Foundations of Financial Management: An Analysis (Part 79)

“Never spend your money before you have earned it.” 

—Thomas Jefferson

 External Growth through Mergers

(Part C)

by

Charles Lamson

Accounting Considerations in Mergers and Acquisitions

The role of financial accounting has significance in the area of mergers and acquisitions. Prior to 2001, there were competing accounting methods for recording mergers and acquisitions. The first method was pooling of interests, under which the financial statements of the firms were combined, subject to minor adjustments, and no goodwill was credited.

To qualify for a pooling of interests, certain criteria had to be met, such as:

1. The acquiring corporation issues only common stock, with rights identical to its old outstanding voting stock, in exchange for substantially all of the other companies voting stock.

2. The acquired firm's stockholders maintain an ownership position in the surviving firm.

3. The combined entity does not intend to dispose of a significant portion of the assets of the combined companies within two years.

4. The combination is affected in a single transaction.

Goodwill may be created when the second type of merger recording---a purchase of assets---is used. Because of the criteria described above (particularly items 1 and 2), a purchase of assets treatment, rather than a pooling of interests treatment, was generally necessary when the tender offer is in cash, bonds, preferred stock, or common stock with restricted rights. Before June 2001, under a purchase of assets accounting treatment, any excess of purchase price over book value must be recorded as Goodwill and written off over a maximum period of 40 years. If a company purchases a firm with a $4 million book value (net worth) $46 million, $2 million of Goodwill is created on the books of the acquiring company, and it must be written off over a maximum period of 40 years. This would cause a $50,000 per year reduction in reported earnings ($2 million/40 years). Under a pooling of interests accounting treatment, you will recall, Goodwill is not created.

The writing off of Goodwill had a devastating effect on postmerger earnings per share for many mergers and was feared by the acquiring firm's management.

In a historic move in June of 2001, the Financial Accounting Standards Board put SFAS 141 and SFAS 142 in place. The impact of the standards was to eliminate pooling of interests accounting and to greatly change the way Goodwill is treated under the purchase of assets method. No longer must merger-related Goodwill be amortized over a maximum period of 40 years, but rather it is placed on the balance sheet of the acquiring firm at the time of acquisition and not subsequently written down unless it is impaired.

In fact, the reporting obligations related to Goodwill are now much more substantial than in the past. At least once a year Goodwill must be tested to see if it has been impaired. The question becomes, "Is the fair value of Goodwill greater or less than its current book value?" This can be determined by taking the present value of future cash flows, subtracting out liabilities, and arriving at a value. If Goodwill is impaired (less than book value), part of it must be immediately written down against operating income.

In writing the new merger reporting requirements, the FASB was generous in one respect. It allowed reporting companies to take a one-time write-down of all past Goodwill impairment at the time of adoption by the firm (the January 1st, 2002, calendar year for most companies). This feature not only gave the firm a one-time opportunity to clear the slate, but the impairment was treated as a "change in accounting principles" and not directly charged to operating results. This is significant because impairment charges (after 2002) come directly out of reported income.

Negotiated versus Tendered Offers

Traditionally, mergers have been negotiated in a friendly atmosphere between officers and directors of the participating corporations. Product lines, quality of assets, and future growth prospects are discussed, and eventually an exchange ratio is hammered out and reported to the investment community and the financial press.

A not-so-friendly offer has been developed, the takeover tender offer, and which a company attempts to acquire a target firm against its will.

An entire vocabulary has developed on Wall Street around the concept of the target takeover. For example, the Saturday night special refers to a surprise offer made just before the market closes for the weekend and takes the target company's officers by surprise. By the time the officers can react, the impact of the offer has already occurred. Perhaps a stock is trading at $20 and an unfriendly offer comes in at $28. Though the offer may please the company stockholders, it's management faces the dangers of seeing the company going down the wrong path in a merger and perhaps being personally ousted.

To avoid an unfriendly takeover, management may turn to a white knight for salvation. A white knight represents a third firm that management calls on to help it avoid the initial unwanted tender offer.

Many firms that wish to avoid takeovers have moved their Corporate Offices to states that have tough prenotification and protection provisions in regard to takeover offers. Other companies have bought portions of their own shares to restrict the amount of stock available for a takeover or have encouraged employees to buy stock under corporate pension plans. Other protective measures include increasing dividends to keep stockholders happy and staggering the election of members of the boards of directors to make outside power plays more difficult to initiate. Possible target companies have also bought up other companies to increase their own size and make themselves more expensive and less valuable. One of the key rules for avoiding a targeted takeover is to never get caught with too large a cash position. A firm with large cash balances serves as an ideal target for a leveraged takeover. The acquiring company can negotiate a bank loan based on the target company's assets and then go into the marketplace to make a cash tender offer.

Also, the poison pill is an effective device for protection. It may give those in an entrenched position the ability to accumulate new shares at well below the market price in order to increase their percentage of ownership. This privilege is usually triggered when an unwanted outside group accumulates a certain percentage of the shares outstanding (such as 25%).

While a takeover bid may not appeal to management, it may be enticing to stockholders, as previously indicated. Herein lies the basic problem. The building bidding may get so high that stockholders demand action. The desire of management to maintain the status quo can conflict with the objective of stockholder wealth maximization. 

*MAIN SOURCE: BLOCK & HIRT, 2005, FOUNDATIONS OF FINANCIAL MANAGEMENT, 11TH ED., PP. 592-595*

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