"To Pool or Not to Pool" Will No Longer Be the Question

By Bobby Chen
Analyst, mPower

In this story: The FASB's Road to Making Pooling Passé How Is Merger and Acquisition Activity Affected Now? Long-term Effects of the New Accounting Rules Necessity Remains the Mother of Reinvention The Arguments Against Pooling Why Pooling-of-Interests Is Popular What M&A and Your 401(k) Will Look like without Pooling At a Glance — Measuring Prosperity

Over the past decade, mergers and acquisitions have changed the shape of the corporate landscape — not just in the United States but all over the world. But, changes on the horizon may bring a new perspective.

The Financial Accounting Standards Board (FASB) has voted to eliminate pooling-of-interests (a way of paying for an acquisition without using cold cash) as a method of accounting for mergers and acquisitions (M&A). New rules that could be in place by 2001 will end pooling, making M&A a lot less attractive for some companies.

The Financial Accounting Standards Board (FASB) has voted to eliminate pooling-of-interests (a way of paying for an acquisition without using cold cash) as a method of accounting for mergers and acquisitions (M&A). New rules that could be in place by 2001 will end pooling, making M&A a lot less attractive for some companies.

The new rules may also prevent smaller companies from following in the steps of companies like Cisco Systems. A networking company that was virtually unknown 10 years ago, Cisco Systems has acquired 47 companies since 1995 and evolved into one of the most valuable companies in the world. This remarkable transformation has been driven largely by the company's insatiable appetite for acquisitions, and most of the deals used pooling.

The FASB's Road to Making Pooling Passé

The FASB's proposal, if adopted, will have a tremendous impact on business combinations, and, potentially, on the investment environment.

The board is currently holding public hearings, with final details to be hammered out shortly after the hearings are concluded. The question at this point isn't whether the board will adopt the proposed changes, but when the changes will actually take effect (probably 2001 at the earliest).

The FASB is comprised of seven members selected by the Financial Accounting Foundation, an independent organization that is required to operate within the meaning of the Internal Revenue Services code: Section 501(c)(3). The Foundation can appoint FASB board members for one additional five-year term.

The proposed rules not only eliminate pooling-of-interests but also reduce the current amortization period for "goodwill" (the value of companies' intangible assets) from 40 years to 20 years.

This means that companies will have less time to pay for the cost of an acquisition, which means a considerable dent in earnings during the shorter time frame — a prospect companies do not relish, since it risks creating negative investor sentiment.

What is the cause of this risk? Current FASB rules require goodwill to be amortized over periods ranging from 10 to 40 years. Goodwill can be a drag on companies' earnings, and it's not tax deductible.

How Is Merger and Acquisition Activity Affected Now?

With the rule change looming, M&A activity may pick up before the window permanently closes on using pooling. This would certainly fuel the fire of already unprecedented M&A activity due to the recent bull market.

This is especially true for technology companies, which have been leading the charge on all fronts. Most technology companies are not capital-intensive and are valued on their intellectual base; thus, they would incur huge goodwill charges in mergers, which would reduce reported earnings.

The pending rule change will force companies to reassess their long-term plans and may lead to more deals in the coming months, like i2 Technologies' pending $9.3 billion acquisition of Aspect Development. If completed, this would be the largest transaction to date in the software-making industry.

Long-term Effects of the New Accounting Rules

It is difficult to gauge the long-term potential impact of the FASB's decision. After all, there are many factors behind companies' mergers and acquisitions strategies, including, primarily, regulatory changes and market conditions.

M&A activity will also, undoubtedly, pick up in the financial services industry due to a recent legal development, the repeal of the Glass-Steagall Act, which permits banks and brokerages to participate in each other's businesses.

Read More: Financial Services

In other words, there are more factors than just the proposed FASB rule changes that will affect M&A activity. The euphoric markets in the last few years have provided many companies, particularly in technology, more than enough paper currency to buy all kinds of "cool toys." Also, the appreciation in equity value, combined with unprecedented access to capital, has been a boon to M&A activity.

Necessity Remains the Mother of Reinvention

In short, overall company strategy will always dominate a company's decision to merge or acquire, in essence, reinventing itself with another company. Having favorable accounting (through pooling) may simply be the icing on the cake.

As long as favorable legislative environments and market conditions exist, M&A activity will continue to be brisk.

It is important to remember that pooling is not used as often as one would expect, given the perceived advantages. The method has only become prevalent in the last couple of years, and during this time, despite the fact the FASB has repeatedly raised the bar for companies wanting to qualify for using the pooling method.

In order to use the pooling-of-interest accounting method, there are specific and restrictive criteria that must be met, which often leads to an arduous and time-consuming process for both the FASB and the companies themselves.

The Arguments Against Pooling

One can clearly see why pooling-of-interests might present a problem for the FASB. As FASB Chairman Edmund Jenkins testified to the Senate Banking Committee, according to a March 2, 2000 news release:

"The current accounting literature allows two economically similar business combinations to be accounted for using different accounting methods that produce dramatically different financial results, which is confusing to investors trying to evaluate the combined companies."

"…using different accounting methods that produce dramatically different financial results…is confusing to investors trying to evaluate the combined companies." — Edmund Jenkins, chairman, Financial Accounting Standards Board

The FASB maintains that pooling was never intended to be an alternative to the purchase method. Opponents of pooling insist that because it ignores the values exchanged in a business combination, investors are provided less complete and relevant information. This makes it difficult for investors to compare companies with their competitors, or to hold management accountable for the subsequent performance of the investment.

Additionally, pooling produces rate-of-return measures that are artificially inflated, compared with the purchase method, even though there are no differences in the company's actual cash flow.

Further, opponents argue that having two methods imposes an unnecessary burden on those who prepare and use financial statements. There are substantial costs involved with analysis and conversion to comparable statements.

In this story: Pooling — What It Is

Pooling also creates an uneven playing field for companies that compete for merger and acquisition targets. Companies that can use pooling tend to be willing to pay higher prices because equity, not cash, is used as currency.

In addition to all of this, the FASB wants to homogenize accounting standards with the rest of the world, as the economy and the investment landscape become increasingly global. Pooling is largely a U.S. phenomenon.

Why Pooling-of-Interests Is Popular

Pooling-of-interests has been the method of choice for many companies in recent years, particularly technology companies. In a market where numbers are constantly scrutinized, pooling represents an attractive proposition for companies looking to achieve growth through acquisitions.

Pooling supporters argue that the technique does not mean investors get less complete and relevant information, since analysts and investors alike will be able to look at cash earnings in place of the diluted accounting earnings.

Those in the pooling camp also argue that eliminating pooling will be detrimental to the overall growth of the economy, as it may impede M&A activity.

They point out that the current market is fueled by positive investor sentiment, and company executives may not be so willing to pull the M&A trigger if it results in even the appearance of diluting earnings.

Pooling supporters also argue that eliminating pooling would truly create an uneven playing field for U.S. companies because many overseas companies, while not using pooling, enjoy more favorable accounting standards in general.

What M&A and Your 401(k) Will Look like without Pooling

Doing away with the pooling-of-interests accounting method will force M&A-minded company executives to be more selective in what they buy.

There may not be as many deals for one-year-old start-ups valued in the billions going forward. If this forces companies and investors alike to take a closer look at what they buy, it will be a good thing!

Investors might wonder what the effect will be on their portfolios. There could be an effect on small-cap growth funds, since these companies will no longer be able to pull off huge valuations after a "pooling" M&A and the resulting increased earnings numbers.

However, the small-cap market isn't driven by fundamentals (such as earnings numbers) in the first place, so it remains to be seen whether this effect will actually occur.

The information provided here is intended to help you understand the general issue and does not constitute any tax, investment or legal advice. Consult your financial, tax or legal advisor regarding your own unique situation and your company's benefits representative for rules specific to your plan.

"To Pool or Not to Pool" Will No Longer Be the Question

By Bobby Chen
Analyst, mPower

In this story: The FASB's Road to Making Pooling Passé How Is Merger and Acquisition Activity Affected Now? Long-term Effects of the New Accounting Rules Necessity Remains the Mother of Reinvention The Arguments Against Pooling Why Pooling-of-Interests Is Popular What M&A and Your 401(k) Will Look like without Pooling At a Glance — Measuring Prosperity

Over the past decade, mergers and acquisitions have changed the shape of the corporate landscape — not just in the United States but all over the world. But, changes on the horizon may bring a new perspective.

The Financial Accounting Standards Board (FASB) has voted to eliminate pooling-of-interests (a way of paying for an acquisition without using cold cash) as a method of accounting for mergers and acquisitions (M&A). New rules that could be in place by 2001 will end pooling, making M&A a lot less attractive for some companies.

The Financial Accounting Standards Board (FASB) has voted to eliminate pooling-of-interests (a way of paying for an acquisition without using cold cash) as a method of accounting for mergers and acquisitions (M&A). New rules that could be in place by 2001 will end pooling, making M&A a lot less attractive for some companies.

The new rules may also prevent smaller companies from following in the steps of companies like Cisco Systems. A networking company that was virtually unknown 10 years ago, Cisco Systems has acquired 47 companies since 1995 and evolved into one of the most valuable companies in the world. This remarkable transformation has been driven largely by the company's insatiable appetite for acquisitions, and most of the deals used pooling.

The FASB's Road to Making Pooling Passé

The FASB's proposal, if adopted, will have a tremendous impact on business combinations, and, potentially, on the investment environment.

The board is currently holding public hearings, with final details to be hammered out shortly after the hearings are concluded. The question at this point isn't whether the board will adopt the proposed changes, but when the changes will actually take effect (probably 2001 at the earliest).

The FASB is comprised of seven members selected by the Financial Accounting Foundation, an independent organization that is required to operate within the meaning of the Internal Revenue Services code: Section 501(c)(3). The Foundation can appoint FASB board members for one additional five-year term.

The proposed rules not only eliminate pooling-of-interests but also reduce the current amortization period for "goodwill" (the value of companies' intangible assets) from 40 years to 20 years.

This means that companies will have less time to pay for the cost of an acquisition, which means a considerable dent in earnings during the shorter time frame — a prospect companies do not relish, since it risks creating negative investor sentiment.

What is the cause of this risk? Current FASB rules require goodwill to be amortized over periods ranging from 10 to 40 years. Goodwill can be a drag on companies' earnings, and it's not tax deductible.

How Is Merger and Acquisition Activity Affected Now?

With the rule change looming, M&A activity may pick up before the window permanently closes on using pooling. This would certainly fuel the fire of already unprecedented M&A activity due to the recent bull market.

This is especially true for technology companies, which have been leading the charge on all fronts. Most technology companies are not capital-intensive and are valued on their intellectual base; thus, they would incur huge goodwill charges in mergers, which would reduce reported earnings.

The pending rule change will force companies to reassess their long-term plans and may lead to more deals in the coming months, like i2 Technologies' pending $9.3 billion acquisition of Aspect Development. If completed, this would be the largest transaction to date in the software-making industry.

Long-term Effects of the New Accounting Rules

It is difficult to gauge the long-term potential impact of the FASB's decision. After all, there are many factors behind companies' mergers and acquisitions strategies, including, primarily, regulatory changes and market conditions.

M&A activity will also, undoubtedly, pick up in the financial services industry due to a recent legal development, the repeal of the Glass-Steagall Act, which permits banks and brokerages to participate in each other's businesses.

Read More: Financial Services

In other words, there are more factors than just the proposed FASB rule changes that will affect M&A activity. The euphoric markets in the last few years have provided many companies, particularly in technology, more than enough paper currency to buy all kinds of "cool toys." Also, the appreciation in equity value, combined with unprecedented access to capital, has been a boon to M&A activity.

Necessity Remains the Mother of Reinvention

In short, overall company strategy will always dominate a company's decision to merge or acquire, in essence, reinventing itself with another company. Having favorable accounting (through pooling) may simply be the icing on the cake.

As long as favorable legislative environments and market conditions exist, M&A activity will continue to be brisk.

It is important to remember that pooling is not used as often as one would expect, given the perceived advantages. The method has only become prevalent in the last couple of years, and during this time, despite the fact the FASB has repeatedly raised the bar for companies wanting to qualify for using the pooling method.

In order to use the pooling-of-interest accounting method, there are specific and restrictive criteria that must be met, which often leads to an arduous and time-consuming process for both the FASB and the companies themselves.

The Arguments Against Pooling

One can clearly see why pooling-of-interests might present a problem for the FASB. As FASB Chairman Edmund Jenkins testified to the Senate Banking Committee, according to a March 2, 2000 news release:

"The current accounting literature allows two economically similar business combinations to be accounted for using different accounting methods that produce dramatically different financial results, which is confusing to investors trying to evaluate the combined companies."

"…using different accounting methods that produce dramatically different financial results…is confusing to investors trying to evaluate the combined companies." — Edmund Jenkins, chairman, Financial Accounting Standards Board

The FASB maintains that pooling was never intended to be an alternative to the purchase method. Opponents of pooling insist that because it ignores the values exchanged in a business combination, investors are provided less complete and relevant information. This makes it difficult for investors to compare companies with their competitors, or to hold management accountable for the subsequent performance of the investment.

Additionally, pooling produces rate-of-return measures that are artificially inflated, compared with the purchase method, even though there are no differences in the company's actual cash flow.

Further, opponents argue that having two methods imposes an unnecessary burden on those who prepare and use financial statements. There are substantial costs involved with analysis and conversion to comparable statements.

In this story: Pooling — What It Is

Pooling also creates an uneven playing field for companies that compete for merger and acquisition targets. Companies that can use pooling tend to be willing to pay higher prices because equity, not cash, is used as currency.

In addition to all of this, the FASB wants to homogenize accounting standards with the rest of the world, as the economy and the investment landscape become increasingly global. Pooling is largely a U.S. phenomenon.

Why Pooling-of-Interests Is Popular

Pooling-of-interests has been the method of choice for many companies in recent years, particularly technology companies. In a market where numbers are constantly scrutinized, pooling represents an attractive proposition for companies looking to achieve growth through acquisitions.

Pooling supporters argue that the technique does not mean investors get less complete and relevant information, since analysts and investors alike will be able to look at cash earnings in place of the diluted accounting earnings.

Those in the pooling camp also argue that eliminating pooling will be detrimental to the overall growth of the economy, as it may impede M&A activity.

They point out that the current market is fueled by positive investor sentiment, and company executives may not be so willing to pull the M&A trigger if it results in even the appearance of diluting earnings.

Pooling supporters also argue that eliminating pooling would truly create an uneven playing field for U.S. companies because many overseas companies, while not using pooling, enjoy more favorable accounting standards in general.

What M&A and Your 401(k) Will Look like without Pooling

Doing away with the pooling-of-interests accounting method will force M&A-minded company executives to be more selective in what they buy.

There may not be as many deals for one-year-old start-ups valued in the billions going forward. If this forces companies and investors alike to take a closer look at what they buy, it will be a good thing!

Investors might wonder what the effect will be on their portfolios. There could be an effect on small-cap growth funds, since these companies will no longer be able to pull off huge valuations after a "pooling" M&A and the resulting increased earnings numbers.

However, the small-cap market isn't driven by fundamentals (such as earnings numbers) in the first place, so it remains to be seen whether this effect will actually occur.

The information provided here is intended to help you understand the general issue and does not constitute any tax, investment or legal advice. Consult your financial, tax or legal advisor regarding your own unique situation and your company's benefits representative for rules specific to your plan.