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Merger mania: should pooling be abolished?

Merger Mania

Should Pooling Be Abolished?

Since the early years of accounting, accountants have strived to present the most informative financial statements possible. As stated by the Financial Accounting Standards Boards (FASB):

"All financial reporting is concerned in varying degrees with decision making. The need for information on which to base investment, credit and similar decisions underlies the objectives of financial reporting to the purposes to be served, and the objectives of financial reporting are focused on the use of accounting information in decision making." [FASB, 1980, p. 1401]

One area of concern related to the informativeness and usefulness of financial statements is business combinations. In recent years, this area has been better termed "merger mania," due to the ever increasing number of business combinations taking place.

It is essential that accountants provide relevant and reliable financial information so that users can make informed investment decisions regarding that information. Currently, there are two acceptable methods of accounting for business combinations -- the purchase method and the pooling-of-interests method. The purchase method basically accounts for the business combination as a purchase of (net) assets and records the purchase at the fair market value of the consideration given up in the exchange.

However, the pooling-of-interests method accounts for business combinations as if the ownership interests or stockholders of two or more companies exchanged their equity securities. An acquisition is not recognized because in the process none of the constituents' resources are disbursed. This results in a continuance of ownership interest, however small, in the larger surviving company. The net assets and stockholder groups remain intact but combined.

Many people feel that the pooling-of-interests method fails to meet the objectives of financial reporting as stated by the FASB. The purpose of this article is to show that the pooling-of-interests method of accounting for business combinations is inconsistent with theoretical accounting principles and, therefore, should be eliminated by the FASB.

History of Business Combinations

A business combination occurs when one or more companies are brought together into one accounting entity. The single, surviving entity carries on the activities of the previously separate entities. These transactions result from a variety of factors, such as expanding or diversifying the enterprise, strengthening management or settling income tax and estate tax problems. According to Catlett [1968, p. 1], the ultimate goal of a business combination is to "improve the effectiveness of the operations of the combined enterprise and, thus, to increase its earnings.

There have been three distinct periods of business combinations in the United States. The first period, which lasted from 1880 to 1904, saw holding companies and trusts created by investment bankers. They were trying to gain a monopoly over certain industries by horizontal integration.

The second period was started by the federal government during World War I and continued through World War II. The government encouraged business combinations to obtain a greater standardization of parts and materials. This discouraged price competition and bolstered the war effort. These combinations used the process of vertical integration to reduce costs and to improve operations and competitive positions.

The third period of business combinations started after World War II and continues to this day. Companies in different industries combined to diversify their business risks. These conglomerates have little or no production or market similarities.

History of Pooling

In the late 1940s, a high inflation rate widened the gap between the market and book value of firms. Accountants were forced to distinguish the acquiring firm from the acquired one. In some cases this distinction was too difficult to identify so the accountants coined the term "pooling of interest" to describe them.

In September of 1950 the American Institute of Accountants' Committee on Accounting Procedure came out with Accounting Research Bulletin No. 40 that dealt with the pooling issue. The bulleting stated that substantially all of the entity interest pooled had to be continued in the surviving entity. The size of the companies, management continuity and similarity of the companies were other factors taken into account. Not all of these additional factors had to be met, but they did have a cumulative effect on meeting the pooling requirement. The criteria for pooling were very subjective. A combination could be categorized as a purchase but assets other than goodwill could be recorded at their old book value. Goodwill would be charged as the excess of cost over other assets and then written off to earned surplus. This created a "pooling effect."

In 1953 the American Institute of Accountants came out with Accounting Research Bulletin No. 43 which reversed the goodwill-related conclusions of ARB No. 40. Under the new bulletin, writing off goodwill to earned surplus after acquisitions was disallowed, charges to earned surplus were discharged and goodwill amortization was encouraged. This distinction between pooling and purchasing only brought to light the subjective criteria of the pooling methods and eventually led to its abuse.

The issuance of Accounting Research Bulletin No. 48 in 1957 accelerated the pooling of interests method by providing greater endorsement than ever before. The difficulties of accounting for goodwill and the unpopularity of the purchase method in a period of rising stock market prices also contributed to the widespread usage of the pooling method. Abusive practices spread as a result of the Institute's subjective language of the pooling method. Some firms which had treated a combination before ARB No. 48 as a purchase restated the combination as a pooling retroactively. Other firms invented the part-pooling, part-purchase method by giving both cash and common stock in the exchange for common stock of another firm.

Pooling Today

Under heavy pressure from the Securities and Exchange Commission (SEC), the Accounting Principles Board (APB) held a symposium on business combinations in June of 1969. The board initially decided to abolish the pooling-of-interests method altogether, but later reversed this decision. This caused criticism from practitioners and theoreticians. Many of them felt that reinstating the pooling-of-interests method would do nothing but reposition the abuse which had occurred in previous years.

The board removed the purchase-pooling option in its APB Opinion No. 16 by stating that the purchase method and the pooling-of-interests method are both acceptable in accounting for business combinations, although not as alternatives in accounting for the same business combination. A business combination which meets (the) specified conditions requires accounting by the pooling-of-interests method. A new basis of accounting is not permitted for a combination that meets the specified conditions. All other business combinations should be accounted for as an acquisition of one or more companies by a corporation.

The opinion went on to state the 12 required conditions to account for a business combination as a pooling of interests.

Accounting Procedures and Shortcomings of Pooling

Issuance of Cash vs. Common Stock

For a business combination to be accounted for as a pooling-of-interests, the issuing company must exchange its common stock for the outstanding common stock of the target company. If some other form of consideration is given (cash, for example), pooling is prohibited. Does this mean that cash is not equivalent to freely tradable common stock? Dewhirst [1972, p. 38] claims that "the form of consideration exchanged...does not appear to justify in itself two different methods of accounting for business combinations. And, since differences in the form of consideration exchanged appear to be the major rationalization supporting pooling-of-interests accounting, one can conclude that pooling accounting is of questionable validity."

Related to this is another illogical concept of pooling. If common stock is required using cash and this stock is used to acquire a company, pooling is disallowed. The concept that cash and common stock are freely interchangeable is acknowledged in this respect. Cash can be used to buy common stock and common stock can be sold for cash, but the pooling ideology is that cash and common stock are not equivalent when they are used as consideration in a business combination.

Net Income and Earnings Per Share

When the pooling of interests method is used, the income statement and balance sheet accounts of the firms are combined in the same amounts as those which appeared on their respective books prior to the merger. The shares that are issued in the combination are considered issued and outstanding for all the reported-upon periods. This can create an instant, retroactive earnings history by the acquirer from the income statement and earnings per share standpoint. The failure to record net assets received at fair market price generally causes future net income to be over-stated because of an unrealistically low level of depreciation expense charged against assets that are matched with revenues. Dewhirst [1972, p. 38] states that "if the consideration exchanged was valued at fair market value as in the case of internal expansion, owner's equity, associated assets, future expenses and net income would be realistically determined."

Of course, the overstating of income causes earnings per share to be overstated as well. Foster [1974, p. 37] claims that pooling "ignores economic reality and cannot be justified in accounting theory." He goes on to state that in this respect, the financial statements do not present fairly.

In regards to income manipulation, Spacek [Catlett, p. 1] stated that "by not accounting for the values exchanged, business can, in effect, report proceeds from the issuance of capital stock as earnings. The sale of capital stock and the credit of the proceeds to profits would be abhorrent; yet, the pooling of interests is the accounting cosmetic that makes such results acceptable."

Another effect that pooling has on income is the treatment of operating results. Under the pooling method, the current period and all prior periods are treated on a combined basis. This concept of the firms always having been together can lead to illogical and unreliable financial statements. Income can be manipulated by an end of the operating cycle merger in this fashion.


In the past, several ways were found to inject cash into poolings in practice. One of these methods was termed a "bailout". This is the practice of taking stock in a pooling and selling it shortly thereafter.

The old pooling rules restricted this practice, but the issuance of APB Opinion No. 16 dropped this restriction. The result was a surge of bailouts. In reaction to this, the SEC produced Accounting Series Releases Nos. 130 and 135, which stated that an affiliate in the business combination could not sell or reduce his risk relative to his common shares for 30 days after the combined operations had been published. All this served was to delay the bailout for 30 days. In regards to this, Foster [1974, p. 38-39] stated, "Apparently pooling has achieved such stature that it is preferable to alter economic reality for 30 days rather than alter rules which ignore reality. Thus, a perceptible cynicism relative to pooling pervades the accounting profession. Getting around the rules is a popular and lucrative game. This is doubtless traceable to the illogic of the basic concept. Given an environment where even the regulatory authorities are willing to alter economic reality rather than the pooling rules, it is not surprising that companies view pooling as an `inalienable right.' It is also not at all surprising that a gradual erosion of the rather arbitrary pooling criteria has taken place."

Comparability and Relevancy

Supporters of the pooling of interests method claim that financial statements accounted for under this method are more comparable and consistent and thus of more informational value than purchase accounting. This is simply not the case. Pooling does not result in a consistent basis of valuation for all parties of a combination because the historical cost book values of the firms are composed of mixed valuation bases. These assets were purchased during different intervals when the current cost levels and the purchasing power of the dollar were different.

Pooling of interests goes against generally accepted accounting principles in that assets should be recorded at their fair market value when purchased and should remain at their acquisition cost in accordance with the cost concept, regardless of the accounting basis of the assets on the books of the purchased company. The practice of carrying assets forward at their previous book values of the acquired company, as in pooling, lacks relevancy. Catlett [1968, p. 114] states that "(the) elimination of pooling of interests accounting results in comparability in accounting for business combinations. Purchase accounting is clearly better than pooling of interests accounting in ascribing more current values to the resources of a business."

Pooling -- An Arrangement Between Stockholders?

Dewhirst [1972, p. 35] states that the idea of a pooling combination as "solely an arrangement among stockholder groups is a naive interpretation of contemporary business reality in the great majority of cases."

Foster [1974, p. 37] went so far as to say that "one almost expects a wink when this rationale is advanced. We know that corporate officers negotiate the transaction from beginning to end." Many corporations actually employ personnel to identify likely acquisition candidates. Management is the one that determines whether to partake in an acquisition and how to account for it. In many poolings, the issuing company shareholders do not even know about a merger until they read about it in a newspaper or a corporate annual report.


The pooling-of-interests method of accounting for business combinations lacks the relevancy, consistency and comparability that users of financial statements need and expect. Pooling results in unrealistic future income and unrealistic earnings per share figures. It also has many loopholes that allow companies to get around its requirements.

APB Opinion No. 16 barely met the required two-thirds vote for adoption. Of the 18-member board, six dissented, stating that "(the) elimination of pooling will remove the confusion that comes from the coexistence of pooling and purchasing accounting (but), above all, the elimination of pooling would remove an aberration in historical cost accounting that permits an acquisition to be accounted for on the basis of the seller's cost rather then the buyer's cost of the assets obtained in a bargain exchange."

The only logical conclusion for the problem of accounting for the pooling-of-interests method is for the board to reconsider these accounting rules and release a statement that supersedes APB Opinion No. 16. This new statement should conclude that the pooling-of-interests method of accounting for business combinations will no longer be condoned or allowed. This action would provide a single, consistent, comparable, relevant and theoretically sound method or accounting for business combinations -- something which is needed in the ever-increasingly complex environment of merger mania.

Clyde E. Herring and Forrest Norris are professors of accounting at Mississippi State University.
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Author:Herring, Clyde E.; Norris, Forrest
Publication:The National Public Accountant
Date:Jun 1, 1990
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