Thursday, August 14, 2008

Business Combination Accounting, difference between Purchase and Pooling method

All business combinations are now, for accounting purposes under IFRS, considered to be acquisitions, whereby one entity (the parent) takes management control of another entity, or of its assets and liabilities. This is independent of the legal form of the business combination.

Thus, two entities may consolidate to create a new, third enterprise. Alternatively, one entity may purchase, for cash or for stock, the stock of another enterprise, which may or may not be followed by a formal merging of the acquired entity into the acquirer.

In yet other cases, one entity may simply purchase the assets of another, with or without assuming the debts of that enterprise. One enterprise may enter into an agreement for another to manage its assets and liabilities.

Pooling of Interests (Uniting of Interests)

Under this method of accounting for business combinations, the premerger book values of each combining entity’s assets and liabilities would simply be added together, with no re-measurement to fair value.

US GAAP eliminated pooling accounting outright (effective mid-2001) and the IASB followed suit, under IFRS 3, from early 2004.

(Business Combinations and Consolidated Financial Statements – WILEY IFRS 2008 Interpretation and Application)

Advanced Accounting Tex-book (Paul M. Fischer, William J. Taylor and Rita H. Cheng) described several major differences between pooling and purchases method of business combination accounting.

Asset valuation : under purchase accounting, assets are recorded at fair value, and goodwill may be recorded. Under pooling, assets were recorded at existing book value (which is generally lower than fair value), and no goodwill was created.

The advantage of pooling : (1) reported income is higher because depreciation expense is lower and there was no new goodwill amortization. (Goodwill was amortized over 40 years or less prior to FASB Statement No. 142); (2) return on assets is greater as a higher income is divided by a lower asset base.

Current-year income : under purchase accounting, the acquired firm’s income is added to the acquiring firm’s income statement starting on the purchase date. Under pooling, the acquired firm’s income was added as of the first day of the reporting period (no matter when the acquisition occurs).

The advantage of pooling : assuming that the acquired firm is profitable, the acquiring firm was able to include the acquired firm’s income, along with its own, for the entire year even if the pooling occurred on the last day of the reporting period.

Retained earnings : in a purchase, the acquired firm’s retained earnings cannot be added to that of the purchasing company. Under pooling, the retained earnings of the acquired firm were added to that of the acquiring firm (with some rare exceptions).

The advantage of pooling : (1) there was an instant increase in retained earnings, which made prior periods look more profitable; (2) prior-year income statements were retroactively combined, thus, the acquiring firm “pulled in” the income of the acquired firm in its prior-year statements.

Direct acquisition costs : in a purchase, these costs are added to the cost of the company purchased. They are typically included in goodwill, which used to increase goodwill amortization in later periods. Now these costs could increase impairment losses in future periods. In a pooling, these costs were expensed in the period of the purchase.

The advantage of pooling : income could have been higher on later periods, since there was no amortization of these costs. However, pooling income was decreased in the period of the acquisition, since these costs were expensed in the period of acquisition.

Total equity : in a purchase, the fair value of the shares issued to pay for the purchase must be added to the equity of the acquiring firm. In a pooling, the book value of the acquired firm’s equity was assigned to the shares issued by the acquiring firm.

The advantage of pooling : total equity was usually lower. Return on equity was greater, since a higher income was divided by a lower equity amount.

The financial statement advantages incurred by the pooling method and the increased “gaming” to use the pooling method led to its elimination in July 2001 with the issuance of FASB Statement No. 141 (Hrd) ***

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