Harvard Business School 9-101-021
Rev. October 20, 2000
Accounting for Mergers & Acquisitions
Mergers and acquisitions, also referred to as business combinations, have become a
significant source of economic activity in the world economy. In 1999, business combinations totaled
$3.4 trillion, $1.6 trillion for combinations of U.S. firms and $1.5 trillion for European combinations.1
Research indicates that on average business combinations create new economic value through
economies of scale, economies of scope, improved target management, tax benefits, or the availability
of low cost financing for financially constrained targets.2 However, mergers and acquisitions also
pose serious risks for acquiring firms, including uncertainties about the value of the target’s assets
and liabilities, and unanticipated challenges in integrating the target to achieve planned synergies.
Recent studies indicate that, as a result of these risks, approximately 50% of all combinations do not
create value for the acquiring firm’s shareholders.3
A merger is defined as the joining of two or more companies to form a single legal entity.
Generally, the assets of the smaller company are merged into those of the larger, surviving company
and shareholders of the target are either bought out or become shareholders in the acquiring
corporation. A merger usually requires approval by the shareholders of both the acquiring
corporation and the target entity. An acquisition, on the other hand, is the purchase of more than
50% of the voting shares of one firm by another. Following the acquisition the two companies can
continue as separate legal entities, with the acquiring company referred to as the parent company and
the target as a subsidiary. An acquisition may be structured in one of four forms: cash purchase of
assets, cash purchase of stock, issuance of stock for assets, or issuance of stock for stock. In contrast to
a merger, in an acquisition the buyer can negotiate which assets it purchases and which liabilities it
assumes. Furthermore, if the transaction is structured as an acquisition of the target’s stock, the
buyer negotiates only with the target shareholders for the sale of their stock.
Depending on the characteristics of a merger or acquisition, the transaction will be accounted
for as either a purchase combination or a pooling-of-interests (pooling) combination.
Purchase Method. Purchase accounting requires the acquirer to record in its financial statements the
fair market value of all assets acquired, both tangible and intangible, and liabilities assumed. The fair
value of an asset is generally its market or appraised value and liabilities are generally valued on a
present value basis. Therefore, where possible the cost of the acquisition is allocated to each
1 See Mergerstat, 1999
2 Palepu, Healy, & Bernard, Business Analysis and Valuation Using Financial Statements, South-Western, 2000.
3 KPMG, Mergers & Acquisitions - A Global Research Report, 1999.
Professor Paul M. Healy and Teaching Fellow Jacob Cohen J.D. prepared this case as the basis for class discussion rather
than to illustrate either effective or ineffective handling of an administrative situation.
Copyright © 2000 by the President and Fellows of Harvard College. To order copies or request permission to
reproduce materials, call 1-800-545-7685, write Harvard Business School Publishing, Boston, MA 02163, or go to
[Link] No part of this publication may be reproduced, stored in a retrieval system,
used in a spreadsheet, or transmitted in any form or by any means—electronic, mechanical, photocopying,
recording, or otherwise—without the permission of Harvard Business School.
This document is authorized for use only in Post Graduate Diploma in Management - 0114 by Prof. Ullas Rao at
SDM Institute for Management and Development (SDMIMD) from January 2014 to July 2014.
101-021 Accounting for Mergers & Acquisitions
identifiable asset or liability being acquired or assumed. Identifiable assets may be tangible (such as
property, plant and equipment, and inventory) or intangible (such as patents, trademarks, and brand
names). Goodwill represents the potential of an entity to earn “above normal” profits. It arises from
factors such as name recognition, superior management, product quality, location, and good
customer relations. In the U.S. any excess or residual purchase price over the fair value of the net
identifiable assets is considered goodwill that must be recorded as an asset and amortized over its
useful life or a maximum of 40 years. An example of the pro forma balance sheet implications of
purchase accounting is presented in Exhibit 1. Income statement effects are shown in Exhibit 3.
Pooling Method. The pooling method accounts for a combination of two firms as a union of the
ownership interests of the two previously separated groups of stockholders. No sale or purchase is
considered to have occurred. The assets and liabilities of the combining firms continue to be carried
at their book values, that is, on the basis of their historical costs. Any goodwill carried on the target’s
books prior to the merger continues to be carried on the merged firm’s books at its historical cost, but
no new goodwill is recognized as a result of the pooling. The stockholders’ equity of the merged
firms is therefore recorded at the sum of the book values of the two firms. An example of the pro
forma balance sheet implications of pooling-of-interests accounting is presented in Exhibit 2. Income
statement effects are shown in Exhibit 3.
In order to qualify for a pooling-of-interests treatment, a merger must meet 12 criteria. These
include the requirement that more than 90% of the consideration paid to target shareholders be in the
form of acquiring firm stock. Exhibit 4 provides the full list of criteria. All combinations that do not
qualify for pooling accounting must be accounted for using the purchase method.
Current Controversy over Pooling
On September 7, 1999, the Financial Accounting Standards Board ("FASB") issued an
Exposure Draft, "Proposed Statement of Financial Accounting Standards on Business Combinations
and Intangible Assets". FASB identified the following four significant changes to existing accounting
practice:4
• Use of the pooling-of-interests method (pooling method) of accounting would be
prohibited. The purchase method of accounting would be required for all
business combinations.
• The current 40 year maximum amortization period for goodwill would be
reduced to 20 years.
• Companies would be required to present separate line items in the income
statement for income before taxes and goodwill amortization, and for goodwill
amortization net-of-tax basis.
• The current 40-year maximum amortization period for acquired intangible assets
(other than goodwill) would be replaced with a presumption that their useful
lives are 20 years or less.
4 Financial Accounting Standards Board, Exposure Draft, Business Combinations and Intangible Assets,
September, 1999.
2
This document is authorized for use only in Post Graduate Diploma in Management - 0114 by Prof. Ullas Rao at
SDM Institute for Management and Development (SDMIMD) from January 2014 to July 2014.
Accounting for Mergers & Acquisitions 101-021
The Financial Accounting Standards Board (FASB) justified its proposal by arguing that
having two methods of accounting for essentially the same underlying transaction had made it
difficult for investors to compare firms’ financial performance.5 FASB Chairman Edmund L. Jenkins
argued that “we think that the transparency provided by purchase accounting is far superior to
pooling of interest. Pooling doesn’t make management accountable for the investments it has
made.”6 Eliminating the use of the pooling method would also increase financial reporting
comparability between U.S. acquisitions and those in other countries, since every other major country
had either outlawed or severely restricted the use of pooling.
However, many corporate executives, particularly those in the high-growth technology
industries disagreed with the FASB proposal. For example, Cisco’s controller, Dennis Powell argued
that “elimination of pooling will derail the engine that is driving the strong economy of this
country.”7
5 Thomas G. Donlan, Cisco’s Bids: Its growth by acquisition will pose problems, Barron’s, May 08, 2000
6 Albert B. Crenshaw, A tech push to keep ‘pooling’ on books, The Washington Post, June 25, 2000
7 id
This document is authorized for use only in Post Graduate Diploma in Management - 0114 by Prof. Ullas Rao at
SDM Institute for Management and Development (SDMIMD) from January 2014 to July 2014.
101-021 Accounting for Mergers & Acquisitions
Exhibit 1 Pro forma balance sheet effect of recording an acquisition using the purchase method
Assume that XYZ, Inc. acquired ABC Corp. on December 31, 2000 for $200,000 in stock, but used the
purchase method to account for the acquisition. XYZ would then revalue the assets and liabilities of ABC
to their fair values at the date of the acquisition and record any identifiable intangible assets that
were not carried on ABC’s books. (See Exhibit 2 for ABC’s book values) Any difference between the
purchase price and the fair value of the net assets would be shown as goodwill arising from the
acquisition.
Assume that the fair market value of the identifiable assets and liabilities for ABC were as
follows:
Cash $6,000
A/R 8,000
Inventory 9,000
PP&E 50,000
Patents 25,000
Trademark 15,000
A/P (14,000)
LT Notes Payable (12,000)
------------
Fair value of net identifiable assets $87,000
======
The goodwill would then be the difference between the purchase price ($200,000) and the fair value
of the net identifiable assets ($87,000), $113,000. The pro forma balance for the combined firm would
be as follows:
XYZ Inc. Balance Sheet ABC Corp. Revalued Post - Merger Balance
at 12/31/00 Balance Sheet Based Sheet at 12/31/00
on XYZ offer at
12/31/00
Assets
Cash $185,000 $6,000 $191,000
Accounts Receivable 90,000 8,000 98,000
Notes Receivable 55,000 -- 55,000
Inventory 140,000 9,000 149,000
PP&E (net) 250,000 50,000 300,000
Goodwill -- 113,000 113,000
Trademark -- 15,000 15,000
Patents -- 25,000 25,000
Total Assets $720,000 $226,000 $946,000
Liabilities & Equity
Accounts payable $90,000 $14,000 $104,000
LT Notes Payable 170,000 12,000 182,000
Shareholders’ equity 460,000 200,000 660,000
Total Liabilities & Equity $720,000 $226,000 $946,000
This document is authorized for use only in Post Graduate Diploma in Management - 0114 by Prof. Ullas Rao at
SDM Institute for Management and Development (SDMIMD) from January 2014 to July 2014.
Accounting for Mergers & Acquisitions 101-021
Exhibit 2 Pro forma balance sheet effect of recording an acquisition using the pooling-of-interests method.
Assume that XYZ, Inc acquired ABC Corp. on December 31, 2000 for $200,000 in stock. Under the
pooling-of-interests method XYZ would record the value of the shares issued to acquire ABC at the
book value of ABC’s equity, rather than their market value at the date of the acquisition. The value of
the assets and liabilities for the new merged firm would be the sum of the book values of the assets
and liabilities of the two firms. The merged firm would recognize any goodwill that appeared on
ABC’s books prior to the merger, but would not show any new goodwill from the acquisition.
Consequently, the pro forma balance sheet for the combined firm would appear as follows:
XYZ Inc. Balance ABC Corp. Balance Post - Merger Balance
Sheet at 12/31/00 Sheet at 12/31/00 Sheet at 12/31/00
Assets
Cash $185,000 $6,000 $191,000
Accounts Receivable 90,000 8,000 98,000
Notes Receivable 55,000 -- 55,000
Inventory 140,000 10,000 150,000
PP&E (net) 250,000 35,000 285,000
Goodwill -- 12,000 12,000
Total Assets $720,000 $71,000 $791,000
Liabilities & Stockholders’
Accounts payable $90,000 $14,000 $104,000
LT Notes Payable 170,000 15,000 185,000
Shareholders’ equity 460,000 42,000 502,000
Total Liabilities & Equity $720,000 $71,000 $791,000
This document is authorized for use only in Post Graduate Diploma in Management - 0114 by Prof. Ullas Rao at
SDM Institute for Management and Development (SDMIMD) from January 2014 to July 2014.
101-021 Accounting for Mergers & Acquisitions
Exhibit 3 Projected income statements under the Purchase and Pooling-of-Interests Methods
The income statement effects of using the purchase methods and pooling-of-interests
are illustrated using XYZ Corp.’s acquisition of ABC, Inc. discussed in Exhibits 1 and 2. The
major differences in income statement effects arise for depreciation and amortization. Under
the purchase method, depreciation and amortization expenses for ABC are based on the fair
value of its long-term assets, whereas under the pooling method they are based on the book
value of ABC’s assets prior to the acquisition. XYZ used the straight-line method of
depreciation with zero residual value and a useful life of 4 years as the basis for depreciating
ABC’s PP&E. Assuming no new purchases of PP&E during 2001, the merged firm would
have a depreciation expense of $71,250 ($285,000/4) under pooling and $75,000 ($300,000/4)
under the purchase method. XYZ amortized patents and trademarks using the straight-line
method with zero residual value and a 10-year useful life, and goodwill over 40 years.
Assuming no new acquisitions of intangibles during 2001, the amortization expense for the
merged firm would be $6,825 ($25,000 + 15,000)/10 + $113,000/40) under the purchase
method, versus $300 ($12,000/40) under pooling.
Post - Merger Income Post - Merger Income
Statement For Year Ending Statement For Year Ending
12/31/01 Under Purchase 12/31/01 Under Pooling
Method Method
Revenues $500,000 $500,000
Cost of Goods Sold 340,000 340,000
Gross Margin 160,000 160,000
Expenses:
Depreciation 75,000 71,250
Amortization 6,825 300
Selling 50,000 50,000
Administrative 20,000 20,000
Other 10,000 10,000
Total Expenses: 161,825 151,550
Net Income $ (1,825) $ 8,450
This document is authorized for use only in Post Graduate Diploma in Management - 0114 by Prof. Ullas Rao at
SDM Institute for Management and Development (SDMIMD) from January 2014 to July 2014.
Accounting for Mergers & Acquisitions 101-021
Exhibit 4 Twelve Criteria for Pooling-of-Interest Accounting
APB Opinion No. 16 requires that certain specific conditions be met for a combination to be treated as a
pooling of interests. The criteria are grouped into three categories.
Attributes of Combining Companies:
1. Autonomous - Combining companies must be autonomous and not have been a subsidiary of
division of another corporation within two years before the plan of combination is initiated.
This ensures that the combination is indeed “the union of previously separable groups of
stockholders”
2. Independent - Prior to the combination, each combining company must have been
independent of the other. Intercorporate investment of ten percent or less of the total
outstanding voting common stock of any combining company is acceptable and will not
impair independence.
Manner of Combining Interest:
1. Single Transaction - The combination must be completed within one year after the plan is
initiated, or completed in a single transaction.
2. Exchange of Common Stock - The combination must be effected through the exchange of
voting common stock. The acquiring company must acquire no less than 90 percent of the
combining company’s voting common stock.
3. No Equity Changes in Contemplation - No changes in the equity interests of the voting
common stock of any combining company may be made in contemplation of a pooling of
interests for a period beginning two years prior to the initiation date of the plan of
combination.
4. No Shares Reacquired for Purposes of Combination - The reacquisition of voting common
stock by any combining company is allowed except for purposes of business combination.
5. No Change in Proportionate Equity Interest - The ownership ratios of the stockholders of the
combining companies must be preserved.
6. Voting Rights Immediately Exercisable - The common stockholders must receive the voting
rights they are entitled to and may not be restricted in any way from exercising those rights.
7. Combination Resolved at Consummation - The entire plan of combination must be effected on
the date of consummation. There may not be any pending provisions for contingent shares to
be issued at a later date.
Absence of Planned Transactions:
1. The combining company may not agree to reacquire or retire any of the stock issued to effect
the combination.
2. The combined company may not enter into any agreement for the benefit of former
shareholders of the combining companies.
3. The combined company may not plan to dispose of substantial amounts of assets of the
combining companies within two years of the combination. However, disposals in the
ordinary course of business of the formerly separate companies and to eliminate duplicate
facilities or excess capacity is permitted.
This document is authorized for use only in Post Graduate Diploma in Management - 0114 by Prof. Ullas Rao at
SDM Institute for Management and Development (SDMIMD) from January 2014 to July 2014.
