Pooling or
Purchase: A
Merger Mystery
John R. Walter
O n September 14, 1998, WorldCom merged with MCI to form MCI
WorldCom, a global telecommunications giant. On September 30,
NationsBank of Charlotte, North Carolina, and BankAmerica of San
Francisco merged to form BankAmerica, one of the largest banks in the United
States. While each case involved the combination of two firms, each used a dif-
ferent accounting method. MCI WorldCom’s merger announcement noted that
the combination would be accounted for as a “purchase”; on the other hand,
BankAmerica’s merger used a method called “pooling of interests” accounting.
In May 1991, American Telephone and Telegraph (AT&T) acquired com-
puter manufacturer NCR Corporation (formerly National Cash Register) for
$110 per share, in what was to that date the largest-ever computer industry
merger. Press reports indicated that during negotiations AT&T upped its offer
by $5 per share, an increase of about $325 million, to secure NCR’s
cooperation in accounting for the acquisition as a pooling of interests.1
Here is the mystery. AT&T paid the additional $325 million to use pool-
ing accounting rather than the alternative—purchase accounting—a choice that
affected accounting numbers but neither added assets, reduced liabilities, nor
changed tax treatment. Why then was AT&T willing to expend an additional
$325 million? Both anecdotal and empirical evidence indicate that AT&T’s
preference for pooling is not unusual. Corporate managers frequently go to
some expense to employ pooling, though there are no obvious benefits.
The article benefited greatly from discussions with and comments from J. David Carroll,
Thomas Humphrey, Jeffrey Lacker, Wenli Li, Raymond Owens, Warren Trepeta, and John
Weinberg. The opinions expressed herein are the author’s and do not represent those of the
Federal Reserve Bank of Richmond or the Federal Reserve System.
1
For a detailed discussion of AT&T’s acquisition of NCR, see Lys and Vincent (1995). For
press reports, see Smith (1991) and Cowan (1991).
Federal Reserve Bank of Richmond Economic Quarterly Volume 85/1 Winter 1999 27
, 2 Federal Reserve Bank of Richmond Economic
These cases raise questions for those not acquainted with the features of
merger and acquisition procedure. What are the differences between purchase
and pooling of interests accounting? Should the choice of accounting method
be of concern to analysts, investors, or others interested in business activity?
Why are two different forms of accounting—purchase and pooling—used for
other- wise similar acquisitions? What drives the choice between the two
methods, and why are acquirers willing to take expensive steps that have only
cosmetic consequences? This article addresses these questions.
Despite firms’ express preference for pooling, the body responsible for
setting U.S. accounting standards, the Financial Accounting Standards Board
(FASB), recently proposed eliminating pooling, even though the accounting
treatment has been used for years. While the change would bring U.S. merger
and acquisition accounting standards more in line with standards used in other
countries, acquisitive corporations are likely to oppose it. The change might
offer some benefits, but the benefits could be offset by efficiency losses.
1. POOLING AND PURCHASE: THE NUTS AND BOLTS
Accountants attempt to report in balance sheets an accurate valuation of a
firm’s assets, liabilities, and equity. But how should accountants value a firm
arising from the combination of two separate businesses? One approach is to
simply sum the dollar amounts of assets, liabilities, and equity of the two
firms as they stood before the combination. This is pooling of interests
accounting. Or, since business combinations are typically one firm’s purchase
of another firm, another valid method would value the purchased firm at its
purchase price, and add the purchase price to the assets of the acquiring firm, as
one would if the acquisition were of a piece of equipment. In broad terms, the
latter approach is purchase accounting. The financial statements of a combined
firm will vary with the choice between pooling or purchase accounting. While
accounting methods for business combinations have changed over time, under
today’s accounting rules both pooling and purchase are acceptable means of
valuing combinations in the United States.
The terms merger, acquisition, consolidation, reorganization, and combina-
tion are often used interchangeably (none is particularly associated with either
pooling or purchase accounting). While no single term predominates, through-
out this article the term business combination will be employed to indicate the
uniting of two firms, regardless of the features of the unification.
Pooling of Interests Accounting
As already implied, pooling of interests accounting is conceptually quite
simple. When a business combination is completed, the balance sheet of the
combined firm reflects assets, liabilities, and owners’ equity at the sum of
these accounts
, J. R. Walter: Pooling or 2
as recorded by the separate companies immediately before the combination
was completed. Income statements will show income and expenses for the
statement period in which the combination occurs as if the companies had been
combined from the beginning of the period (FASB 1992, pp. 213–14).
Purchase Accounting
Purchase accounting is somewhat more complicated. Under purchase account-
ing the acquiring and acquired firms are treated differently, so the first step
is to identify which is which. FASB holds that in a typical combination the
acquiring company pays out cash or other assets or issues the stock used in the
acquisition and is the larger of the firms (FASB 1992, pp. 213–14).
Once acquirer and acquired are identified, accounting for the acquisition
can proceed. The acquirer is to record on its books the acquisition at the price
paid to the acquired firm’s owners, using a two-step process. First, assets and
liabilities from the acquired firm (target) are recorded on the acquirer’s books
at individual market values. Second, any positive difference between
acquisition price and market value of net assets (assets minus liabilities) is
recorded as an asset called goodwill. Once recorded, goodwill is depreciated by
equal annual charges against the combined firm’s earnings for a period of years
over which, in the accountant’s estimate, the combined firm benefits from the
goodwill built by the acquired firm. The amortization period is limited to at
most 40 years (FASB 1992, pp. 227–28). If the market values of the acquired
assets and liabilities are accurately measured, goodwill is the value of the
acquired firm as a going concern. Alternatively, goodwill can represent
promising products developed by the target, or the price the acquirer is willing
to pay for eco- nomic gains, such as economies of scale, expected from the
merger (Brealey and Myers 1996, p. 930).
The following example may help illustrate purchase accounting. Assume
Honest Auto Maintenance, Inc. (HAM), an auto repair shop management com-
pany, agrees to pay $100 million cash to acquire Wally’s Import Repair, a
regional chain. Following the acquisition, the assets and liabilities purchased
in the acquisition are recorded on HAM’s books at their current market values
as determined by appraisers hired by HAM. The appraisers value the assets
at $160 million and the liabilities at $90 million. So HAM has purchased
net assets with a market value of $70 million ($160M–$90M). To record the
difference between the market value of the net assets and the $100 million
purchase price, $30 million of goodwill is recorded on HAM’s balance sheet.
For the next 40 years (the estimated life of the goodwill according to HAM’s
accountants) HAM will record on its income statement an after-tax expense
of $750,000 ($30M/40 years), decreasing its reported net income each year by
this amount.
Purchase: A
Merger Mystery
John R. Walter
O n September 14, 1998, WorldCom merged with MCI to form MCI
WorldCom, a global telecommunications giant. On September 30,
NationsBank of Charlotte, North Carolina, and BankAmerica of San
Francisco merged to form BankAmerica, one of the largest banks in the United
States. While each case involved the combination of two firms, each used a dif-
ferent accounting method. MCI WorldCom’s merger announcement noted that
the combination would be accounted for as a “purchase”; on the other hand,
BankAmerica’s merger used a method called “pooling of interests” accounting.
In May 1991, American Telephone and Telegraph (AT&T) acquired com-
puter manufacturer NCR Corporation (formerly National Cash Register) for
$110 per share, in what was to that date the largest-ever computer industry
merger. Press reports indicated that during negotiations AT&T upped its offer
by $5 per share, an increase of about $325 million, to secure NCR’s
cooperation in accounting for the acquisition as a pooling of interests.1
Here is the mystery. AT&T paid the additional $325 million to use pool-
ing accounting rather than the alternative—purchase accounting—a choice that
affected accounting numbers but neither added assets, reduced liabilities, nor
changed tax treatment. Why then was AT&T willing to expend an additional
$325 million? Both anecdotal and empirical evidence indicate that AT&T’s
preference for pooling is not unusual. Corporate managers frequently go to
some expense to employ pooling, though there are no obvious benefits.
The article benefited greatly from discussions with and comments from J. David Carroll,
Thomas Humphrey, Jeffrey Lacker, Wenli Li, Raymond Owens, Warren Trepeta, and John
Weinberg. The opinions expressed herein are the author’s and do not represent those of the
Federal Reserve Bank of Richmond or the Federal Reserve System.
1
For a detailed discussion of AT&T’s acquisition of NCR, see Lys and Vincent (1995). For
press reports, see Smith (1991) and Cowan (1991).
Federal Reserve Bank of Richmond Economic Quarterly Volume 85/1 Winter 1999 27
, 2 Federal Reserve Bank of Richmond Economic
These cases raise questions for those not acquainted with the features of
merger and acquisition procedure. What are the differences between purchase
and pooling of interests accounting? Should the choice of accounting method
be of concern to analysts, investors, or others interested in business activity?
Why are two different forms of accounting—purchase and pooling—used for
other- wise similar acquisitions? What drives the choice between the two
methods, and why are acquirers willing to take expensive steps that have only
cosmetic consequences? This article addresses these questions.
Despite firms’ express preference for pooling, the body responsible for
setting U.S. accounting standards, the Financial Accounting Standards Board
(FASB), recently proposed eliminating pooling, even though the accounting
treatment has been used for years. While the change would bring U.S. merger
and acquisition accounting standards more in line with standards used in other
countries, acquisitive corporations are likely to oppose it. The change might
offer some benefits, but the benefits could be offset by efficiency losses.
1. POOLING AND PURCHASE: THE NUTS AND BOLTS
Accountants attempt to report in balance sheets an accurate valuation of a
firm’s assets, liabilities, and equity. But how should accountants value a firm
arising from the combination of two separate businesses? One approach is to
simply sum the dollar amounts of assets, liabilities, and equity of the two
firms as they stood before the combination. This is pooling of interests
accounting. Or, since business combinations are typically one firm’s purchase
of another firm, another valid method would value the purchased firm at its
purchase price, and add the purchase price to the assets of the acquiring firm, as
one would if the acquisition were of a piece of equipment. In broad terms, the
latter approach is purchase accounting. The financial statements of a combined
firm will vary with the choice between pooling or purchase accounting. While
accounting methods for business combinations have changed over time, under
today’s accounting rules both pooling and purchase are acceptable means of
valuing combinations in the United States.
The terms merger, acquisition, consolidation, reorganization, and combina-
tion are often used interchangeably (none is particularly associated with either
pooling or purchase accounting). While no single term predominates, through-
out this article the term business combination will be employed to indicate the
uniting of two firms, regardless of the features of the unification.
Pooling of Interests Accounting
As already implied, pooling of interests accounting is conceptually quite
simple. When a business combination is completed, the balance sheet of the
combined firm reflects assets, liabilities, and owners’ equity at the sum of
these accounts
, J. R. Walter: Pooling or 2
as recorded by the separate companies immediately before the combination
was completed. Income statements will show income and expenses for the
statement period in which the combination occurs as if the companies had been
combined from the beginning of the period (FASB 1992, pp. 213–14).
Purchase Accounting
Purchase accounting is somewhat more complicated. Under purchase account-
ing the acquiring and acquired firms are treated differently, so the first step
is to identify which is which. FASB holds that in a typical combination the
acquiring company pays out cash or other assets or issues the stock used in the
acquisition and is the larger of the firms (FASB 1992, pp. 213–14).
Once acquirer and acquired are identified, accounting for the acquisition
can proceed. The acquirer is to record on its books the acquisition at the price
paid to the acquired firm’s owners, using a two-step process. First, assets and
liabilities from the acquired firm (target) are recorded on the acquirer’s books
at individual market values. Second, any positive difference between
acquisition price and market value of net assets (assets minus liabilities) is
recorded as an asset called goodwill. Once recorded, goodwill is depreciated by
equal annual charges against the combined firm’s earnings for a period of years
over which, in the accountant’s estimate, the combined firm benefits from the
goodwill built by the acquired firm. The amortization period is limited to at
most 40 years (FASB 1992, pp. 227–28). If the market values of the acquired
assets and liabilities are accurately measured, goodwill is the value of the
acquired firm as a going concern. Alternatively, goodwill can represent
promising products developed by the target, or the price the acquirer is willing
to pay for eco- nomic gains, such as economies of scale, expected from the
merger (Brealey and Myers 1996, p. 930).
The following example may help illustrate purchase accounting. Assume
Honest Auto Maintenance, Inc. (HAM), an auto repair shop management com-
pany, agrees to pay $100 million cash to acquire Wally’s Import Repair, a
regional chain. Following the acquisition, the assets and liabilities purchased
in the acquisition are recorded on HAM’s books at their current market values
as determined by appraisers hired by HAM. The appraisers value the assets
at $160 million and the liabilities at $90 million. So HAM has purchased
net assets with a market value of $70 million ($160M–$90M). To record the
difference between the market value of the net assets and the $100 million
purchase price, $30 million of goodwill is recorded on HAM’s balance sheet.
For the next 40 years (the estimated life of the goodwill according to HAM’s
accountants) HAM will record on its income statement an after-tax expense
of $750,000 ($30M/40 years), decreasing its reported net income each year by
this amount.
