Accounting for Consolidations: Review

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Introduction

Consolidations encompass the amalgamation of different small groups of companies into large ones. From an accounting theoretical paradigm, consolidation refers to the processes of aggregation of various small company units’ accounting statements. There are three main methods of consolidation accounting. These are pooling of interest, which is also known as merger accounting or pooling methods, purchase method, which is also referred as acquisition accounting, and the fresh start method (Ayers et al., 2000, p.4). Consolidation of financial statements has both domestic and international implications. As the profession moves toward the convergence to international standards (IFRS), several issues related to the preparation of consolidated statements arise. This paper is divided into two main sections. In section 1, it discusses the implication of deployment of the acquisition method or purchase method compared to pooling of interests methods. It also scrutinizes how acquisition method/purchase method differs from the pooling of interests method coupled with the impact on financial statement reporting quality and the potential impact on decision-making. Finally, an opinion backed by reasons on the best reporting methods is given. Section 2 first establishes the difference(s) between consolidation standards under current U.S GAAP and IFRS. Secondly, opinion on the issues that need resolution is given, which underscores the recommended reporting standard between US GAAP and the IFRS

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Implication of the acquisition method compared to pooling of interests method

Different accounting methods for amalgamations have different implications to financial reporting. In pooling of interests method, liabilities and assets possessed by an organization, which has been acquired, are not treated or measured at fair value, rather they are retained at the book value. The implication here is that no goodwill is generated under the pooling interest method. Under the purchase method, the difference between the book value and the purchasing value of assets and liabilities of the acquired organization is treated as goodwill (Ayers, 2002).

Purchase method/acquisition method produces lower earnings trends since pre-acquisition accounting income statements combination do not occur as in the case of pooling of interests method. For the case of the purchases method, the sales trends of the acquiring firms may be distorted due to attribution of increased growth to the amalgamation (Ayers, 2002). However, in the case of pooling of interests, sales trends show more accuracy due to the combination of incomes statements of the two amalgamated firms. Pooling of interest method for financial accounting, in corporate combinations, results in combination of financial statements of the acquired and acquiring firms over the entire period of reporting as opposed to as at the date of acquisition. This aspect allows the pooling of interests methods yield higher earnings per share compared to the purchase method.

Differences between acquisition/purchase method and pooling of interests method

In the discipline of financial accounting, the selection of the accounting methodology encompasses one of the controversial issues when corporate mergers occur. Ayers (2002) contends with this argument by further reckoning that at the “heart of this controversy is how acquiring firms account for the difference between the price paid for the acquired company (target) and the book value of stockholders’ equity on the target’s balance sheet” (p.5). In the resolution of this issue, Ayers (2002) adds, “Purchase methods and pooling of interest method have been historically used in financial accounting for mergers or acquisitions” (p.6).

During the preparation of financial accounts for organizations, accountants report accurate valuation of an organization’s liabilities and assets coupled with equities. For mergers, this process is accomplished through either pooling of interests accounting or the purchase accounting. Under the first approach, the dollar value of liabilities and equities coupled with assets for each organization are summed together as they were before amalgamation (Walter, 1999, p.28). This approach reflects the concept of an organization pulling together resources to increase its market share or competitive advantage. In the approach of purchase accounting, the assets, liabilities, and equities of organizations forming an acquisition involving the purchase of other organizations are measured at the fair value of the purchase price. The purchase price is then added to the value of liabilities, assets, and equities of the acquiring organization’s liabilities, assets, and equities.

Impacts on financial statement reporting quality and decision-making

The differing methods of consolidation accounting produce differing implications to the approach adopted to pay for an acquisition by the parent organization, the manner for assets evaluation, and the liabilities. The type of accounting method also affects the mechanism of evaluation of the “equities of the acquirer and/or the target company subsequent to acquisition, on recognition of goodwill, on the amount of retained earnings reported, amount of future earnings, and on rate of return of assets” (Agami, 2000, p.5). The choice of any particular method of accounting is based on several reasons among them the capacity of the method adopted to reflect quality reporting and to act as the basis of good decision-making. The work of Ayers et al. (2000) supports this line of thought by evidencing that firms “structure acquisitions as pooling or purchase acquisitions depending upon the relative financial statement benefits of pooling versus purchase accounting” (p.6). Based on this theoretical paradigm of selection of the appropriate method of accounting consolidations, pooling of interests is perhaps unattractive method for decision making.

The argument above is justifiable as firms spend more money in the form of acquisition premiums in deployment of the pooling methods in comparison to acquisition methods. However, most US corporations prefer the use of pooling method compared to the acquisition methods. Agami (2000) suggests that such a decision is informed by the reason that pooling methods result in high rates of returns coupled with higher incomes (p.5). Hence, such an accounting reporting method portrays quality accounting practice. However, an interrogative emerges on whether reflection of a merger in a more positive way actually truncates reflection of value of an organization to its owners, viz. the shareholders.

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Researches on business amalgamations contend that pooling method gives higher stock prices. This observation implies that one of the “reasons for concern about reporting lower earnings if the pooling method is disallowed could be the management’s fear that these lower earnings would cause lower stock prices” (Hong et al., 1978, p.32). This argument suggests that the quality of any reporting method calls for evaluation in the context of the manner in which it presents an amalgamated organization to the stockholders. The discussion of literature on acquisitions methods and pooling interest method creates a perception that organizations are free to choose which method to utilize as it would be the case of stock valuation methods such as FIFO and LIFO. However, Spero and Kreiser (2003) posit, “For a company to use the pooling method, it must comply in advance of an acquisition with 12 conditions listed in accounting principles board’s opinion no.16 and also additional SEC criteria” (p.215). Non-compliance to the provisions only leaves organizations without choice, and thus they have to use the purchases method.

Several provisions are made to regulate the manner in which pooling methods and acquisitions accounting methods are applied by amalgamations organizations by various accounting regulation bodies. For instance, the APB 16, in paragraph 47, states that alterations in the “equity interest of the voting common stocks of any combining company may be made in contemplation of a pooling of interest” (Spero & Kreiser, 2003, p.217). In paragraph 48, APB rule proceeds to “prohibit repurchasing of post-acquisition shares, in particular the ones issued to the various stockholders of the combined organization” (Spero & Kreiser, 2003, p.217). Any situation leading to the likelihood of violation of the rules calls for a combined organization to deploy purchases/acquisitions method. SEC, through SAB 96, prohibits ‘planned transactions’ to develop the ability to sue the pooling method. These regulations pose the question whether accounting regulation bodies favor amalgamations to deploy purchases method of accounting for acquisitions.

Recommendation

Considering the discussion of the issues considered in decision-making and quality reporting, as discussed in the above sections, the question remains: which is the recommended accounting method for acquisitions? As discussed before, both acquisition accounting and polling accounting have their merits and demerits. Can organizations also deploy pooling method while preventing dilution of their additionally issued common shares? Should they welcome the fact that pooling method exposes them to various costs associated with extra shares outstanding? In the context of these queries and discussion of the implication of acquisitions and the pooling accounting method, I recommend pooling accounting method. It presents an amalgamation as having better performance, which is perhaps important in helping to build investors’ (shareholders) confidence. In a bid to operate in a regulatory environment for the pooling method, two recommendations for organizations determined to deploy the approach are important.

Firstly, organizations should not abandon pooling method as the most preferred approach of accounting for acquisitions. The approach gives “organizations the advantage of higher returns while operating with lower values of assets and with elimination of recorded good will” (Spero & Kreiser, 2003, p.121). Hence, even though a requirement may be placed for issuing extra dilution common shares, the method is still attractive to an organization. Firms can venture into the open markets to repurchase or buy common shares. Even though planned transactions are not permitted by SEC and APB regulations, firms still have an option. They can wait for a period of six months and repurchase the common shares. Secondly, organizations can adopt the acquisition/purchases approach, but lobby for alteration of accounting rules. One of such alteration is abandoning the pooling method as the most preferred method under the precondition that good will generated while utilizing acquisition method does not lead to amortization of earnings so that a firm is worth the premiums.

Differences between current US GAAP and IFRS consolidation standards

Convergence is a major issue for various accounting bodies, especially the standards promulgated by the US financial accounting standards board (FASB) and IASB (international accounting standards board). The FASB develops the US GAAP standards, while the IASB is responsible for the development of the IFRS standards. Even if accounting bodies in different nations continue to restructure their standards to enhance compliance to the IFRS standards, certain differences inevitable. From the context of business combinations, both the US GAAP and IFRS standards are similar, but different in some ways.

The IFRS’s chapter on business combination provides various guidelines for accounting controls for acquisitions or mergers. The IFRS requires the accounting of acquisitions be done from the basis of the acquisitions method, which is also referred as the purchase method in the 2004 version of the IFRS guidelines of acquisition accounting. This aspect implies that assets and liabilities “are assumed to be measures at their fair value at firms’ acquisition date” (Deloitte, 2004, p.9). The IFRS clearly does not recognize the fresh start method of accounting for acquisitions. Under the provisions of IFRS 3.6, an acquiring organization must be precisely identified. This step encompasses the first move in the application of the acquisitions methods under IFRS provisions. The second step requires the accountants to identify the date in which the acquisition was done. The third step demands the “determination and measurement of the identifiable assets acquired, the liabilities assumed, and any non controlling interest in the acquiring firm” (Deloitte, 2004, p.9). In the forth step, measurements coupled with determination of good will and/or gains derived from bargain on purchases are recognized. It is important to note that the US GAAP also requires the assets, equities, and liabilities of the acquired firms to be based at fair value as at the date of acquisition.

In the preparation of consolidated financial statements for subsidiary and the parent company, “the US GAAP permits the entities to prepare the accounts at fiscal ends with at most three months difference” (Ernst & Young, 2012, p.9). The IFRS requires all entities to prepare financial statements as at the same date. In case of differing ends of reporting periods between various entities forming the acquisition, “the subsidiary prepares (for consolidation purposes) additional statements as of the same date as the financial statements of the parent unless it is impeccable to do so” (Ernst & Young, 2012, p.11). However, ownership for 50 percent of voting stock is required for consolidation to take place under the two accounting for consolidation systems. Literature on accounting for acquisition documents arguments and counterarguments against the acquisition methods and the purchase methods in an effort to lay a foundation on the most preferred method. The main points of concern in the literature are the mechanism of valuation of the liabilities and assets of the subsidiary firms and treatment of good will.

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In the attempt to determine the capacity of differing accounting systems deployed by different nations to converge with the international standards, it is crucial to consider how these two elements are treated under the US GAAP and IFRS. IFRS includes “limited guidance on the overall approach to measuring the fair values of various assets and liabilities” (Ernst & Young, 2012, p.5). Under the current standards of IFRS, no particular guidance is provided for in terms of detailing the methodologies of valuation. Comparatively, the US GAAP provides particular guidance of measurement of fair value coupled with hierarchies for fair value. The US GAAP also makes provision for “general valuation guidance and disclosure requirements” (Ernst & Young, 2012, p.6). The IFRS recognizes good will as an asset, which is considered as a residual. IFSR recognizes residual as either profits or losses depending on the sign convention of the residual after the re-assessments of various values deployed in acquisition accounting.

The US GAAP treats goodwill in a similar manner as IFRS. This convergence suggests that good will has similar implications to the acquisitions accounting under the US GAAP and the IFRS standards. Under IFRS, in the calculation of goodwill “the acquisition-date fair value of the consideration transferred, the amount of any NCI, and the acquisition-date fair value of the acquirer’s previously-held equity interest in the acquiring firm are considered” (Deloitte, 2004, p.13). The difference of these parameters and the net amounts of the identifiable liabilities and the assets at the acquisition dates give the amount of the good will.

Recommendations

Acquisitions are not only limited to organizations operating within a nation, but also to organizations operating in different states. Where differences exist in the acquisition accounting standards deployed by different nations, challenges emerge on the business combination methods to be invoked in a situation involving international acquisition. For this reason, it is important for different acquisition accounting standards to converge. IFRS accounting standard for acquisitions is a good example of this endeavor. FASB has developed the US GAAP to reflect similar approaches of accounting for acquisitions. Since both the US GAAP and the IFRS are more similar than different in the treatment of business combinations, IFRS is recommended for adoption by different nations.

The IFRS standards can create an effective harmonious way of accounting for acquisitions, especially in situations involving international amalgamations. While both the US GAAP and IFSR require adoption of acquisition accounting approach by all business combinations, adoption of IFRS provides means of comparing the operations of different amalgamations both nationally and internationally. Through the adoption of IFRS, the question and the debate over presentation of an amalgamation financial reporting at higher returns is eliminated since no alternative approach to accounting of acquisitions are provided.

Reference List

Agami, A. (2000). Impacts of Accounting Rules on Competiveness of U.S. Corporations in Business Acquisitions Decision Making. Multinational Business Review, 8(1), 1-12.

Ayers, B. (2002). Do Firms Purchase the Pooling Method? Review of Accounting Studies, 7(2), 5-32.

Ayers, B., Lefanowicz, C., & Robinson, J. (2000). The Financial Statements Effects of Eliminating the Pooling -Of- Interests Methods of Acquisition Accounting. Accounting Horizons, 14(1), 1-19.

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Deloitte. (2004). Business Combinations: A guide to IFRS 3. Web.

Ernst & Young. (2012). US GAAP vs. IFRS. Web.

Hong, H., Kaplan, R., & Mandelker, G. (1978). Pooling Vs. Purchase: The Effects of Accounting for Mergers on Stock Prices. The Accounting Review, 53(1), 31-47.

Spero, A., & Kreiser, L. (2003). Pooling Accounting and Purchase Accounting. Ohio Journal of Accounting Journal, 56(1), 212-126.

Walter, J. (1999). Pooling or Purchase: A Merger Mystery. Federal Reserve Bank Of Richmond’s Economic Quarterly, 85(1), 27-46.

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