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A 19 pages term paper on FASB Eliminating the Pooling of Interest Method for Business Combinations

           The Financial Accounting Standards Board ("FASB") recently issued two new Statements of Financial Accounting Standards. These two pronouncements, Statement No. 141, Business Combinations, and Statement No. 142, Goodwill and Other Intangible Assets, significantly change the accounting for business combinations. Importantly, the new rules do not change the current accounting for purchased in-process research and development costs.

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           FASB had originally proposed eliminating pooling no later than mid-2000, and requiring that all business combinations be accounted for using purchase accounting. Tremendous outcry ensued - commentors were uniform in their opposition to FASB's original proposal.

           Throughout 2000 and early 2001, there were several public and Congressional hearings, presentations to FASB by various groups, including TechNet and NVCA, and FASB-conducted field testing of several companies, including some TechNet members. FASB even took the unusual step of issuing a Revised Exposure Draft and allowing a second round of comments.

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           Although FASB ultimately eliminated pooling of interest accounting for any business combination initiated after June 30, 2001, FASB also abandoned the long-standing method of accounting for acquired goodwill. Under the new pronouncements, goodwill is no longer amortized. Instead, it is tested for impairment and an impairment loss is recognized only if, and when, the carrying amount of acquired goodwill exceeds its implied fair value. The arbitrary drag on earnings required under the former purchase accounting rules is, therefore, eliminated. See, for example, Earnings Reports Will Look Better With Goodwill Gone, Wall Street Journal (8/6/01); Firms Fatten Up Profit Outlooks on FASB Rule, Wall Street Journal (8/21/01).

           Although the goodwill impairment test is to be performed annually, FASB attempted to reduce the burden on companies by setting forth a two-part test. If the first part is satisfied, no further testing is required. TechNet and NVCA had significant input in the process that resulted in the final impairment test.

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           Certain intangible assets that meet specified criteria also must be reported separately from goodwill. If a useful life can be determined for these assets, they must be amortized. If not, or if circumstances indicate that these assets may be impaired, they are tested for impairment. This is another area where the final rules are significantly different from those originally proposed by FASB.

           Under the new rules, for purposes of testing goodwill for impairment, identifiable intangible assets and goodwill must be assigned to "reporting units." Based on the comments of many who found the original reporting unit definition unworkable, a reporting unit is now defined as a financial reporting segment, or one level below the segment.

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           In the first step of the impairment test, the fair value of the reporting unit is determined and that value is compared to its carrying value. If the fair value exceeds the carrying value, no further testing is required. For example, if the fair value of the reporting unit were $10 million and its carrying amount were $8 million, no further testing would be required. Only if the fair value were less than the carrying value of the entire reporting unit would a company be required to perform the second step of the impairment test.

           The second step of the impairment test requires that the fair value of the reporting unit be allocated to items other than goodwill. Any excess of the fair value over the allocated amounts is the implied value of the goodwill. For example, if $7 million of the $10 million fair value were allocable to other assets and liabilities assumed, the remaining $3 million would be the implied value of the goodwill. This implied value would then be compared to the carrying value of the acquired goodwill. An impairment charge would be recognized only to the extent that the goodwill's carrying value exceeded its implied value.

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           Of course, valuation and allocation issues will arise. Valuation determinations and allocations must be based on all of the relevant facts and circumstances. However, the two-part test set forth in the new pronouncements should reduce these issues to some degree because a fair value allocation to specific items will not be required unless the fair value of the reporting unit as a whole is less than its carrying amount.

           In recognition of the potential burden associated with performing the annual testing, in certain, limited circumstances, an entity is not required to perform a re-determination of the fair value of the reporting unit in a subsequent period. Although this provision will generally be inapplicable to highly acquisitive companies, companies that do not engage in many business combinations may be able to further reduce their compliance burden.

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           In general, the new rules are effective for business combinations initiated after June 30, 2001, or all purchase method transactions with an acquisition date of July 1, 2001 or later. Prior pooling transactions are not restated. Prior purchase transactions generally are subject to the new rules for the fiscal year that begins on or after December 15, 2001. Early adoption of the new pronouncements is permitted in limited circumstances for companies with fiscal years beginning after March 15, 2001.

           TechNet and NVCA have been engaged in the business combinations issue for over two years. These efforts have resulted in a workable standard that takes into account sometimes competing interests. However, much of the guidance relating to fair value determinations, purchase price allocations, and the like were simply carried over into Statement No. 141 from APB Opinion No. 16, Business Combinations. FASB has announced that it intends to reconsider "some or all of that guidance (as well as related Emerging Issues Task Force [EITF] issues) in another project." Thus, some of the provisions of Statement No. 141 are likely to change. (The impairment tests are contained in Statement No. 142 and FASB has announced no effort to reconsider those standards.). Business combinations accounting also is on the agenda of the new International Accounting Standards Board. TechNet and NVCA members must continue to be vigilant in this area to help assure that any changes to these standards are appropriate.

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           On September 9, 1999, the FASB voted unanimously to eliminate the opportunity for merging companies to account for their business combinations as a "pooling of interests." The FASB is the independent professional group that establishes U.S. accounting rules. This new regulation will go into effect as of January 1, 2001.

           The FASB believes the elimination of the pooling of interests method will allow investors to understand better how much was paid for an acquisition. Also, the FASB believes the purchase method of accounting is more representative of how all other accounting transactions are recorded. Finally, by discontinuing the pooling of interests method, U.S. accounting practices will be more in line with international accounting standards.

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           Current accounting standards give companies two options for accounting for a merger or business combination, the "purchase method" or the "pooling of interest method."

           Under the purchase method, the buyer and the seller determine a price for the company. The difference between the total price paid and the fair market value of the purchased company’s underlying assets and liabilities is generally considered “goodwill.” Goodwill represents the value assigned to the ongoing operations of the purchased business. Specifically, goodwill usually represents the monetary value for the customer base, product niche, hard work of the owners, and other intangible assets that have made the company so valuable. This intangible asset is then amortized over a period not to exceed 40 years. (The new regulation requires all companies to amortize goodwill over a period not to exceed 20 years.) The amortization of goodwill directly reduces future earnings of the combined business.

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           Under the pooling of interests method, the merged or combined companies add the historical cost value of the underlying assets and liabilities together with no goodwill being recognized. In a pooling of interests transaction, the buying company offers substantially all stock to existing stockholders of the selling company. This method allows for all assets and liabilities to be combined at historical cost values. The only item affected is the number of outstanding shares of common stock. Outstanding common shares are increased, usually, due to the issuance of shares as consideration for the business combination. There should be criteria that must be in place for a business combination to be accounted for, as a pooling of interest is very stringent. The underlying theory of a pooling transaction is that the “rights and risks” of the combining entities continue after the merger. This concept is not true in most business combinations, as one entity is generally recognized as the “purchaser.” The reason most companies desire to use the pooling of interests method is that reported earnings after the combination are not diluted by amortization of the goodwill (Isaacs).

           It should be noted that the purchase method and the pooling of interest method were never considered as alternatives for the same business combination. The requirements governing “rights and risks” of the combining companies for a pooling of interests were so specific that only a select group of business combinations would qualify. All other combinations were required to use purchase accounting.

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           Business combinations present a complex maze of operational and financial issues. By eliminating the pooling of interests method, the FASB hopes to at least simplify one route in this maze (Isaacs).

           At a hearing on May 4, 2000 by the House Commerce Committee's Finance subcommittee on the proposal by the FASB to eliminate the pooling method of accounting for business combinations, Dr. Wm Frederick Lewis, President and CEO of Prospect Technologies representing the U.S. Chamber said that eliminating the pooling method will jeopardize mergers involving high tech companies in the current fast moving economy. The proposal was also attacked by Committee Chairman Tom Bliley (R-VA), Rep. Call Dooley (D-CAL) and Rep. Tom Davis (R-VA). Rep. Billy Tauzin (R-LA) warned FASB Chairman Edmund Jenkins who also testified that legislation might be passed unless FASB changes its position on the proposed standard. The standard is set to be issued no earlier than the end of 2000.

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           Since 1970, two methods have existed for accounting for mergers and acquisitions. The method of preference has depended on meeting certain criteria. In most cases, companies have preferred to structure deals to take advantage of the pooling-of-interest accounting method. In this way, they avoid recording goodwill on the balance sheet of the surviving company. They also avoid the decrease to net income that results from writing off the goodwill over subsequent years (Cassandra).

           In its simplest terms, pooling-of-interest allows combining companies to add together the existing book value of their assets and liabilities and continue that basis into the future. The combination is structured as the fusion of the ownership interests of two or more companies by exchange of equity securities (Cassandra).

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           Several criteria must be met to qualify as a pooling. Ownership is combined, but does not change, and the previous bases of accounting are carried forward into the new entity. The income of the newly combined entity includes income of the companies coming together for the entire fiscal period when the combination occurs.

           If the criteria for pooling are not met, the combination must be accounted for as a purchase. Under a purchase, the deal is considered an acquisition of one company by another. It requires the acquiring company to determine the fair value (market value) of the assets and liabilities of the company acquired. These values are brought onto the books of the acquiring company.

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           Since the price paid to acquire a company frequently exceeds fair value, the difference must be recorded as goodwill. Goodwill is amortized and charged against earnings over a period, which currently cannot exceed 40 years.

           In addition to eliminating pooling accounting, the FASB proposes to reduce the write-off period for goodwill to 20 years. It is this reduction against future earnings that companies desire to avoid when they structure a pooling-of-interest deal.

           The two methods are not intended to be alternatives for the same transaction. But practically speaking, savvy financial management has found ways to structure transactions to get the accounting it wants, usually a pooling. The FASB believes that the time has come to provide more consistent accounting for business combinations and is likely to eliminate the use of pooling, perhaps as soon as the beginning of next year (Cassandra).

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           A company should not rush to accomplish a merger, but instead should wait for acquisition to take advantage of the last days of pooling.  Because, despite the perceived advantages of pooling, there are plenty of good reasons to wait.

           The reasons to wait involve the conditions that must be met to qualify for pooling-of-interest accounting. A primary concern is the requirement that there must be an absence of certain planned transactions after the combination. One of the prohibited transactions is stock buybacks. Under SEC rules, pooling companies must rescind or forgo stock repurchase plans to be eligible for pooling. This may eliminate valuable advantages to your stockholders. For example, remaining stockholders are unable to increase their overall ownership percentage. Tax advantages to your company and your stockholders may be lost. Finally, you lose an important way to send a positive message to analysts about your company's future prospects.

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           Before plunging into a pooling, carefully consider implications for any stock option plans. Any changes to terms within two years of the pooling are closely scrutinized. If they constitute changes to equity interests, they will disqualify your pooling. You may not want to take the planning actions necessary to avoid this pitfall (Cassandra).

           Also consider the sophistication level of market analysts. The perceived benefit of avoiding relatively large decreases to net income from amortization of goodwill does not stand up to reality. Analysts are skilled at adjusting for the book decrease in net earnings after purchase accounting is applied to a merger. Market analysts take the cosmetic difference between two similar combinations into account.

           A more practical reason is that the stock price of the company being acquired may well exceed the cost of the same stock acquired in a more deliberate combination. It is just too easy to make mistakes when you are rushing to take the plunge! You may make costly mistakes and fail to act in your stockholders best interests.

           Do not plunge into a pooling without carefully considering the possible disadvantages, including restrictions on stock repurchase and stock option plans, the inflated share price that may occur, and the high risk of making mistakes in haste (Cassandra).

           Finally, consider whether purchase accounting may be the best answer for your company After all, if it is good enough for the huge AOL/Time Warner merger, it may be right for your company too. Whatever your decision, with FASB action pending, the clock is ticking (Cassandra).

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           The Financial Accounting Standards Board’s plan to rewrite the accounting rules for mergers has turned into a political football.

           FASB has been working since 1996 to eliminate the pooling of interest method for merger accounting, and its work should be largely finished next year (2000).

           Back when the process got started, all Edmund Jenkins, the trade group’s chairman, seemed to have had in mind was bringing U.S. accounting rules more in line with international standards and leveling the playing field for all mergers and acquisitions. The pooling method is employed in many financial and high-tech mergers and permits merging companies to “pool” their financial statements at historic cost, effectively eliminating the write-offs against purchased goodwill corporate acquirers have to take.

           In mergers outside the tech and financial industries, acquiring companies tend to rely on the purchase method of accounting, where goodwill is amortized against future earnings. The majority of companies outside of the tech and financial sectors are in favor of eliminating the pooling method.

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           But like the proverbial camel, Congress has been sticking its nose under FASB’s tent. Earlier this year, there were several rounds of hearings, and more recently, in early October, a dozen Senators, including vice presidential nominee Joseph Lieberman (Dem. – Conn.), wrote to FASB asking it to delay its action on the issue. In addition, Reps. Christopher Cox (Rep. – Calif.) and Calvin Dooley (Dem. – Calif.) introduced a bill earlier this month that, if passed, would impose a one-year moratorium on any attempt by FASB to eliminate the pooling method for mergers (Cox).

           For its part, FASB has politely told the prying legislators to butt out, and it’s receiving the support of at least five other Congressmen and Ernst & Young, the big five accounting firm.

           A day after Cox and Dooley submitted their bill, four of their colleagues, all of whom happen to be certified public accountants, wrote a “Dear Colleague” letter to other members of the House, asking that they reject the Cox-Dooley proposal. The letter was signed by Clay Shaw (Rep. – Fla.) and three Democrats, Brad Sherman of California, Collin Peterson, of Minnesota, and Owen Pickett of Virginia (2000).

           Last week, Rep. Christopher Shays (Rep. – Conn.), whose district happens to include FASB headquarters in Norwalk, also penned a “Dear Colleague” letter opposing the Cox- Dooley bill (Cox).

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           Both letters said the Cox-Dooley bill would “politicize the process” for setting accounting standards and compromise FASB’s autonomy. Since the early 1970s, the Securities and Exchange Commission has largely backed off from issuing accounting regulations in favor of private sector standards set by FASB (2000).

           Jeffrey Mahoney, a project manager in the trade group’s Washington office, said that the Cox-Dooley bill would set an unwelcome precedent that could come back and haunt the private sector.   “Most of corporate America and most investors support private sector standards setting,” Mahoney said to CFO.com. “I think you’ll see more opposition as more people become aware of this legislation.”

           In the meantime, the issue still has months to play out. In his response to the letter from Sen. Lieberman and the 12 other senators, FASB chairman Jenkins said a rule formally eliminating the pooling method isn’t likely to be issued until the first quarter of next year. But Jenkins also assured the senators that FASB was “not rushing to any final conclusions.”

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           Kim Petrone, the project manager for the business combinations effort at FASB’s headquarters, says that several related issues still have to be resolved - - including the treatment of goodwill and intangible assets under the purchase method - - until the trade group’s board can again revisit pooling (Radigan, 2000).

           The board, which meets almost weekly, isn’t likely to continue its discussions on pooling before December, she said.   “Right now we’re kind of in a holding pattern,” Petrone said.

Speaking at the annual Meet the Experts accounting standards conference in London recently, FASB international director Jim Leisenring said that a new business combinations accounting standard would be released by the second quarter of next year. He added that pooling will become illegal in January 2001 (Accountancy magazine). 

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           During the last 12 months FASB has faced mounting opposition from sections of the U.S. business community over its proposal to eliminate pooling. Opposition culminated in the autumn when Sen. Spencer Abraham and 12 other senators wrote to express "reservations about FASB's apparent plan to move ahead with its proposal for eliminating the pooling-of-interest method of accounting."

           In October, FASB decided to concentrate on accounting for goodwill amortization instead of reaching a decision on merger accounting. But Leisenring maintains that FASB's decision was not a response to pressure from the senate. He explains that goodwill was central to the issue of merger accounting, and had to be dealt with before the board could resolve business combinations.

           He added that while FASB reviews opinions expressed by the Senate on behalf of the U.S. business community, senators are not in a position to force the standard setter's decision: "The only way the senate can bring pressure to bear on the FASB is to ask the U.S. Securities and Exchange Commission to overrule us. The SEC doesn't want our problems - they don't want to set a precedent for setting accounting standards."

           FASB's current business combinations standard allows a choice of two methods of merger accounting -- the pooling method for mergers of equals, and the purchase, or acquisition method. FASB says true mergers of equals never occur, and that business combinations always involve one company purchasing another (Accountancy magazine).

           The senators said that the elimination of pooling would damage the U.S. economy by making mergers between hi-tech companies prohibitively expensive. High-tech companies have large amounts of goodwill on their balance sheets. Acquisition accounting requires companies to write off goodwill as a charge against earnings over a fixed period.

           Leisenring said the Senator's argument masks the real issue: "Companies want to use pooling to avoid goodwill -- it's not that they can't afford the merger, they just don't want to amortize assets . . . pooling is an invitation to gamesmanship and mischief."

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           FASB expects some resistance to continue, but Leisenring remains defiant: "Abraham lost his seat when the new senate was elected, so the opposing groups no longer have a ring leader." (Accountancy magazine)

Works Cited

AccountancyMagazine.comFASB Makes Decision on Elimination of Pooling.  Dec. 8, 2001 <http://accounting.smartpros.com/x28113.xml>

Cassandra, A.  The pooling of interest rules changes.  Dec. 8, 2001 <http://www.ccrweb.com/masstechhigh.html>

Christopher Cox.  (2000) Cox Proposes Moratorium on Changes to Merger Accounting Rules.  Abolition of “pooling of interests” would await study of accounting treatment for intangibles.  WASHINGTON, D.C. October 3, 2000.  Dec.8, 2001 <http://www.house.gov/cox/press/releases/2000/100300fasbmoratorium.htm>

Isaacs, G. B.  POOLING OF INTERESTS ACCOUNTING ELIMINATED.  Dec. 8, 2001 <http://www.cmcpa.com/newpage1.htm>

Radigan, J.  (2000). FASB’s effort to change the accounting rules for mergers has sparked a brawl with Congress. Pooling: Put Up Your Dukes.  CFO.com Oct 16, 2000.  Dec. 8, 2001 <http://www.cfo.com/printarticle/1,4580,0%7C83%7CAD%7C1060,00.html>


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