One of the issues confronting the parties in any transaction between two companies is the accounting treatment of a merger. As pointed out during the AT&T/NCR takeover contest, AT&T could significantly enhance its earnings during the first ten or more years of a friendly merger with NCR—if the transaction could be treated for accounting purposes as a pooling of interests. This "savings" could be accomplished by eliminating goodwill from the transaction.
Accounting theoreticians have long agreed on two methods of accounting for business combinations: "pooling of interest" and "purchase." Prior to October 31, 1970, it was also possible to treat certain business combinations as "part pooling" and "part purchase." As of that date the AICPA eliminated the heterogeneous treatment, and simultaneously made poolings considerably more difficult to attain.
The essential theory behind a pooling of interests is simple. A pooling is possible when two companies are combined in their entirety, to continue previously separate operations. So far, so good! A pooling, however, must not appear in any of its aspects to represent buying or selling interests, but an intent to share risks and rights. While the theory thus obviates "buyer" or "seller," in actuality this is almost never the case. It will be interesting to see how this will apply following five months of continuing takeover attempts. We can only presume that accounting and regulatory approval of the transaction as a pooling will discount the takeover contest as nothing more significant than prelude to a successfully completed business combination. We must also wonder if this represents a proper interpretation of current accounting principles.
There have been many subsequent explanations of the 1970 ruling, based upon individual aspects of specific types of transactions. These "interpretations" have made the pooling of interest concept one which sends all but the most theory-oriented accountants to their book shelves before rendering an opinion on use of the technique.
Poolings of interest are not new in accounting theory. The pooling was a beloved technique of conglomerators during their heyday in the 1960s. The approach was popular because of its effect on the combined earnings of newly merged entities, more particularly the earnings of "buyer." Under pooling treatment, the income of merging entities is combined, as though the companies had always existed as a single entity. A popular tactic of the 60s was to effect one or more poolings during an unprofitable, or less profitable year. Even if accomplished at the eleventh hour of the fiscal year, earnings of a profitable merger partner were combined. and treated as though earned throughout the year by the "buyer" company. Earnings for prior years were also combined, assuming that the two entities had always been one. This aspect was of particular benefit to conglomerators in the issuance of additional "paper," with which to continue their growth by acquisition. Abuses of this particular aspect of the pooling theory was a key reason behind the 1970 changes.
Another of the more attractive benefits achieved by pooling treatment is the elimination of "goodwill." Simply calculated, goodwill is the difference between the eventual purchase price and the net value of assets acquired. The resulting goodwill value is set up as a "asset" on the balance sheet of an acquiror, but is rarely considered as such by bankers, investment analysts, and others reviewing the company's financial statements.
A very important aspect in the establishment of goodwill is that current accounting principles require it to be amortized over periods typically ranging from 10 to 40 years, as a charge against each year's current income. Aggressive acquirors in industries where goodwill arises regularly in business combinations may also be faced with the problem of building an unattractively high amount of goodwill. Of equal import, for many years, the IRS did not permit amortization of goodwill as a deduction for income tax purposes.
Purchasers faced with large amounts of goodwill in an impending transaction can customarily take one of two approaches to its treatment. Companies primarily interested in earnings per share will generally book the maximum amount of available goodwill, and amortize it over the longest possible period, thereby minimizing the negative impact on annual earnings. Accounting firms will rarely concern themselves with 40 year amortization, although problems can arise in this area. In certain rare cases, where the goodwill amount represents a benefit which can theoretically be exhausted in fewer than 40 years, accounting firms may insist on more rapid amortization. This can also occur if goodwill is accelerating to an unbalanced position on an acquiror's balance sheet.
Those acquiring companies more concerned with cash flow than reported periodic profits, will usually take a different approach to that portion of purchase price which could be established and amortized as goodwill. A business combination is one of very few instances in which companies may be permitted to revalue their assets, and book such increased values.
In such cases, some or all of the excess of purchase price over net assets received may be attributed to specific assets and the value of such assets increased on the books of the newly combined entity. These revalued assets can then be amortized more rapidly for either or both book and tax purposes—reducing income to some degree—but also reducing taxes and increasing cash flow.
Unmistakable assets subject to revaluation may include such things as fully depreciated production and transportation equipment; undervalued land, buildings, and other real estate; and occasionally inventories. Such revaluations are generally accomplished more easily through use of an independent third party appraiser. If revalued assets represent material amounts, when related to total balance sheet assets, outside appraisals are an absolute necessity.
Intangible assets can also be revalued, and may represent considerable benefit to acquirors. In many cases, an acquisition will permit intangible assets to have values established and booked for the first time. Such items as internally developed computer software; widely diverse types of databases; and other intangibles, can all be valued, booked, and subsequently amortized to reduce future taxes on income. The tax benefits realized by such treatment of potential goodwill items can substantially shorten the payback period on completed transactions. This valuation of intangible assets often looked upon by bankers and analysts as "non-assets," is generally viewed in a more positive manner when used to offset goodwill.
Great care must be taken when deciding which intangibles to value for balance sheet purposes. Accounting primers traditionally define goodwill as a broad group of factors which combine to make one company more attractive than another. This rather amorphous definition is one of the reasons behind the lengthy period in which goodwill may be amortized—40 years apparently being considered somewhat "indefinite."
A good combination of advertising, research, management talent, and product timing can give one company a dominant market position, for which another company may be willing to pay a very high price. Many intangibles acquired with such a company may be valued and set up on the newly combined balance sheet but also may arguably be classified as precisely those items which fall within the classic definition of goodwill. Databases, customer lists, subscriber lists, and similar items are typical of intangibles which fall into this gray area. It is possible, however, to define a value for all of them and thus gain the benefits of faster amortization—and concomitant tax benefits.
To accomplish the goal of converting questionable intangibles from goodwill to more valuable assets, buyers must carefully establish a rationale which clearly demonstrates the "perishable" nature of items under discussion. Each item to be valued must be supported fully by cogent arguments which relate specifically to the asset under discussion.
Customer lists are a clear indication of market dominance. As such, they are clearly part of goodwill—or are they? It is certainly possible to establish value for customer lists. This can be based on a calculation of periodic revenue per customer, frequency of purchase per customer, length of customer tenure, and similar quantifiable measurements. Buyer must construct a logical argument which demonstrates that customer lists have measurable value at the time of their acquisition—the eventual asset value. This must be followed by substantiation of the fact that such value will be exhausted during a finite period of time—the period of amortization. Buyer must finally arrive at a measurement technique to quantify how the asset will be exhausted—the method of calculating periodic amortization. Through use of such methods with similar intangible assets, buyers should be able to convert large portions of goodwill into beneficial assets.