The two principal accounting methods used in mergers and acquisitions are the pooling of interests method and the purchase method. The main difference between them is the value that the combined firm’s balance sheet places on the assets of the acquired firm, as well as the depreciation allowances and charges against income following the merger.
The pooling of interests method assumes that the transaction is simply an exchange of equity securities. Therefore, the capital stock account of the target firm is eliminated, and the acquirer issues new stock to replace it. The two firms’ assets and liabilities are combined at their historical book values as of the acquisition date. The end result of a pooling of interests transaction is that the total assets of the combined firm are equal to the sum of the assets of the individual firms. No goodwill is generated, and there are no charges against earnings. A tax-free acquisition would normally be reported as a pooling of interests.
Under the purchase method, assets and liabilities are shown on the merged firm’s books at their market (not book) values as of the acquisition date. This method is based on the idea that the resulting values should reflect the market values established during the bargaining process. The total liabilities of the combined firm equal the sum of the two firms’ individual liabilities. The equity of the acquiring firm is increased by the amount of the purchase price.
Accounting for the excess of cost over the aggregate of the fair market values of the identifiable net assets acquired applies only in purchase accounting. The excess is called goodwill, an asset which is charged against income and amortized over a period that cannot exceed 40 years. Although the amortization “expense” is deducted from reported income, it cannot be deducted for tax purposes.
Purchase accounting usually results in increased depreciation charges because the book value of most assets is usually less than fair value because of inflation. For tax purposes, however, depreciation does not increase because the tax basis of the assets remains the same. Since depreciation under pooling accounting is based on the old book values of the assets, accounting income is usually higher under the pooling method. The accounting treatment has no cash flow consequences. Thus, value should be unaffected by accounting procedure. However, some firms may dislike the purchase method because of the goodwill created. The reason for this is that goodwill is amortized over a period of years.