opinion no. 16 instead instituted 12 conditions that give little regard to the substance of the merger.

Although a comparable-size test was included in the exposure draft of Opinion no. 16, intense pressure from the business community ultimately forced its removal from the final version. Absent also was the notion a true pooling could hardly occur without a continuity of management or complementary lines of business. The requirement that a fusing of equity take place remains, but in reality, the fusion need last only a moment in time, as shareholders are basically free to sell once the merger is consummated. As for the 12 rules themselves, numerous practitioners readily admit many of them defy logic. One large accounting firm published a 200-page interpretation of Opinion no. 16 (and a related statement, APB Opinion no. 17, Intangible Assets); the two opinion themselves total only 20 pages.

The complex rules of APB Opinion no. 16 have achieved one desired objective: The use of pooling has decreased steadily. As exhibit 2, page 103, illustrates, the number of poolings for the 600 companies tracked in Accounting Trends & Techniques declined from 185 to 1969, the last full year before Opinion no. 16 became effective, to 18 in 1989. While these statistics might give the impression poolings eventually will disappear, the total number of poolings in any given year is significantly larger than these data indicate and at least one industry--banks and savings and loans--uses the pooling method extensively. These data also highlight the first of four major controversies


that justify reexamining the pooling method's appropriateness.


In recent years, four major controversies have arisen challenging the validity of accounting for certain types of transactions as poolings.

1. Most poolings are really acquisitions. Exhibit 2 shows a fairly steady decrease not only in poolings but also in the percentage of material poolings, in which the pooled company was large enough to warrant restatement of prior year's financial statements as required by Opinion no. 16. Exhibit 3, page 104, illustrates this. Assuming lack of restatement implies immateriality, there were several years in the 1980s when immaterial poolings outnumbered material ones. In other words, using a reasonable materiality threshold of 10%, over half the poolings in some years involved target companies at least 10 times smaller than the acquiring entity.

Research studies have found the average relative size of pooled companies, both before and after Opinion no. 16, is about 20% of the acquirer. Rarely do pooled companies approach 50% of the acquirer and many are less than 5%. Except in the most unusual circumstances, it seems inconceivable a true pooling of interests could occur when one merger partner is 5 to 20 times larger than the other.

Rule makers in the United Kingdom agree with this position; the U.K. Accounting Standards Board's February 1990 Exposure Draft (ED) no. 48, Accounting for Acquisitions and Mergers, proposes to restrict poolings to combinations in which "none of the combining parties is more than 50% larger than any other enterprises [that] is a party to the combination unless special circumstances prevent the larger from dominating the other(s)." This rule translates to a relative size of 40% to 60% for the pooled entity. The ED also says, "A merger [which is the British term for a pooling] is a rare business combination. . . . The great majority of business combinations are acquisitions."

Poolings are rare indeed. According to my study of a sample of 108 U.S. pooling method merges during 1971-82 as published in the July 1990 issue of the Accounting Review, a 40% size restriction would have eliminated all but one of them.

As further evidence of worldwide opposition to poolings, the IASC's ED E32, Comparability of Financial Statements, though not incorporating a specific size test, would require purchase method accounting if the acquirer can be identified and says, "Conditions where an acquirer cannot be identified are expected to be very rare." Perhaps if the original size guidelines in ARB no. 40 had been retained, this controversial issue would now be moot. But in the view of pooling critics, even ARB no. 40 has a fatal flaw.

2. The equity exchange is based on market value, not book value. Although both ARB no. 40 and Opinion no. 16 require an equity exchange in a pooling, little credence is accorded book value when the two sides argue over the stock exchange ratio. In fact, the value of the shares exchanged often is far above the pooled company's share price at the announcement date. Yet that fair value, along with any implied goodwill, is ignored and the assets and liabilities are combined at book value.

3. The illusion of higher earnings. It was noted previously that pooling of interests accounting normally results in higher--and often much higher--earnings than when purchase accounting is used. This is due to

* Lower, book-value-based tangible asset depreciation.

* Higher gain recognition when book-value-based assets, such as marketable securities, are sold.

* The absence of goodwill amortization.

What is often forgotten is the incremental earnings caused by these three factors produce virtually zero extra cash flow. Why? Because the lower earnings in a purchase method merger, caused by higher depreciation-amortization charges and lower gain recognition, generate negligible tax savings. While the extra depreciation and lower gain recognition can produce tax benefits, amortization of goodwill is never tax deductible and the goodwill element usually is far larger than the first two factors.

In the recent Time-Warner merger, which started out as the largest-ever pooling at $9 billion but ended up being accounted for as a $14 billion purchase, $11 billion--80% of the purchase price--was for non-tax-deductible goodwill. Of the $12.9 billion Philip Morris paid Kraft Inc. in 1988, 90%--$11.6 billion--was for goodwill. Even today, many players and observers in the merger arena still don't understand one simple fact: Goodwill amortization has no real impact on the financial statements because it has no cash flow impact. As a result, they mistakenly believe either goodwill is bad because of its impact on income and earnings per share or, alternatively, the pooling method is beneficial because it avoids these charges. Samples from the rash of financial press surrounding these two mergers are provided in the sidebar on page 106.

Two recent research studies, one published in the January 1990 Accounting Review and the other in the fall 1988 Journal of Accounting and Public Policy, found that on the average, acquiring entities pay a larger premium over book value in pooling method mergers than in puchase method mergers. If the stock market is any judge, however, such premiums are wasted. Other studies have documented the market does not react positively to window dressing--earnings differences caused solely by accounting method choices. One study specifically examined the purchase--pooling method choice and found pooling mergers did not generate any extra stock market returns during the period when postmerger combined earnings were announced.

4. The global push for harmonization of accounting standards. Not only have the rules of Opinion no. 16 become increasingly difficult to use in a more sophisticated and complex merger environment but the global economy also is saying "no" to pooling. There has never been a worldwide movement to embrace the pooling method; on the contrary, as evidenced by exposure drafts from the United Kingdom and the IASC, the impetus is to virtually eliminate it.


Leonard M. Savoie, the chief staff officer of the AICPA in 1969, said the AICPA would propose abolishing the pooling method. One year later, however, Opinion no. 16 was enacted. Dissent was strong and it passed by the slimmest possible vote. Instead of a vehicle to ensure a pooling was truly a fusing of two relatively equal equity interests, Opinion no. 16 was a rule-based labyrinth that bore very little relationship to economic reality.

Most mergers that meet the pooling rules are not poolings in substance. Moreover, not recording the true economic value results in materially misleading financial statements. Instead of providing a reasonable alternative to the purchase method, the intervening years have borne out Savoie's concerns and substantiated the objections voiced by other critics. Perhaps these concerns are best summed up by three dissenting members of the APB: "The opinion . . . seeks to patch up some of the abuses of pooling. The real abuse is pooling itself. On that, the only answer is to eliminate pooling."


First impressions are often correct--the AICPA was on the right tract in 1969 when it announced its intention to abolish poolings. The evidence clearly indicates the rules of Opinion no. 16 do not produce true poolings but acquisitions disguised as poolings, resulting in potentially misleading cosmetic improvements in earnings. The international community is taking steps to severely restrict pooling. The FASB must also make good on the APB's 22-year-old first impression and critically reevaluate the appropriateness of pooling of interests accounting in the United States.

MICHAEL DAVIS, CPA, PhD, is associate professor of accounting and KPMG Peat Marwick Faculty Fellow at Lehigh University, Bethlehem, Pennsylvania. He is currently a visiting professor at Swinburne Institute of Technology, near Melbourne, Australia.
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Author:Davis, Michael
Publication:Journal of Accountancy
Date:Oct 1, 1991
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