76 Tax Notes 810

Tax Notes

AUGUST 11, 1997

LENGTH: 2965 words

DEPARTMENT: Special Report (SPR)

CITE: 76 Tax Notes 810

HEADLINE: 76 Tax Notes 810 - TIME TO GET OUT OF THE POOL: POOLING METHOD FOR ACQUISITIONS. (446)

AUTHOR: Johnson, Calvin H.

Tax Analysts

CODE: 446

GEOGRAPHIC: United States

INDEX: accounting methods; FASB; SEC

REFERENCES:

Subject Area:

Accounting

Business Tax Issues

TEXT: 04 AUG 97

The Financial Accounting Standards Board has added a project to its agenda to review the standards for accounting for business combinations in financial statements given to investors and shareholders. /1/ Current accounting standards allow an acquiring corporation to report an acquisition with voting stock under what is called the 'pooling method of accounting.' /2/

This article supports the repeal of the pooling method for all business combinations between unrelated parties. Bargaining between unrelated parties provides information about the current value of assets that is relevant to the investor's current decisions and is sufficiently reliable to be reported to investors. The pooling method is per se misleading when the differences from the purchase method are material.

What's pooling? The pooling method of accounting allows the acquiring corporation to report its costs for assets acquired in a merger or other takeover by stepping into the shoes of the target corporation and using the target corporation's original accounting costs for assets, less depreciation. 'Pooling' is the nontax analogue of the tax-free merger, although the rules for eligibility for pooling are now stricter than for tax-free mergers. /3/ The purchase method, which is the alternative to pooling, requires that the acquirer calculate depreciation and cost of goods sold from the price the acquirer paid to the target or its shareholders for the assets. Pooling is almost always softer on earnings than the purchase method because the target's original accounting costs, less accumulated depreciation, are almost always significantly lower than the current fair market value of business assets. The lower costs derived from pooling allow the acquiring firm to report much higher subsequent earnings than if it had to report its costs sold starting from the price it paid for the assets. Pooling is so valuable in its impact on reported earnings that many mergers and acquisitions never take place if they cannot be made to fit into the eligibility rules for pooling. /4/ Still, pooling is always misleading, except to those investors who are sophisticated enough not to be misled by terrible accounting, and hence highly inappropriate in an accounting standard.

FASB IS SERVANT TO THE MARKET

Accounting standards are set by FASB to satisfy Securities-and- Exchange-Commission-mandated reporting by a company to its shareholders. The purpose of FASB-mandated standards is to help investors allocate capital among competing investments according to real economic value and relying on accurate information. Better accounting information serves the efficient market by improving the accuracy and reducing transaction costs of investment of capital. The pooling method tends to be 'pro-management' over the short run by allowing management to understate its costs. FASB's duty, however, runs not to management but to the market as a whole. Management of any specific business gets nothing from mandatory standards, except, of course that the standards make the markets for equity as efficient and accurate as possible and so reduce the cost of equity capital for all businesses.

STOCK IS A COST

Business combinations reported under the pooling method of accounting must be acquisitions with voting stock of the acquirer. Stock is a cost to the issuing corporation, however, equal to its fair market value. Stock to the issuing corporation is nothing but a proxy for the discounted present value of the distributions the issuing corporation will make on the stock in the future. The fair market value of stock is nothing but the stock market's estimate of the discounted present value of the distributions on the stock. Distributions cannot be mandated by law, but the pro rata rule -- historic and newly issued shares must receive the same distributions -- enforces distributions on all stock quite well.

Issuing stock is always a cost, for which management has fiduciary responsibility to historic shareholders, because stock diverts cash distributions to the new shareholders and away from the historic shareholders. The party to whom the stock was issued should be required to give back consideration (to the issuing corporation) that equals the value of the stock. That can happen in bargaining only if the management of the corporation issuing the stock knows that the stock is a cost equal to its value.

POOLING METHOD IS ALWAYS MISLEADING

The pooling method of accounting overstates the acquirer's profit whenever the acquired target has been successful. Assume, for instance, a company, Founder Inc. started in Founder's garage with $100,000 of capital. Founder's company then grows to the point that it generates $1,000,000 of income per year. Under the historical-cost convention, Founder has a return on capital of 10 times the initial investment or 1,000 percent annually, a healthy investment return. Assume that an unrelated Acquirer comes along and determines that a 10 percent discount rate is appropriate for the risks, and so pays Founder $10,000,000 for the business, all in the form of Acquirer voting stock.

The pooling method allows the acquirer to continue to state the assets of Founder Inc. as $100,000. The acquired business thus reports 1,000 percent annual return on investment, and the acquiring firm includes that return in its consolidated reports to its shareholders.

The reported 1,000 percent profit is a fictitious product of understatement of the firm's assets. Founder's initial $100,000 does not matter to the acquirer. While Founder in a real sense can be said to be making a 1,000 percent investment on its externally supplied capital, no acquirer should be able to use the Founder's original historical cost. The $1,000,000 of net income the business generates is just the normal 10 percent return on the acquiring firm's $10,000,000 investment.

Depreciable assets. Depreciation expense needs to measure the wasting of resources according to the resources' real current value. Reporting waste of assets, understated at original cost, will be per se misleading if material.

Assume now, that Founder Inc. depreciates its assets straight- line over four years. Assume, for instance, that after acquisition, the Acquirer alienates Founder, does not replace the depreciating assets, and wastes Founder Inc. assets so that the acquired firm becomes worthless pro rata over four years, declining in value from $10,000,000 to $7,500,000 to $5,000,000 to $2,500,000 to 0.

If we assume $1,000,000 of income (before depreciation), as before, and the pooling method, Acquirer will report depreciation of only $25,000 each year, yielding $975,000 of net income per year. In fact, Acquirer has paid $10,000,000 for Founder Inc. and wasted $2,500,000 per year so that it has no profit from this transaction. Founder Inc. in Acquirer's hands is not a profit-making enterprise. It loses $1,500,000 a year.

Management is the fiduciary that has the responsibility for the care of the assets stated at their current costs. To state the assets as if they were worth only their initial historic costs, understates the malfeasance of a management that wastes assets.

Reliable bargains give relevant information. Investors need current information, based on current fair market value, to make investments currently. 'The reported cost of holding an asset -- its depreciation and cost of goods sold will best approximate the real cost of holding that asset when its net book value approximates its current market value.' /5/ Initial cost of assets (less depreciation) does not give investors relevant information about what price to pay for investments currently. Because historic-cost information is not relevant, the historic-cost convention needs to be limited to cases in which measurement of current value is impossible or highly inadministrable. If any reliable data about current value become available, financial reporting needs to use it.

Arm's-length bargaining between the two parties of a business acquisition will provide information that is sufficiently reliable to be used.

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o A business combination is a significant economic event which

results from bargaining between independent parties. Each

party bargains on the basis of his assessment of the current

status and future prospects of each constituent as a separate

enterprise and as a contributor to the proposed combined

enterprise. The agreed terms of combination recognize

primarily the bargained value. /6/

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Bargaining is never perfect. Two bargains on different days, or just in different rooms, can come up with different results for the same business. Either side may misassess the value of the stock or business being exchanged or be underinformed in important ways. But given the irrelevancy of historic cost to the investors' decisions, bargaining can tolerate much imperfection and still provide considerably better data than historic cost.

Bargain equation. No party bargaining at arm's length will give up more than it gets and two adverse parties will bargain over value until they each get at least as good as they give. Parties will thus bargain to equality of values. Bargaining to equality means that financial accounting can look either to the value of the voting stock or to the value of the business, whichever is more accurate. Thus, if publicly traded voting stock is given to acquire a business with many intangibles of uncertain value, the value of the firm can be ascertained by looking to quoted stock prices. If the class of stock given is similar to the publicly traded issue, the most reliable method for valuing the firm is to rely on the publicly traded stock's quoted price. Thus, public corporations, whose stock is traded on an established market, should never use pooling for acquisitions.

No-acquirer situations. The SEC has opined that both sides may continue using the original asset accounts to compute depreciation and cost of goods sold for those business combinations in which it was impossible to identify the acquirer. /7/ There is no need to be able to 'identify the acquirer' to mark the asset to bargained value. If two equal parties bargain at arm's length, their bargaining will provide sufficient information about current value to rely on it for reporting to both sets of shareholders, so long as some reasonable approximation is possible of the value of the consideration given by one or the other party.

Intangibles. As manufacturing becomes an ever less common source of firm value, more and more multibillion-dollar companies will consist of nothing but 'soft costs' or intangibles. It is usually a target's soft assets, the accumulated wisdom of the organization, that provides the core motivation for the acquisition. Economic value does not have to be made of steel to be real; silicon, electrons, and human minds and organization give real value too.

The bargain exchange provides enough reliable information to allow soft costs to be stated on the balance sheet. Management has responsibility to preserve valuable intangible assets as well as tangible assets. Companies need to be required to state intangible assets on the balance sheet so that management will be responsible for them.

Securities Accounting Bulletin (SAB) No. 48. In SAB No. 48, the staff of the SEC required that newly formed business continue to use the promoter's historic cost for assets contributed by the promoters. /8/ SAB No. 48 applies especially to intangible assets, such as customer base, that are hard to value apart from the success of the business being promoted. SAB No. 48 is wise if the value of soft assets with no clearly ascertainable market value is set unilaterally by the promoters or established only by appraisal. The historic role of the SEC is to try to prevent snake oil salesmen from selling their stock by overstating the value of the snake oil. SAB No. 48 is not wise, however, for those situations in which there is bargaining between adverse parties over value.

No big bang. A number of acquisitions in recent years have avoided reporting amortizable goodwill in a takeover, by treating the costs of acquired intangibles as immediate R&D deductions. /9/ Writing off all acquisition costs allocated to R&D at the time of the acquisition will create a 'big bang' or an immediate write- off, which providers hope will not affect the corporation's earnings-per- share multiples. The immediate write-off of acquired R&D projects is erroneous. R&D has proven value once an acquirer is willing to pay for it. Immediate write-off of assets as if they were worthless tends to encourage mismanagement of those valuable assets. FASB Interpretation No. 4 needs to be repealed.

Nonacquired intangibles. Financial accounting provides far too little information about R&D, goodwill, investments in employees and customer base by assuming that such investments, no matter how wise, have zero value when made. In the next century, more and more of America's wealth will be found in such intangibles. Understatement of intangible resources as assets encourages management to waste and underproduce such resources. FASB needs to increase the reporting of intangible resources as assets. While that attitude should provide instruction for the business combination project, settling the treatment of all soft costs in this project would just distract from the proper focus on business combinations.

GLOBALIZATION

The United States is unique in allowing a corporate takeover to be reported with the acquirer stepping into the target's asset accounts and ignoring the price that the acquirer has paid for those assets. In the coming years, a major goal of accounting standards will be to try to reach agreement with our major trading partners so that financial accounting under any country's standards can be understood worldwide. Reaching conformity of international standards is an extraordinarily important goal requiring delicate negotiations among nations. Accounting standards should be a level playing field; no standard setters can afford to be perceived as cheating in the global competition for capital by allowing its home corporations to use misleading standards.

U.S. accounting standards are the best in the world on numerous issues and on many, foreign standard setters will need to accede to U.S. standards. On pooling, however, the U.S. needs to accede to international norms by repealing the method, because on pooling, international norms are right on the method's merits.

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FOOTNOTES:

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/1/ See L. Todd Johnson & Bryan D. Yokley, 'Issues Associated with the FASB Project on Business Combinations,' Special Report, Financial Accounting Series 174-A (Financial Accounting Standards Board, June 1997).

/2/ Accounting Principles Board, Opinion No. 16, Business Combinations (1970).

/3/ To be eligible for pooling method, only voting common stock of the acquirer may be used. No substantial cash or other boot may be paid. The target may not be customized with a preparatory redemption or spin-off. Pooling may not be used if the target was a subsidiary of some other corporate affiliated group within the last two years. Section 368(a)(1)(A), by contrast, allows tax-free 'mergers' without voting stock, with substantial boot, with substantial customizing of the target and even if the target is a subsidiary in some other corporate group.

/4 See, e.g., Arthur Wyatt, 'Efficient Market Theory: Its Impact on Accounting,' 155 J. of Account'cy 56 (Feb. 1983).

/5/ James F. Fotenas, 'Accounting for Business Combinations: A Critique of APB Opinion Number 16,' 23 Stan. L. Rev. 330, 340 (1971).

/6/ APB No. 16, supra note 2, section 19.

/7/ SEC Staff Accounting Bulletin No. 97, Business Combinations prior to an Initial Public Offering (July 1996).

/8/ Staff Accounting Bulletin No. 48, Transfer of Assets by Promoters and Shareholders (1982).

/9/ Abraham Briloff, 'Big Blue Haze,' Barron's 17 (Dec. 23, 1996) (criticizing IBM's immediate write-off of more than half of the $3.2 billion acquisition cost of Lotus); Elizabeth MacDonald, 'More Firms Write Off Acquisition Costs,' The Wall St. J. at A2 (Dec. 2, 1996.) (providing a tabular list of recent write-offs). The big bang write-offs apparently arise from FASB Interpretation No. 4, Applicability of FASB Statement No. 2 to Business Combinations Accounted for by the Purchase Method, which ruled that acquisition costs allocated to R&D of the target were immediate expenses rather than assets or goodwill (amortizable over 40 years or less). Some of the big bang acquisitions may result from allocating too much of the total purchase price to R&D and too little to 'goodwill' and thus represent a misuse of Interpretation No. 4. Interpretation No. 4, however, tries to maintain a silly distinction under which R&D projects with strong commercial potential are always considered worthless expenses or losses immediately, whereas even less tangible potential to make future projects is categorized as goodwill, because the purchaser has paid for it, and assigned as much as a 40-year life. The true distinction is between self-produced R&D, which like self-made goodwill and other intangibles is difficult to value, and purchased R&D, which like purchased goodwill is a fine asset with a reliably set value equal to the bargain purchase price.

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Calvin H. Johnson is the Andrews & Kurth Centennial Professor of Law, University of Texas. ____________________________________________________________________

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