There is one final decision that, in our view, seems to play a disproportionate role in the way in which acquisitions are structured and in setting their terms, and that is the accounting treatment. In this section, we describe the accounting choices and examine why firms choose one over the other.

Purchase versus Pooling

There are two basic choices in accounting for a merger or acquisition. In purchase accounting, the entire value of the acquisition is reflected on the acquiring firm’s balance sheet, and the difference between the acquisition price and the restated[8] value of the assets of the target firm is shown as goodwill for the acquiring firm. The goodwill is then written off (amortized) over a period of 40 years, reducing reported earnings in each year. The amortization is not tax deductible and thus does not affect cash flows. If an acquisition qualifies for pooling, the book values of the target and acquiring firms are aggregated. The premium paid over market value is not shown on the acquiring firm’s balance sheet. For an acquisition to qualify for pooling, the merging firms have to meet the following conditions:

· Each of the combining firms has to be independent; pooling is not allowed when one of the firms is a subsidiary or division of another firm in the two years prior to the merger.

· Only voting common stock can be issued to cover the transaction; the issue of preferred stock or multiple classes of common stock is not allowed.

· Stock buybacks or any other distributions that change the capital structure prior to the merger are prohibited.

· No transactions that benefit only a group of stockholders are allowed.

· The combined firm cannot sell a significant portion of the existing businesses of the combined companies, other than duplicate facilities or excess capacity.

The question whether an acquisition will qualify for pooling seems to weigh heavily on the managers of acquiring firms. Some firms will not make acquisitions if they do not qualify for pooling, or they will pay premiums to ensure that they do qualify. Furthermore, as the conditions for pooling make clear, firms are constrained in what they can do after the merger. Firms seem to be willing to accept these constraints, such as restricting stock buybacks and major asset divestitures, just to qualify for pooling. The bias toward pooling may seem surprising, since this choice does not affect cash flows and value, but it is really not surprising, when we consider the source of the bias. Firms are concerned about the effects of the goodwill amortization on their earnings, and about stockholder reactions to the lower earnings.

Are firms that use purchase accounting punished by markets when they report lower earnings in subsequent periods? Hong, Kaplan and Mandelkar (1978) examined the monthly excess returns of 122 firms that acquired other firms between 1954 and 1964 using the pooling technique for 60 months after the acquisition. They compared these findings to 37 acquisitions that used the purchase approach to see if markets were fooled by the pooling technique. They found no evidence that the pooling raised stock prices or that the purchase technique lowered prices. The results are shown in Figure 26.6.

Figure 26.6: Pooling versus Purchase Accounting: Effect on Excess Returns

Panel A: Excess Returns for 122 firms that used Pooling

Panel B: Excess Returns for 37 firms that used Purchase Accounting

Note that there are no positive excess returns associated with pooling in the 60 months following the merger, nor are there negative excess returns associated with purchase in the same time period. . Lindenberg and Ross (1999) studied 387 pooling and 1055 purchase transactions between 1990 and 1999. They find that the stock price reaction to the acquisition announcement is more positive for purchase transactions than for pooling transactions, and that the market value of firms that use purchase accounting is not adversely affected by the reduction in earnings associated with amortization.

They conclude that the earnings multiples of firms that use purchase accounting adjust to offset the decrease in earnings caused by amortization. To illustrate, a 10% decrease in earnings because of goodwill amortization is accompanied by a 12.1% increase in the price earnings ratio; the net effect is that stock price does not drop. Thus, markets seem to discount the negative earnings effect of amortizing goodwill. There is another consideration, as well. When pooling is used, the shareholders of the acquired firm can transfer their cost basis[9] to the shares they receive in the acquiring firm and not pay taxes until they sell these shares. When purchase accounting is used, the stockholders of the acquired firm have to recognize the capital gain at the time of the transaction, even if they receive stock in the acquiring firm. Given the substantial premiums paid on acquisitions, this may be a significant factor in why firms choose to use pooling.

In-process R&D

In the last few years, another accounting choice has entered the mix, especially for acquisitions in the technology sector. Here, firms that qualify can follow up an acquisition by writing off all or a significant proportion of the premium paid on the acquisition as inprocess R&D. The net effect is that the firm takes a one-time charge at the time of the acquisition that does not affect operating earnings[10], and it eliminates or drastically reduces the goodwill that needs to be amortized in subsequent periods. The one-time expense is not tax deductible and has no cash flow consequences. In acquisitions such as IBM of Lotus and MCI by Worldcom, the in-process R&D charge allowed the acquiring firms to write off a significant portion of the acquisition price at the time of the deal.

The potential to reduce the dreaded goodwill amortization with a one-time charge is appealing for many firms, and studies find that firms try to take maximum advantage of this option. Lev (1998) documented this tendency and also noted that firms that qualify for this provision tend to pay significantly larger premiums on acquisitions than firms that do not. In early 1999, as both the accounting standards board and the SEC sought to crack down on the misuse of in-process R&D, the top executives at high technology firms fought back, claiming that many acquisitions that were viable now would not be in the absence of this provision. It is revealing of managers’ obsession with reported earnings that a provision that has no effects on cash flows, discount rates, and value is making such a difference in whether acquisitions get done.

Final Considerations

The managers of acquiring firms clearly weigh in the accounting effects of acquisitions, even when accounting choices have little or no effect on cash flows. This behavior is rooted in a fear of how much financial markets will punish firms that report lower earnings, largely as a consequence of the write off of goodwill. Given the transparency of this write off (firms report earnings before and after goodwill amortization), we believe that this fear is misplaced, and the empirical evidence backs us up. When accounting choices weigh disproportionately in the outcome, the results can be expensive for stockholders in the acquiring firm. In particular,

· Firms will reject some good acquisitions, simply because they fail to meet the pooling test or because in-process R&D cannot be written off.

· Firms will overpay on acquisitions, just to qualify for favorable accounting treatment.

· To meet the requirements for pooling, firms will often acquire entire firms rather than the divisions that they are interested in and defer asset divestitures that make economic sense.

If the signals emerging from both the SEC and FASB have any basis, the rules for both pooling and writing off in-process R&D will be substantially tightened. In fact, it looks likely that firms will not be able to use pooling past 2001 and that they will have to write off goodwill over a much shorter period than the current 40 years[11]. These changes, though bitterly opposed by many top managers, should be welcomed by stockholders.

Following up on the Acquisition

We have described how firms value, pay for and structure an acquisition. The real work in an acquisition occurs after the transaction. In this section, we examine both the evidence on the success or failure of mergers at enhancing value and the reasons why many mergers do not work.

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8 The acquiring firm is allowed to restate the assets that are on the books at fair value. This changes the tax basis for the assets, and can affect depreciation in subsequent periods.

9 For tax purposes, the cost basis reflects what you originally paid for the shares. When pooling is used, the stockholders in the target firm can transfer the cost basis of the shares they have in the target firm to those that they receive in exchange. This allows them to defer the capital gains tax until they sell the stock.

10 The write-off of in-process R&D is viewed as a non-recurring charge and is shown separately from operating income.

11 Given the formidable lobbying skills of incumbent managers, we would not be surprised to see this change modified or delayed past 2001.

Prof. Aswath Damodaran

Next: The Post-Deal Performance of Merged Companies

Summary: Index