TH: EMPAET 08" PQQZUNG AND E’Ufi‘CHAfi ACCQ’HN‘FEHG ON {QRMJRATE anvécm. $TATEMENTS: A MUST WUQY Them To:- fim Dayna 0‘? DH. D. MEEIHQM STATE UKWERSETY Bean Syemer Eikeman 219367 m; ' .nflwnfikuma a n w 1"- I F LIUAAAI ; Michigan State A University TH 85!! This is to certify that the thesis entitled THE IMPACT OF POOLING AND PURCHASE ACCOUNTING ON CORPORATE FINANCIAL STATETENTS: A PILOT STUDY ' presented by Dean Spencer Eiteman has been accepted towards fulfillment of the requirements for M— degree in Wing ifl L47 (.61: uWéA/ Major professor May 9, 1967 Date 0-169 ABSTRACT THE IMPACT OF POOLING AND PURCHASE ACCOUNTING ON CORPORATE FINANCIAL STATEMENTS: A PILOT STUDY by Dean Spencer Eiteman A variety of recording practices for business combinations have been held to be in accordance with generally accepted accounting princi- ples. Because the criteria of Bulletin No. 48 are not sufficiently objective as standards in distinguishing between a "purchase" and a "pooling of interests," the decision to purchase or pool is influenced more by the subjective attitudes of management than by sound accounting theory. Considering the varying consequences arising from the applica- tion of alternative treatments, the reliability of financial information is questionable when management can select whichever method gives the most favorable results. The primary objectives of this study were: (1) to examine the variety of pooling-purchase treatments in order to discover the ration- ale behind their existence; (2) to measure the consequences of various acquisition-merger accounting treatments on published financial state- ments of selected companies; and (3) to evaluate the changes in finan- cial statement analysis resulting therefrom. From the findings, a rational approach to business combination accounting procedures was developed to lessen inconsistency in practice, thereby improving the general usefulness of financial statements as a basis for intelligent decision-making by outsiders. nu... .x. .- Q_o:"‘ W- o--~-4 .4 ' I " 'v- i v " in... .f 9“- ‘Vfiuu , -.__ ‘.I .., '_‘ — .. ’-...HR :.-'Qb l' ..“'b 2. ‘-- . ‘ - L' '-_.- . “-.\.- ‘ -'.'.- ' "\ I Ib..v-. \ as. _,.‘ . ‘ ‘yl \ 5. n ‘u .‘... . hb‘:: ‘v‘, .‘_ ‘. \- . “e V ‘J .- s “V." “o u" L h 5 Q4.- . ‘l b Dean Spencer Eiteman The study found that existing combination accounting practices allow too much inconsistency in financial reporting. Financial state- ments of a business enterprise with an active history of acquisitions and mergers were affected substantially by the consistent application of alternative treatments. The manner in which business combinations are recorded had important consequences on selected financial data, many financial ratios, and in turn investment analysis. Alternative pooling-purchase accounting procedures were found, for example, to affect (1) the level of reporting earnings, (2) asset and equity values carried forward into subsequent financial statements, (3) efficiency ratios, (4) profitability ratios, (5) dividend payout ratios, (6) inter- est coverage ratios, and (7) growth rate analysis. Some important conclusions of this research are: 1. Most business combinations represent "investment" expendi- tures from the point of view of a dominant acquiring enterprise. To promote sound and informative financial reporting, the acquisitions and mergers made by a specific business entity should be accounted for as purchases in the context of an investment decision--regardless of whether the combinations are effected by the payment of cash or other property or by the issuance of stock. 2. When consideration for a business combination is in the form of ownership equities, the shares of stock used by the acquiring corpora- tion to effect the exchange should be valued at their implied cash cost, i.e., the amount of money which could have been raised through the .....s .— 'U‘l u.--... . I‘- .-. I- has _ a .._..' .— "~..o_-- I‘.‘ '- — -.,_‘._ ' :.'.‘- —-. . r v 'u__‘._- -: c .-'.A. a- 0ve§yc. g; .‘-l 3—, -\ "V .~,. - - ‘R V. i I u..~‘9. \ ‘-- " -'.'.— uu.‘.; ‘ J .0 -". .‘ a. s- . fl , . ‘v. n‘ .4 W . l .O I ‘-‘i- . ‘-«u"‘s“ - ‘I v --‘Q u u,_ , ' 's“: . - 'o. ' "¥~ - h.. h o. “ \- . . ‘. ._\ \ a ,‘ p__‘ \C‘. \‘~ ,‘ .,A _f . “H A. “ I'_ d‘ . t J ‘7 ‘. ‘1 ‘P h‘. . . a . | .O fl.‘ . Va ._ ~- ~F .., ‘u n 1‘ . . t . . -:L ‘ ‘ L t~ _.‘ ‘ H‘ e Dean Spencer Eiteman public issue of the securities to investors as indicated by the stock market. Recorded values of properties on the books of an acquired company generally are irrelevant to the investment decision and should not be assumed to express acquisition cost to the buying enterprise. 3. In general, pooling-of-interests accounting should be dis- continued because it fails to account for all costs of buying a going concern. The significance of information presented in the financial statements of a dominant enterprise is distorted when meaningless his- torical cost data of acquired companies are injected into its record- keeping process. Useful analysis of accounting reports as a basis for intelligent decision-making by outsiders is not improved by the consis- tent application of the pooling technique. 4. At the time a business combination occurs, a careful process of investigation, evaluation, and reporting of results should be required to reflect as accurately as possible the fair value and true nature of the resources and property rights acquired. Tax aspects of the exchange transaction should not dictate allocation procedures for purposes of financial reporting. Any portion of the purchase price that can be reasonably identified with limited-term intangible assets should be amortized as expenses over their estimated service lives. 5. Amounts assigned to unlimited-term intangibles (such as goodwill) should not be charged to stockholders' equity at the date of acquisition; they should be carried at unamortized cost as long as there is no evidence that their value has been permanently impaired and/or that their term of existence has become limited. The general license to -..--~' ' C .v. pn— . .. -; ’n , - N.......' v .._. -. . , >4 Ruin ..- ...,.... ' I F “us—u.» 00v 1y '.u.‘, ._ r . 5.... :‘3 ‘.o. .h .- '. .1 I (l‘ A. _“ “un'.,, Dean Spencer Eiteman amortize unlimited-term intangibles as production cost or expense over arbitrary periods makes financial statements less reliable to outsiders using them for analytical purposes. 6. A merger between separate and equal entities that has the characteristics of a genuine corporate marriage (similar to the condi- tions for a "fair-value pooling"), however, merits the pooling-of- interests treatment. Such a corporate amalgamation could be viewed as involving no change of economic substance since no dominant reporting entity is determinate; thus, accountabilities for the resultant enter- prise may be reflected from the point of view of both constituent corporations as they were before combination. THE IMPACT OF POOLING AND PURCHASE ACCOUNTING ON CORPORATE FINANCIAL STATEMENTS: A PILOT STUDY by Dean Spencer Eiteman A THESIS submitted to Michigan State University in partial fulfillment of the requirements for the degree of DOCTOR OF PHILOSOPHY Department of Accounting and Financial Administration 1967 6: Copyright by DEAN SPENCER EITEMAN 1967 ACKNOWLEDGMENTS It is impossible to acknowledge all those who contributed to the development and writing of this dissertation. Many companies provided annual reports, proxy statements, and other data. Although it is not feasible to list their names here individually, I wish to express my thanks to all of them. The New York Stock Exchange and the Securities and Exchange Commission should be mentioned for supplying information pertinent to this study. The Price Waterhouse Foundation should be acknowledged for supporting part of the research financially. My sincere thanks go to Dr. Charles Lawrence who, as a dedicated teacher and an inSpiring advisor, provided continuous encouragement in the preparation of this thesis. My appreciation also extends to Dr. Roland F. Salmonson and Dr. Richard F. Gonzalez for the valuable assistance they gave. My debt to Dr. James Don Edwards and the Department of Account- ing and Financial Administration at Michigan State University is so great that mere acknowledgment cannot suffice. Some day I hope to repay this debt by offering to future graduate students the same kind of encouragement and kindness that I have received. For the sacrifice made by my wife, Elfriede, and my parents, my debt is beyond comprehension. iii “mi,- “ .. .' ‘ f ‘7'". .4...'.. -"‘.’\'tm“-. 'v .-.‘, 1‘7"”. .. .. "at Y 44.1.2, ' up... ~| " A... \ U , \, Wu. ‘a' ‘ a .,‘ ‘ . ..“ x. 5A. ‘h TABLE OF CONTENTS ACKNOWLEDGMENTS . LIST OF EXHIBITS . . . . . . . . . . . . . . . . LIST OF APPENDICES Chapter I. II. III. IV. THE IMPACT OF POOLING AND PURCHASE ACCOUNTING ON CORPORATE FINANCIAL STATEMENTS: A PILOT STUDY . Purpose of the Study . Introduction . . The Problem Defined . . . . . . . Approach to the Problem . . . . . . . . TYPES OF COMBINATION ACCOUNTING TREATMENTS Introduction . . . . . . Purchasing and Pooling Fundamentals Some Unique Situations . Some Variations of Pooling and Purchase Accounting . Summary . . . . . . . . . . . . . . . . BACKGROUND . The Growth of Business Combinations . ‘Trends in Accounting for Business Combinations . Trends as Published by the AICPA . . . Recent Observations on Acquisitions and Mergers Discussion on Important Trends . METHODOLOGY’ Review of TWO Case Studies . Empirical Approach to the Study Comparative Analysis . . . . iv Page iii vi ix 10 14 18 18 19 32 55 62 65 65 72 90 101 112 118 118 121 128 .' -‘--‘.. . .',, u..- ‘1 I -...‘.,4 Chapter Page V. THE IMPACT OF ALTERNATIVE COMBINATION ACCOUNTING PRACTICES ON FINANCIAL STATEMENTS AND INVESTMENT ANALYSIS . . . . . . . . . . . . . . . . . . . . . . 131 Effect of Alternatives on Financial Data . . . . . . 132 Effect of Alternatives on Financial Ratios . . . . . 149 Effect of Alternatives on Growth Rate Analysis . . . 168 VI. SUMMARY AND CONCLUSIONS . . . . . . . . . . . . . . . 172 Conclusions . . . . . . . . . . . . . . . . . . . 174 Final Comments on the Pooling-of—Interests Concept . 185 APPENDICES . . . . . . . . . . . . . . . . . . . . . . . . . . . . 191 BIBLIOGRAPHY . . . . . . . . . . . . . . . . . . . . . . . . . . . 211 E vi.— Exhibit 1. 10. ll. 12. 13. LIST OF EXHIBITS BRISTOL-MYERS COMPANY AND DRACKETT COMPANY--UNAUDITED PRO FORMA COMBINED BALANCE SHEET KRYLON, INC., AND BORDEN COMPANY--UNAUDITED PRO FORMA COMBINED CONDENSED BALANCE SHEET . . . . WITCO CHEMICAL COMPANY, INC., AND ARGUS CHEMICAL COR- PORATION--UNAUDITED PRO FORMA COMBINED CONDENSED BALANCE SHEET . SMITH KLINE & FRENCH LABORATORIES-~SUPPLEMENT TO PRIOR LISTING APPLICATION TO NEW YORK STOCK EXCHANGE, NO. A-18692 . . . . . . . . . . . . . . GILLETTE COMPANY--AN ILLUSTRATION WHERE GOODWILL WAS SYSTEMATIOALLY AMORTIZED AS A SPECIAL CHARGE, 1956-57 GILLETTE C(MPANY--WRITE-0FF OF GOODWILL AND OTHER INTANGIBLES, 1949-61 GILLETTE COMPANY--EARNINGS PER SHARE OF COMMON STOCK BEFORE AND AFTER SPECIAL CHARGES, 1953-58 . MERGERS AND ACQUISITIONS--MANUFACTURING AND MINING CON- CERNS ACQUIRED, 1949-64 . . . . . . . . . . . . ACQUISITIONS OF LARGE MINING AND MANUFACTURING CORPORA- TIONS, WITH ASSETS OF $10 MILLION AND OVER, 1948-64 . MERGERS AND ACQUISITIONS--MANUFACTURING CONCERNS ACQUIRED FOR SIX LEADING INDUSTRY GROUPS, 1957-64 . NUMBER OF ACQUISITIONS OF 500 LARGEST INDUSTRIALS BY INDUSTRY AND PER.FIRM5 1951-61 . . . . . . EXAMPLES OF PURCHASE TREATMENT--EXCESS OF COST OVER BOOK.VALUE CHARGED TO RETAINED EARNINGS, 1951-53 REPORTED INTANGIBLE ASSETS HISTORY FOR SIX COMPANIES, 1954-65 . . . . . . . . . . . . . . . . . . . vi Page 26 30 37 51 58 59 60 66 67 68 69 74 80 Exhibit Page 14. INTANGIBLE ASSETS FOR SIx COMPANIES, ALL POOLINCS CONVERTED TO PURCHASES WITHOUT AMORTIZATION, 1954-65 . 82 15. SELECTED INFORMATION ON THIRTEEN POOLINCS OF INTERESTS, 1960-65 . . . . . . . . . . . . . . . . . . . . . . . . 84 16. BREAKDOWN OF 124 ACQUISITIONS AND MERGERS, 1956-65 . . 88 17. BUSINESS COMBINATIONS REPORTED, 1960-65 . . . . . . . . 91 18. BREAKDOWN OF COMPANIES REPORTING POOLINGS OF INTERESTS. 93 19. BREAKDOWN OF COMPANIES REPORTING POOLINCS OF INTERESTS AND PRESENTING FINANCIAL STATEMENTS IN COMPARATIVE PORM . . . . . . . . . . . . . . . . . . . . . . . . . 93 20. BREAKDOWN OF COMPANIES WITH POOLINCS OF INTERESTS AND PRESENTING TEN-YEAR INCOME SUMMARIES . . . . . . . . . 94 21. PRESENTATION OF INTANGIBLE ASSETS or 600 SURVEY COMPANIES, 1952-65 . . . . . . . . . . . . . . . . . . 97 22. TYPES OP INTANGIBLE ASSETS . . . . . . . . . . . . . . 98 23. INTANGIBLE ASSETS--BALANCE SHEET PRESENTATION, 1964-65. 99 24. ACCOUNTING FOR GOODWILL: BALANCE SHEET VALUATION AND AMORTIZATION . . . . . . . . . . . . . . . . . . . . . 100 25. 1965 FINANCIAL DATA FOR POUR DRUG COMPANIES . . . . . . 135 26. 1965 FINANCIAL DATA FOR FOUR DRUG COMPANIES (COMMON EQUITY PER SHARE) . . . . . . . . . . . . . . 136 27. SELECTED DATA FOR ALLIED CHEMICAL AND WARNER-LAMBERT, 1957-65 . . . . . . . . . . . . . . . . . . . . . . . . 145 28. EFFECTS OF ALTERNATIVE POOLING-PURCHASE ACCOUNTING TREATMENTS ON EFFICIENCY RATIOS OF WARNER-LAMBERT AND CHAS. PFIZER, 1962-65 . . . . . . . . . . . . . . . . . 151 29. EFFECTS OF ALTERNATIVE POOLING-PURCHASE ACCOUNTING TREATMENTS ON PROFITABILITY RATIOS 0F WARNER-LAMBERT AND CHAS. PFIZER, 1962-65 . . . . . . . . . . . . . . . 152 30. EFFECTS OF ALTERNATIVE POOLING-PURCHASE ACCOUNTING TREATMENTS ON EARNING POWER.POR EIGHT COMPANIES, 1965 . 155 vii Exhibit Page 31. EFFECTS OF ALTERNATIVE POOLING-PURCHASE ACCOUNTING TREATMENTS ON RETURN ON CAPITAL FOR EIGHT COMPANIES, 1965 . . . . . . . . . . . . . . . . . . . . . . . . . 156 32. EFFECTS OF ALTERNATIVE POOLING- PURCHASE ACCOUNTING TREATMENTS 0N RETURN ON COMMON STOCK.EQUITY FOR EIGHT COMPANIES, 1965 . . . . . . . . . . . . . . . . . . . 157 33. EFFECTS OF ALTERNATIVE POOLING-PURCHASE ACCOUNTING TREATMENTS ON CASH PLOW T0 COMMON STOCK EQUITY FOR EIGHT COMPANIES, 1965 . . . . . . . . . . . . . . . . . 158 34. EFFECTS OF ALTERNATIVE POOLING-PURCHASE ACCOUNTING TREATMENTS ON DEBT-TO-CAPITAL RATIOS FOR THREE COM- PANIES, 1962-65 . . . . . . . . . . . . . . . . . . . . 163 35. EFFECTS OF ALTERNATIVE POOLING-PURCHASE ACCOUNTING TREATMENTS ON INTEREST COVERAGE RATIOS FOR THREE COM- PANIES, 1962-65 . . . . . . . . . . . . . . . . . . . . 164 36. EFFECTS OF ALTERNATIVE POOLING-PURCHASE ACCOUNTING TREATMENTS ON PRICE-TO-BOOK-VALUE RATIOS FOR EIGHT COMPANIES, 1965 . . . . . . . . . . . . . . . . . . . . 166 37. COMPARISON OF GROWTH RATES FOR SELECTED COMPANIES, 1956-65 . . . . . . . . . . . . . . . . . . . . . . . . 169 38. GROWTH RATE ANALYSIS FOR FOUR SELECTED COMPANIES, 1956-65 . . . . . . . . . . . . . . . . . . . . . . . . 170 viii ‘0 In 4 ...:‘.CLX 11' r“! '1’ Appendix LIST OF APPENDICES Page LIST OF COMPANIES CLASSIFIED UNDER SIC GROUP NUMBERS 281, 283, AND 284 . . . . . . . . . . . . . . . 192 Acquisitions by Leading Chemical Firms . . . . . . 192 Acquisitions by Leading Drug Firms . . . . . . . . 193 Acquisitions by Leading Cosmetic Firms . . . . . . 193 LIST OF COMPANIES POSSIBLY TO BE SELECTED FOR.THE STUDY . . . . . . . . . . . . . . . . . . . . . . . 194 LIST OF EIGHT COMPANIES SELECTED FOR CASE ANALYSIS . 195 LIST OF ACQUISITIONS AND MERGERS FOR EIGHT SELECTED COMPANIES, 1951-65 . . . . . . . . . . . . . . . . 196 SELECTED INFORMATION ON SEVEN POOLINCS OF INTERESTS . 199 FINANCIAL RATIOS AND GROWTH RATE FACTORS . . . . . . 200 COMPUTER.PRINT‘OUT'FOR.CHAS. PFIZER & COMPANY, INC., UNDER FOUR.ALTERNATIVE WAYS OF ACCOUNTING FOR BUSINESS COMBINATIONS . . . . . . . . . . . . . . . 203 Alternative 1. Pooling Concept . . . . . . . . . . 203 Alternative 2. Mixture, As Reported . . . . . . . . 205 Alternative 3. Purchase Without Amortization . . . 207 Alternative 4. Purchase With AmortiZation . . . . . 209 ix CHAPTER I THE IMPACT OF POOLING AND PURCHASE ACCOUNTING ON CORPORATE FINANCIAL STATEMENTS: A PILOT STUDY Pur ose of the Stud The primary task here is to analyze the effects of alternative pooling-purchase accounting treatments on the presentation and inter- pretation of corporate financial statements. The research will demon- strate the consequences of various acquisition-merger accounting tech- niques on published financial statements of selected companies in three industries--chemicals, cosmetics, and drugs. 'The study will also eval- ‘uate the changes in investment analysis resulting therefrom. A logical 'bOdy'of accounting principles and procedures applicable to business Ccnnbinations will be suggested by which the financial operations and Ccumdition of an enterprise may be described, thereby improving the general understanding and usefulness of financial statements. Introduction Business combinations are found in a wide variety of forms. Examples are acquisition, merger, sale of assets, gentleman's agreement, FH3c>1_ cartel, community of interests, cooperative, trust, and consolida- 3 t:l()rl- In this study the term "business combination" will be used in a bzr c>£i«.' .. -~. b:— ‘x 1 O h. v P '_ v 9-,.“ a. V4,; . ‘ ‘Q‘W V H, ,_,_ “x (2) the abandonment or sale of a large part of the business of one or more of the constituents; (3) a material alteration of the relative voting rights between the constituents; (4) the elimination or reduction of the management of one of the constituents; (5) the intention to retire a substantial part of the capital stock issued to the owners of one or more of the constituent corporations; and (6) a situation where one of the constituent corporations is clearly dominant; for example, if the stockholders of the dominant corporation retain at least 90 to 95 per cent of the voting interest in the combined enterprise. In practice, none of these suggested criteria is necessarily controlling, although the major consideration is that substantially all of the former ownership interests should continue in the combined enter- 1 prise. Because most acquisitions and mergers are based on a complex Inixture of interacting motivations, it is impractical to say that any (nae of the above criteria is more important than the others. Further- “Hire, one authority even contends that these criteria "are artificial guidelines and fail to provide substantive clues to the nature of the Combination transaction." Professor Jaenicke believes that accountants can justify the Pooling treatment even in the face of seemingly substantial changes in ownership because "no one of the criteria suggested in ALB No. 48 is in \- 1Eldon S. Hendriksen, Accounting Theory (Homewood, 111.: Richard 13' Irwin, Inc., 1965), pp. 443'44. 2 Arthur R. Wyatt, A Critical Study of Accountingffor Business 5 (New York: American Insti- C W, Accounting Research Study No. ‘5 Of Certified Public Accountants, 1963), Conclusion No. 6, p. 104. itself determinative."l Another author states that the "established criteria identifying a pooling are subjective and irrelevant for account- ing purposes.2 After discussing the principal criteria, Arthur Andersen & Company conclude: Thus, it can be seen that many of the criteria initially advanced have little practical effect. They were not only unsound and unsupportable from an economic standpoint, but also ill- conceived when related to the intended objectives. In short, because the criteria set forth in ARB No. 48 fail to clarify the concept of a pooling-of—interests combination, the tests for pooling are now so liberally applied that, for all practical purposes, they have eroded to the point where they are no longer determinative. AS a consequence, when accounting for a business combination, management tends to decide on the method which will give the most favorable results. For the moment, the expression "favorable results" will not be ex- Plained.4 From management's point of view, the pooling treatment IJsually has a favorable effect on financial statements in the sense that 1t overstates managerial efficiency in operations and tends to maintain earnings per share at their precombination level. M‘— 1Henry R. Jaenicke, "Ownership Continuity and ARB No. 48," The éflglfigpal of Accountancy, CXIV (December 1962), 63. 2Anelise N. Mosich, one of the conclusions in his dissertation eutiitled "An Evaluation of Purchase and Pooling Concepts of Accounting {1501' Corporate Mergers and Acquisitions," unpublished Ph.D. dissertation, niVersity of California at Los Angeles, 1963. It 3Arthur Andersen & 00., Accounting and Reportinngroblems of the -£E£ES!§g£ing:Profession (2nd ed.; Chicago: Arthur Andersen & 00., October .IS>(5;:>, p. 73. 4Later chapters will expound on this point. .. .. . . .R n. \ Tl.- This view is held by Martin M. Eigen, a financial analyst asso- ciated with Johnson & Johnson. Writing in The Accounting Review, he states, At present, accounting for business combinations is so clouded that almost any treatment may be suitable in a given situation. Because of the variety of interpretations under ARB No. 48, the natural tendency of the companies, if supported by their inde- pendent accountant, is to choose the method which will create the most favorable financial impression. In recent years pressure has been exerted upon the accounting profession to accept the pooling-of-interests treatment for a business combination even when an investigation of the attendant circumstances surrounding the combination, as suggested in ARB No. 48, clearly indi- cates that the event merited purchase accounting treatment. Not only do statistical data show that the pooling-of-interests method is being used in an increasing number of business combination situations, but also some combinations initially accounted for as purchases have been retroactively adjusted to conform to the pooling method. It is interesting to observe how the pooling-of-interests tech- nixlue has expanded over the years. At first it was limited to companies of Irelatively equal size whose stockholders had joined together. Soon M— 1MartinM. Eigen, "Is Pooling Really”Necessary?" The Acgounting 3%, x1, (July 1965), 537. Professor Jaenicke also supports the view bat management tends to decide on the method that creates a more favor- a 19 impression. See Henry R. Jaenicke, "Management's Choice to Pur- ghaSe or Pool," The Agcounting geyiew, XXXVII (October 1962), 765, where 6’ writes that analysis indicates "that management usually has a genuine Egoice of whether to pool or to purchase, and that the choice is made on e: basis of that method which will give the most favorable results." 2H. A. Finney and Herbert E. Miller, Principles of Accounting, I lggtiea edi te (6th ed.; Englewood Cliffs, N. J.: Prentice-Hall, Inc., 65): p. 504. the acquired company began to be smaller, but pooling treatment was allowed; at present the relative size criterion is meaningless and can support a pooling even in tenths of one per cent. The size relation- Ship of the constituents involved in a business combination is commonly referred to as the "relative size criterion." This relationship is the number of shares given to the stockholders of the acquired company, ex- pressed as a percentage of the total number of shares outstanding sub- sequent to the combination.2 Where one corporate party to a combination is quite small in comparison with another (less than 5 to 10 per cent), ARE NO. 48 implies that the transaction should not be regarded as a pooling of interests. Originally stockholders had to promise to retain the stock resulting from the pooling combination, but now they are permitted to sell off up to 25 per cent.3 As a practical working limit on the amount 0f sell-off that could be considered as acceptable and still allow pool- idng treatment for the business combination, the staff of the SEC has E”Stablished the informal "25% rule." Although public accounting firms l'lave the basic responsibility for determining whether a particular com- bidlation is a pooling or a purchase, the SEC also has a keen interest in tile! accounting for business combinations involving registered companies. .A. 1Theodore L. Wilkinson, "United States Accounting as Viewed by iccOuntants of Other Countries," The International Journal of Account- -Jl£§. I (Fall 1965), 9. 2See Wyatt, op. cit., pp. 27-28. 111 3Howard L. Kellogg, "Comments on SEC Practice as to Pooling of De terests," The Quarterly, XI (New York: Touche, Ross, Bailey & Smart, Celube..- 1965), 35. L In determining the permissive accounting treatment for a business combi- nation, Certified Public Accountants now seem to be more influenced by the SEC views regarding poolings than by the criteria set forth in ARB No. 48. It appears that SEC practices as to poolings of interest have become the "generally accepted accounting principles" of the accounting profession. At first the exchange medium had to be entirely in common stock shares; now a significant portion of the payment can be in cash (25 per cent) and the entire payment can be in preference shares, without void- ing the pooling treatment. At first the managements had to be merged into joint managements or boards. Now when small firms are being acquired, the services by officers of the smaller companies on division- al committees of the combined enterprise are deemed sufficient to pro- vide continuity of management. Originally companies had to merge together into one; now the absorbed companies are permitted to survive as subsidiaries. At first ("11y two corporations could pool; later a corporation could pool with a P£trtnership; and now pooling is allowed even for acquiring proprietor- stlips. Possibly pooling soon will be permitted whenever stock is ex- c1Langed for stock, with no other requirements.2 If the present trend of circumventing requirements continues, ultimately even 100 per cent cash acquisitions may be accounted for as poolings of interests.3 __~___‘________ LWilkinson, op. cit., pp. 9-10. 21bid., p. 10. 3See discussion in Chapter III on treasury stock poolings. Two recent pronouncements issued by the Accounting Principles Board of the American Institute of Certified Public Accountants provide additional support for the pooling concept as acceptable accounting practice. The Board believes that AccountingtResearch Bulletin No. 48 should be continued as an expression of the general philosophy for differentiating business combinations that are purchases from those that are poolings of interests, but emphasizes that the criteria set forth in paragraphs 5 and 6 are illustrative guides and not necessarily literal requirements. Treasury stock delivered to effect a "pooling of interests" Should be accounted for as though it were newly issued, and the cost thereof should receive the accounting treatment appropriate for retired stock.2 The first statement changes Bulletin No. 48 so that it conforms nKrre closely with the prevailing accounting practice. The second justi- fisas the pooling treatment on the basis of the issuance of equity shares regardless of their source. Both pronouncements support the pooling—of- interests method even though the test of ownership continuity is dubious Although still vigorously condemned by some accountants, the pooling-of-interests treatment is presently well accepted and widely Used in accounting for business combinations. This is so even when there is every indication that both sound accounting theory and the posi- tiJDII (Jf Bulletin No. 48 have been unjustifiably flouted, especially in _I_‘__‘_~“_____ 1Accounting Principles Board, Opinion No. 6, Status Of Accoun - 1 Age eSe ch Bulleti (New York: American Institute of Certified Public ountants, October 1965), par. 22. concerning the revision of ARE 4 -- 11 Quitness Combinations. The Opinion is published as "Statement in of tie," MW. CXX (November 1965). 54-57. Most e: Criteria as set forth in paragraphs 5 and 6 are stated earlier in t his chapter. 2Ibid., par. 12c. concerning the revision of ARE NO. 43, Cha p ' 1B‘s’l’reasury Stock. the case of combinations involving treasury stock and preferred stock or those involving both cash and shares. Can alternative acquisition and merger accounting practices exist side by side and both be equally acceptable? Do both treatments adequately describe the finanCIal activ- ities of a business enterprise in an understandable manner which is not likely to be the source of misleading inferences” Obviously the financial statements of a business enterprise with a history of combinations will be affected by the consistent application of either the pooling or the purchase technique. The significance of different methods is important because from them stem changes in reported earnings, changes in rates of return on investment, interpreta- tion of financial reports by investors, and other reactions. While there is little empirical evidence on this point, it is hypothesized that the use of the pooling method in accounting for business acquisi- tions and mergers has had favorable effects in recent years on most corporate financial statements. Later chapters will show how pooling has favorable effects on financial statements especially in the sense that it overstates managerial efficiency in operations. It is likely that the manner in which business combinations are recorded has dis- torted many financial relationships, which in turn may have important re pereussions on investor decisions. \_ R. 1This is the goal of acquisition accounting as suggested by Salmonson, "Reporting Earnings After an Acquisition," The Journal F. W. CXVII (March 1964), 54. Combi 2Samuel R Sapienza, "Pooling Theory and Practice in Business nations," The Accountin Revi w, xxxvn (April 1962), 278. 10 The Problem Defined Even when attendant circumstances surrounding a combination clearly indicate the characteristics of a purchase, the accounting pro- fession- -with the sanction of the Securities and Exchange Commission-- has increasingly recorded and reported such a transaction in the pool- ing-Of-interests manner. Conflicting conclusions can be drawn from the application of the criteria mentioned in ARE NO. 48 to any given busi- ness acquisition or merger. Consequently, the decision as to which accounting treatment will be used for the combination transaction is more the result of the subjective attitude of management than the result Of the objective application of the criteria. Furthermore, if economic substance, rather than legal form or tax considerations, is the primary determinant of accounting recognition for the business combination ex- Change transaction, serious doubt exists among many accounting scholars as to whether the pooling-of-interests method satisfies any test of Sound accounting practice. The real problem in evaluating the propriety of Pooling versus purchase accounting is revealed by Professor Wyatt When he writes: The issue here appears to be clearly drawn from a conceptual Has an exchange transaction taken place significant Standpoint. eIIOugh to warrant an accounting treatment consistent with that accorded other exchange transactions, or is the transaction primar- 1y one of form with so little substance that existing accountabil- 1t1es should not be disturbed? In an effort to minimize or eliminate goodwill and other conse- Qu enceS flowing from the application of purchase accounting, businessmen \— 1 Wyatt, op. cit., p. 72. 11 and accountants alike have developed a liberal interpretation of the guidelines in A35 No. 48 and have favored pooling over purchase when- ever possible. As a result, in recent years the pooling criteria have been stretched to the point where many combinations which earlier would have definitely been considered as purchases have been accounted for as poolings. This is especially true for the criteria of relative size, continuity of management, relative voting rights, and sale of securities received in exchange by the selling stockholders. It is also true for recent combinations involving both cash and an exchange of stock which are being accounted for by a method described as "part purchase, part pooling," or simply "partial pooling," representing a distinct change from the previous "all or none" pooling philosophy (full 100 per cent Pooling versus purchase) .1 Considering the varying consequences arising from the applica- tiOn of alternative treatments, is it desirable ethically for the accounting profession to allow companies to choose whichever method (POOIing or purchase) is to their own advantage? Can alternative choices in the area of acquisition-merger accounting equally satisfy the American Institute's notion that alternative principles and practices are accepta- ble if they have "substantial authoritative support?" Are there valid reasons why a business combination effected by the issuance of equity shares (regardless of type or source) should not disturb existing a ccountabilities? At present there is a wide disparity in financial ac c:ounting between the critical conclusions of Accounting Research Study 1 Kellogg, op. cit., p. 34. 12 NO 5, the authoritative position of Accounting Research Bulletin No. 48, and actual practices in accounting for business combinations. Surely research efforts Should be made to determine appropriate practice and to narrow the areas of difference and inconsistency in practice. While most combinations of corporate enterprises are so complex as almost to defy classification under a purchase or a pooling heading, still a reasonable position must be reached to guide the accounting pro- fession in this decision. The existence of radically different account- ing procedures to record essentially similar economic events (business acquisitions and mergers) is especially questionable from the point of View of the financial analyst. Professionally trained to appraise in- vestment opportunities, the financial analyst is concerned with finan- Cial statements, financial relationships, and comparative analyses--a11 A review of 015 Which are affected by the accounting procedure followed. the literature on the subject of business combinations makes it apparent that no one method has yet received unanimous approval. Research is needed to develop a rational approach to combination accounting proce- dureS that results in continuous improvement in and greater comparabil- 113’ Of corporate financial statements. Obviously, a rational approach to combination accounting proce- dUreS should promote sound and informative financial reporting and try to satisfy the Primary purpose of accounting. In this study the basic obj ec-til.ve of accounting will be that as. stressed by Professor Hendriksen that financial accounting should provide the relevant information neces- or the making of various types of economic decisions by interested Par ties outside of the reporting enterpriseuprimarily stockholders, 13 other investors, and creditors. Although much has been written on the subject of accounting for business combinations, one major question remains unanswered. What im t d the lter ati e r ctices ’n cco nt fo bu iness c ui i- tions and mergers have mon conventional financigl statements and in- yestmept analysis? An important test of whether any proposed method of acquisition-merger accounting should be adopted by the profession is whether or not the method will improve the end product, i.e., the finan- cial statements. Unless we have a realistic understanding of the impact of any accounting procedure on the underlying financial statements, we are handicapped in determining its merits. Is there perhaps one best method to record the combining of business enterprises? This disserta- tion will attempt to answer the question. In the business combination area, many accountants seriously doubt whether alternative practices can exist and can be equally accept- able, i.e., faithfully describe the realities of an enterprise's opera- tiofls and financial condition in a fair, understandable manner which is not likely to be the source of misleading inferences. Inconsistencies that are permitted over the long run have no place in acquisition-merger accounting. A single reasonable position must be reached on this issue to 1eSsen the degree of misrepresentation of annual corporate statements. Unless accounting guidelines are established so that the permissive qual- it y is reduced in the selection of the pooling approach or the purchase a PProach’ the usefulness and reliability of financial information \— 1 Hendriksen, op. cit., pp. 81-83. a... ‘6 -c 14 remains ques tionab 1 e . Approgch to the Problem An analysis of the various pooling-purchase treatments used in corporate acquisitions and mergers is presented in Chapter II. The variety of treatments which have been held to be in accordance with "generally accepted accounting principles" are carefully examined to determine the rationale behind their existence. Special attention is given to illustrating how alternative pooling-purchase accounting prac- tices produce widely varying differences in a company's financial posi- tion and earnings. In Chapter III, data on the growth of business combinations are evaluated, with particular emphasis on acquisition and merger activity in the industries selected for this dissertation study-"chemicals, cos- metil—cs, and drugs. Certain trends in accounting for business combina- tiol'ls and the related issue of goodwill are discussed to gain valuable insight into the nature of the problem. Chapter IV is devoted to the methodology followed in the study. A review of two published case studies dealing with the income and asset effects of alternative combination accounting treatments provides The empirical approach to the study explains a cthenient introduc tion. After describing alter- ho w the industries and companies were selected. n atLVe ways of presenting financial statements, the chapter explains how to mparative analysis was made for each of the respective companies. \— Samuel R. Sapienza, "An Examination of AICPA Research Study N 590- 15 The impact of alternative pooling-purchase accounting treatments on conventional financial statements and on investment analysis is ap- praised in Chapter V. Actual comparisons of operating statistics and significant financial ratios for the selected companies are studied to determine the influence of different acquisition-merger accounting methods on financial statement analysis. Significant financial informa- tion is discussed to find out what effect the use of alternative com- bination methods actually had on the presentation and interpretation of corporate financial statements. The study concludes in Chapter V1 with a summary of the find- 1ngs, some conclusions, and a statement of a reasonable approach to cambination accounting procedures that promotes sound and informative financial reporting, that narrows the areas of difference and inconsist- ency in practice, and that provides greater comparability in corporate financial statements . Throughout this study one guiding principle is followed: 152g;- kc 1 Consistency rather than "substantial authoritative support" should dictate the interpretation of exchange transactions and accounting pro- cedures adopted for recording such transactions. Without this goal, accounting information of specific entities would lack even the nominal SenSe Of objectivity and usefulness, for the comparability and signifi- cance Of a series of successive financial statements over time would be destrOYed. Mbre specifically, the above guiding principle involves con- 813 tent application of accounting principles. It is taken to mean com- Par ahility in the manner of recording and reporting events relating to 16 various exchange transactions of a single firm. Such a requirement is necessary for effective communication of dependable and significant in- formation to stockholders, creditors, and other persons having bona fide interests in the reporting enterprise. From year to year it adds great- ly to the usefulness and comparability of financial statements for a specific entity.1 Although the concept of consistency does not imply comparability among independent entities, uniformity in the application of accounting principles by different firms in one industry and, to the extent practi- cable, by companies in various industries is also a desirable standard. If financial statements are to possess validity and usefulness, account- ants should make every practical effort to adopt accounting principles and reporting standards which facilitate comparisons among enterprises. For example, if accountants support the principle that asset transactions should be recorded at cost of acquisition, then for a SPeCific business entity arbitrarily to record a transaction involving assets at cost at one time and to record a similar transaction at more or less than cost at another time spells inconsistency. If an account- ing Practice contradicts logical reasoning, it should be carefully weighed before being accepted. This especially holds true for combina- t ion accounting practices. But on what basis should the inconsistent application of an a ccounting principle be judged? For purposes of this study, four basic \— leg 1Paul Grady, Inventory of Generally Accepted Accounting Princi- MBusiness Enterprises, Accounting Research Study No. 7 (New ‘ merican Institute of Certified Public Accountants, 1965) , pp ‘ 31-32. 17 standards-“relevance, verifiability, freedom from bias, and quantifia- bility--sha11 be used as criteria in evaluating the acceptability of alternative accounting methods.1 Thus, the study will attempt to fOllow the principle of logical consistency in accounting for business combination transactions. But the ultimate adequacy of any acquisition- merger accounting practice that violates this consistency principle will be judged on the basis of these four criteria to improve measurement and comunication techniques in accounting for business combinations. \ Went 1American Accounting Association Committee to Prepare a State- Ame on Basic Accounting Theory, A Stgtement of Basic Accounting Theory Sion:1can Accounting Association, July 1966), pp. 7-13. The conclu- New ACOf this statement are summarized by Charles T. Zlatkovich in "A Auguscounting Theory Statement," Thg Journgl of Accountancy, CXXII t 1966), 31-36. CHAPTER II TYPES OF COMBINATION ACCOUNTING TREATMENTS mm Before evaluating the effect of alternative pooling-purchase accounting treatments on corporate financial statements, one should understand the existing methods of accounting for business combinations. AS indicated in Chapter I, a business combination falls into one of two categories for accounting purposes: a purchase or a pooling of inter- @5113. But under each category a variety of accounting practices are aCCePted and some acquisition-merger practices overlap into both categories. For the moment no attention shall be given to the reasoning underlying the difference between a purchase and a pooling of interests. InStead the study develops working knowledge of the variety of combina- tion accounting treatments which have been held to be in accordance with I 'generally accepted accounting principles." This chapter will show that accountants themselves are not certain of the distinction between a pur- Chase and a pooling. Finally, a discussion of these alternative pooling- PurchaSe practices is extremely important in setting the stage for the d etafled analysis of later chapters. 18 19 Purchasing and Pooling Fundamentals If one corporation acquires the net assets or capital stock of another corporation for cash or cash equivalent (which includes debt instruments such as notes and debentures) or a combination of cash and securities (where the stock portion of the acquisition is insignifi- cant), accounting practice generally requires the purchase treatment. Accountants' early views on the subject of business combinations indi- cate that exchange media such as nonconvertible preferred stock or recently acquired common treasury shares also satisfied the concept of cash equivalent. A quotation from a recent New York Stock Exchange listing application serves to explain important details concerning the purchas e me thod . The investment of the Company in Standard will be recorded in the accounts of the Company as a purchase. The total aggregate consideration to be paid by Cenco will be ’No Million Dollars ($2,000,000.00), one half of which shall be paid in cash. The balance of One Million Dollars ($1,000,000.00) being paid in Cenco COmmon stock approximates the aggregate value of the 28,684 shares to be delivered determined by reference to the closing price of such stock on the New York Stock Exchange on the date the contract Was executed. The capital account will be credited with $26,484.00 (the par value of the Cenco shares); the treasury stock account Will be credited with $65,165.00, the cost of the treasury shares, and additional paid-in capital will be credited with the excess of the fair market value of the Cenco shares over (i) the par value of the 26,484 shares to be issued and (ii) the cost of the treasury Shares. This accounting treatment has been approved by the Com- Pany's auditors, Seidman 5: Seidman, as being in accordance with generally accepted accounting principles. The amount of the nVestment in excess of the book value of the net tangible assets at Standard will be treated in consolidation, as an asset termed c3ost in excess of book amount of net tangible assets of businesses acquired." The amount charged to "cost in excess of book amount of net tangible assets of businesses acquired" will not be amor- 1iized, so long asi in the opinion of management, its value is eing maintained . \— 1 Cenco Instrtmtents Corporation, NYSE Listing Application 20 A summarized accounting entry to record Cenco Instruments' acquisition of Standard X-Ray Company is presented below. While this particular acquisition is not a typical purchase, it was selected for illustrative purposes to Show how various types of consideration (such as cash, unissued shares, and treasury acquiring another company. Current assets . . . . . . . . . . . . Property, plant and equipment--net . Other assets . . . . . . . . . . . . . Excess of cost over book value . . . . Current liabilities . . . . Cash . . . . . . . . . . . . 'Treasury stock--cost . . . . Common stock--par . . . . . Paid-in capital in excess of shares) may be used jointly in par value $1,036,169 69,335 20,445 1,089,688 $ 215,637 1,000,000 65,165 26,484 908,351 ‘The underlying interpretation for this accounting treatment is: When a combination is deemed to be a purchase, the assets acquired should be recorded on the books of the acquiring corpora- ‘tion at cost, measured in money, or, in the event other considera- tion is given, at the fair value of such other consideration, or at tile fair value of the property acquired, whichever is more clearly (Evident. This is in accordance with the procedure applicable to accounting for purchases of assets. Under the purchase treatment a new basis of valuation for the net Elssets is established, and there is no transfer of the acquired cor- PoraIELOn}s retained earnings to the surviving company's position state- ment , ‘Typically, the value assigned to the shares given as considera- tion 18 based on the average or closing market price of such stock on or \— No. l\ ~22840, November 1, 1965, p. 1; concerning the acquisition of the c Sagital stock of Standard X-Ray Company for $1 million cash, 26 ,484 res unissued common stock, and 2,200 common treasury shares. R9863 1American Institute of Certified Public Accountants, Accounting _.‘..§EEE§HIBu11etin;NQ, 48 (January 1957), par. 8. 21 near the date of agreement between the constituent corporations. To the extent that the purchase cost is not allocated to tangible assets and intangible assets, such as patents or trademarks, there is goodwill, more commonly termed "excess of cost over value assigned to net tangible assets acquired." This excess of purchase cost over amounts allocable to specific assets is dealt with generally in one of three ways. 1. written off immediately against either paid-in capital or retained earnings. 2. .Amortized by systematic charges in the income statement over a period of years. 3. Carried at cost as an asset on the balance sheet, so long as its value is being maintained. Three quotations serve as illustrations of these alternative Practices . u ch e--I edi te W ite-off of xcess On June 12, 1953, the Company entered into an agreement to [Nirchase all of the issued and outstanding shares of capital stock (Jf J. B. Roerig and Company, J. B. Roerig and Company, (Canada) lbindted, and J. B. Roerig International Company for an aggregate thrice of $6,000,000, subject to certain terms and conditions. In accordance with its established practice of stating intangibles 81: a nominal value the Company has charged to earnings retained and employed in the business an amount of $5,070 ,400, represent- 1113 the excess cost of its investment in the aforementioned sub- 8tidiaries over the amount of net tangible assets [at book values] of such subsidiaries, at date of acquisition, July 31, 1953.2 \— 1It should be emphasized that since AR; No. 4;, Chap. 5, issued acc , this particular practice has not been considered acceptable Dunting. 2 801 Chas. Pfizer & Co., Inc., 1 ort 1953, "Notes to Con- ida.ted Financial Statements," Note No. 7 (page not given). 22 Purchase--Systematic Amortization of Excess The transaction will be accounted for as a purchase in the consolidated financial statements of the Company. The excess of the purchase price (determined on the basis of the market value of the shares issued) over net book value of the assets acquired will be allocated to Research and Development and other intangi- ble assets, and will be amortized over various periods not in excess of five years. The Company's independent accountants, Peat, Marwick, Mitchell & Co. have reviewed and approved this accounting treatment as being in accordance with generally accepted accounting principles.1 Purchase--Excess Carried as an Unamortized Asset Goodwill increased from $755,468 to $4,497,243, representing the goodwill of the new businesses purchased during 1955. Revised accounting rules require that any write-off of purchased goodwill at time of acquisition be made against current earnings and not against surplus. Ybur management is of the firm opinion that purchased goodwill is not a proper charge against current earnings and, thereforeé is electing to carry the item as an asset on the balance sheet. It should be stressed that each of these ways of handling good- will in an acquisition has a different effect on the financial state- ments. The net effect of the immediate write-off treatment is to aCCCHInt for the assets acquired as if the business combination were a Pooling of interests. The purchase treatment with systematic amortiza- tion by charges to income usually has a material effect on both the in- come statement and the balance sheet, while the "purchase without amor- tizatilon" method has its greatest impact on the balance sheet. \— 06 11‘31ectrmmlc Specialty 00-. NYSE Listing Application No. 71-22906, t tOber 21’ 19652 P- 1; in connection with the acquisition of the prOper- y aura assets of Syntorque Corporation for 4,000 shares common stock. Cash, 2Standard Brands, Inc., Annual Report 1955, p. 4; concerning the Pany acquisitions of Animal Foundation, Inc., Old Trusty Dog Food Com- the ’ Best Yeast Limited, and Dr. Ballard's Animal Foods Limited during Partiear of 1955. This quotation was especially chosen to show how one Purcqlclllar company's management feels on the subject of accounting for as'i‘d goodwill. 23 Furthermore, these alternative ways of handling acquisition goodwill have differing effects on some financial ratios. Chapter V discusses the impact of these alternative methods on corporate financial state- ments and investment analysis. In those cases where one corporation acquires the net assets or capital stock of a company in exchange for voting stock, accounting practice allows either the purchase or pooling-of-interests treatment. Various quotations serve to illustrate this point and explain important details concerning the alternative methods. Acguisition of Net Assets for,Common Shgres--Purch§se Treatment Red Owl intends to treat the acquisition of Foodtown's net assets as a purchase for accounting purposes. Accordingly the investment will be recorded at cost measured by the approximate fair value (at date of agreement specifying number of shares to be paid as full consideration) of the 105,592 shares of Red Owl (Sommon Stock to be issued, $20.00 per share or $2,111,840. It is estimated that such fair value will exceed the recorded book ‘value of net assets to be acquired from Foodtown at the closing 1flate by approximately $170,000; this excess will be allocated, if Shipportable by appraisals or other evidence, first to specific (iepreciable assets and the balance will be designated as goodwill Eiubject to amortization or charge-off only in the event of evi- (ience of diminution in value. . . . Peat, Marwick, Mitchell & CM3., independent certified public accountants, have reviewed and iipproved the above described treatment as bein in accordance Vvith generally accepted accounting principles. Ac i of e sse fo Commo Shar -- 01 e t For accounting purposes, the exchange of shares of the Com- Pany's Common Stock for substantially all the net assets of Chesterton is to be treated as a pooling of interests. .Accord- ing, the assets, liabilities and surplus of Chesterton will be c£irried forward without change into the consolidated financial \— Feb 1Red Owl Stores, Inc., NYSE Listing Application No. A-23086, Supzuary 4, 1966, p. 1; in connection with the acquisition of Foodtown r Markets, Inc., for 105,592 shares common stock. 24 statements of the Company. The excess of the stated value of the shares of Common Stock of the Company to be issued over the stated capital of Chesterton will be charged to capital surplus to the extent thereof, and the balance will be charged to retained earn- ings. This treatment has been reviewed by the Company's auditors, Peat, Marwick, Mitchell & Co., and approved as being in accordance with generally accepted accounting practice. Acgui§ition of Capital Stock for Common ShareS‘-Purchase Treatment With respect to the Rexall stock to be issued in exchange for the capital stock of Albert, the amount to be credited to the capital stock account will be the number of shares times the par value per share ($2.50). The amount to be credited to the paid in capital account will be the difference between such aggregate par value and the total fair market value of the 11,000 shares of Rexall stock taken at $42.125 per share, the closing price of Rexall shares on the New YOrk Stock Exchange on September 30, 1959, the date of the agreement between Rexall and Albert. The excess, if any, of the fair value of the Rexall shares issued (taken at the aforementioned $42.125 per share) over the fair market value of the underlying net assets of Albert will be treated as an intangible. It is the present policy of Rexall not to amor- tize such intangibles until such time as it becomes evident that their term of existence has become limited. Rexall's independent accountants, Price waterhouse & Co., Los Angeles, California, have reviewed and approved the above described accounting treatment as being in accordance with .generally accepted accounting principles.2 AC lxisition of Ca ital Stock or Common Sha e --Pool ‘T eatment For accounting purposes, the Company and F. W. LaFrentz & Co., independent public accountants, who regularly audit the books and éiccounts of the Company, deem this acquisition to be a "pooling of iJIterests." F. W. LaFrentz & Co., has reviewed and approved this 'treatment as being in accordance with generally accepted accounting Principles.3 \\—.— 0c 1Beatrice Foods Co., NYSE Listing Application No. A-2284l, CatIHJer'll, 1965, p. l; in connection with the acquisition of Chesterton ndy Company, Inc., for 100,838 shares in common stock. A‘1847 2Rexall Drug and Chemical Company, NYSE Listing Application No. t e ‘4“ October 7: 1959, p. l; in connection with the acquisition of all of coutstanding shares of Albert Tool 5: Gage Co., Inc., for 11,000 shares apital stock. 3Chas. Pfizer & Co., Inc., NYSE Listing Application No. A-20999, 25 Under the pooling-of—interests method, the acquired company's assets and retained earnings are generally transferred to the records of the acquiring unit at the acquired company's book value. A simple cross-addition of accounts, except for minor adjustments that may be required to bring about uniformity of accounting procedures and proper presentation of legal capital accounts, becomes the basis of accounta- bility for the business combination transaction. An example of this combining procedure is seen in the proxy statement of Bristol-Myers Com- Pany which is reproduced in Exhibit 1. Based on the information in this exhibit, a summarized account- ing entry to record Bristol-Myers' acquisition of the Drackett Company is Presented thus: Current assets . . . . . . . . . . . - - $17,063.034 Property, plant and equipment--net . . . . . . . 9,104,740 Intangible assets . . . . . . . . . . . . . . 4,261,228 Current liabilities . . . . . . . . . . . . . . $ 8,021,102 Other liabilities and minority interest . . . . . 1,114,163 Common stock-"par value . . . . . . . . . . . . 2,017,391 2,923,286 Capital in excess of par value of stock . . . . Retained earnings . . . . . . . . . . . . . . . 16,353,060 The above intangible assets of approximately $4.3 million do not r13present purchased goodwill; they are the cost of patents, trade- marks ’ and other intangible assets on Drackett's books prior to the co"mil-nation. The fair market value of the shares of stock which Bristol- Myet“ £§ave in the exchange approximated $150 million, or about $128.7 millir>r1 greater than the book value amount at which they were accounted \— Mar ch 28: 1963, p. 2; in connection with the acquisition of the outstand- in 3 Shares of Desitin Chemical Co., Inc., for a maximum of 220,653 shares Of CO (3t! stock. 26 Exhibit 1 BRISTOL-MYERS COMPANY ‘ THE Ducxarr COMPANY Unaudited pro forma combined balance sheet March 31, 1965 ASSETS Pro forma adjustments Pro forma Bristol. Dr. (Cr.) balance Myers Drackett (Note 2) sheet CURRENT ASSETS: ' 3 9 299 398 8 3 I98 863 3 12 498 261 fi'if'ial‘iilmifir‘ifii'.” '.'.'.'.'.I'.'.'.I'.'.'. ........... 26.931.283 1.542.553 28,473,836 ' ' unt ' “filmi‘oJfifi‘Ji “323,133 28???? .‘.°.'. 932°. . . .’ 34,555,556 4.019.354 38.575.110 Inventories .................................. 23,804,953 6,947,018 30,751,971 Prepaid expenses ............................. 2.497.788 1.355.046 3.852.834 Total current assets ............... 97,088,978 17,063,034 w Oman Assars: - ° Investments in and advances to unconsolidated subsidiaries less reserve of 52,065,000 ........ 12,127,805 12,127,805 Miscellaneous investments and sundry assets ..... 2.741.681 2,741,687 14,869,492 14,869,492 Paoraarv.PuNr mo Eourruzm', at cost less depreciation 33,230,175 9,104,740 42,334,915 GOOOWILL. T sane-Mans, Om: MANOIBLES ...... 20,805,224 4,261,228 25,066,452 ‘ 316529.239 33.014.22.202. --..._,_.,._.—_ , 21.22.1233; I. l A B I L l T l E S Gunsm- Lusrtrrras: - Notes and accounts payable .................. . 5 7,268,263 5 4,466,221 5 11.734.484 Accrued liabilities ............................ 23,586,843 1,048,452 24,635,295 U. S. and Canadian taxes on income ............. 15.0413 56 2,506,429 17,542,181 Total current liabilities ............ 45,898,462 8,021,102 53,919,564 Oust-1a Luann-res: Deterred U. S. and Canadian taxes on income . . . . 2,143,723 101,205 2.244.928 Miscellaneous ............................... 1.865.557 349.771 2.215.328 4,009,280 450,976 4,460,256 Lone-Team Dear: . Long-term loans and instalments ............... . 500,000 ~ 500.000 Twenty year 3% debentures. due April 1. 1968 . . . . 1,068,000 1,068,000 Twenty- ve year 335% debentures, due June 1, 1977 2,975,000 2,975,000 4,043,000 500,000 4.543.000 Mmoamr lair-2am .............................. 163,187 163,187 STOCKHOLDERS EQUITY Carma. Srocrt: Bristol-Myers Company: Preferred stock ............................. 4,200,000 ' 4.200.000 Common stock ............................... 10,537,304 (2,017,391) 12,554,695 The Drackett Companycommon stock ............. . 4,385,634 4,385,634 Curran as Excess or Part VALUE or Srocx .......... 14.689.742 555,043 (2,368,243) 17.613.028 Ramuao EARNING! .............................. 83,985,952 16,353,060 100,339,012 Deduct—cost of treasury preferred stock ....... 'l.369.871) (1.369.871) - 2.043.127 21,293,137 — 133,336,864 3: =155,993,369 5 30,429,002 _:____ 3:: 929-4313“ Horas: ' l. Pamcrrtas or Pao Foam Couaman anca Sueer: The accompanying pro forma combined balance sheet reflects the combining of the unaudited consolidated balance sheets of Bristol-Myers Company and North American subsidiaries and of The Drackett Company and subsidiaries, , both as of March 31. 1965, in a “pooling of interests," giving effect to the transactions described in Note 2 below. Such statement should be read in conjunction with the other financial statements and notes thereto of the constituent com- panies appearing elsewhere herein. 2. ho Fours Anwsrnanrs: The pro forma adjustment is based on the issuance of 46 shares of Bristol-Myers Common Stock for each 100 shares of Drackett Common Stock outstanding as provided for in the plan for acquisition of The Drackett Compan as set forth elsewhere herein. The excess 01 the Drackett Common Stock account over the par value 01 the Bristol. yers shares to be issued is credited to Capital in Excess of Par Value of Stock. - 27 for.1 If purchase accounting had been accorded this exchange transac- tion, the $128.7 million excess of market over book value would have been apportioned to tangible and intangible assets. Without expressing any judgment as to the propriety of the pooling treatment accorded this combination, a summarized entry as if purchase techniques had been fol- lowed is given. Current assets . . . . . . . . . . . . . . $ 17,063,034 Property, plant and equipment--net . . . . . . . 9,104,740 Intangible assets . . . . . . . . . . . . . . . 4,261,228 Excess of cost over book value . . . . . . . . . 128,706,263 Current liabilities . . . . . . . . . . . . . . $ 8,021,102 Other liabilities and minority interest . . . . . 1,114,163 Common stock--par value . . . . . . . . . . . . . 2,017,391 Capital in excess of par value of stock . . . . . 147,982,609 It is interesting to note that this "excess of cost over book value" is greater than the book value of Bristol-Myers stockholders' equity ($112 million) prior to the business combination and more than four times as great as the combined net income of the companies in 1964 ($28 million). This example alone illustrates one important aspect of the purchase treatment, i.e., the problem of accounting for the differ- ence between purchase cost and book values of assets acquired. In short, the pooling concept pretends that the constituent companies were affil- iated prior to the combination and carries forward at net book value assets of the disappearing company in the combined enterprise, thus 1In this example the value of the shares given as consideration is based on the closing market price of such stock on or near the date of the agreement between the constituent corporations. A review of many stock listing applications over the span from 1954 to 1965 shows that this particular method of valuing shares under the purchase treatment is a prevalent one. Throughout the study this valuation technique shall be used extensively (see Chapter IV). 28 eliminating the problem of recording the excess and assigning it to specific tangible and intangible assets or goodwill. "The pooling method serves as a convenient means of keeping large amounts of goodwill and other intangibles off the balance sheet in the acquisitions and mergers of going concerns. If the fair value of the assets acquired in a business combina- tion is greater than book value (which is the usual case), the purchase treatment is especially disadvantageous from management's point of view for a number of reasons. 1. The recording of the acquired assets at higher values often necessitates larger depreciation and amortization charges in the income statement, resulting in lower reported net incomes for several years. 2. If the combination is a "tax-free reorganization" (the usual case where an exchange of stock is involved), then the extra depreciation and amortization charges are not deductible for income tax purposes. 13.. Because purchasing eliminates the retained earnings of the acquired corporation, it thereby reduces the amount available for dividends out of accumulated income although the legal amount available may not be altered.1 Some business enterprises do use the purchase method even when Siz«able amounts of goodwill and other intangibles result and the acqui- sitirnrr is effected solely by the issuance of equity shares. An out- Stanliinng example of such an enterprise is the Borden Company, which followed the purchase-without-amortization method for the stock acquisi- t ions of Krylon, Inc., Ozon Products, Inc., and Columbus Plastic \— D. I 1Eldon S. Hendriksen, AggguntingJZhegry_(Homewood, 111.: Richard min, Inc., 1965), p. 443. 29 Products, Inc., in January and February of 1966. Exhibit 2 illustrates the combining procedures for Borden's acquisition of the prOperty and a specific business combination which qualified assets of Krylon, Inc., mi"tax free" under the provisions of the Internal Revenue Code. Based on the information in this exhibit, the accounting entry for this purr chase transaction is presented. . . $ 3,058,000 Current assets . . . . . . . . . . . Property and equipment--net . . . . . . . . 1,232,000 Deferred charges and intangibles on Krylon's . 195,000 beaks I O O O O O I I O O O O O o O I I Excess of cost over book value . . . . . . s o o o $ 1 , 614 ’000 Current liabilities . . . . . . . . . . Reserves on Krylon's books . . . . . . . . . . . . 24,000 Capital stock--par value . . . . . . . . . . . . . 919,000 Capital surplus . . . . . . . . . . . . . . . . . 10,106,000 . . 8,178,000 The excess of the fair value of the capital stock of Borden iSSued over the net assets of Krylon, according to Exhibit 2, was added t0 Inbrden's balance sheet intangibles account. Generally, this excess is reatained on the firm's books as an intangible asset not subject to amortzzization until such time as it becomes clearly evident that its Vallle! is diminished. The following schedule of intangible assets on BOrder-1's consolidated balance sheet during the period 1958-65 reveals that: ‘tire excess of purchase price over value assigned to net tangible assets of businesses acquired (for corrrnon shares and/or cash) is being c arried on the balance sheet as an unamortized asset. \— A‘ZBC) 1The Borden Company, NYSE Listing Applications No. A-23029, No. 89 . and No. A-23105; respectively dated 1-3-66, 1-10-66, and 2-2-66. Incou, 2Krylon, Inc., Proxy Statement dated Nevember 1, 1965, "Federal must: Tax Consequences of the Plan," p. 6. For a description of what 1:L‘ltes a tax free exchange, see Secs. 354 and 368 (a)(1)(C) of the Inte rTIEII- Revenue Code of 1954, as amended. '30 Bxhi bit 2 xenon. INC. AND SUBSIDIARY COMPANY THE BORDEN COMPANY AND CONSOLIDATED SUBSIDIAnIss . UNAUDI'I'ED PRO FORMA COMBINED CONDENSED BALANCE SHEET July 31, 1965 (In Thousands of Dollars) A S S E '1‘ S Krylou Borden Cumur Assers: Cash ........................................................ 3 223 $ 39,085 Marketable securities—at cost, which approximates market value: United States Government ................................ -— 3,963 Other .................. . ................................. — 19,886 Receivables: Trade .... ................................................ 1.416 129,638 Due from unconsolidated foreign subsidiaries .............. — 2,371 Other ................................................. .. . 36 3,797 Less reserve ............................................. (31) (4,246) Inventories : - Finished goods .......................................... 882 89,240 Materials and supplies ...... . ............................ 586 43,226 Other ............... . ........................................ 2 1 — Total current assets ............................. 3.133 326,960 I""‘rfllzmrs ans Orrin Assn-s: U'|¢=t‘.)rrsolidatctl foreign subsidiaries—at cost .................. — 14.551 Unconsolidated domestic subsidiaries—at cost ..... -— Loo: Fifty-” cent owned companies—at cost ........ ....... ....... - 1.329 Securities on deposit (pursuant to workmen's compensation laws, etc-)~at cost ............................................. . —- 1.804 'Mmages. receivables. etc. (less reserve) ..................... — 12.369 hem AND EQUteusur—At cost: 14""! and mineral deposits ................................... :9 20.842 - Bm'dinas ....................... . ........................... 674 146,427 ' Mtachiflel’y, equipment, etc. . . . . . . . . . .. ........................ 990 301.175 ’ ‘CCumulated provision for depreciation .................. (471) (201.307) D? C uaacas: T I” discount and expense - 1,446 m’o rents, insurance, etc. .................................. 71 6,625 , In areal-Lassl’rincipally at cost . . . . . . . . . . . . . . . . .. ............... 124 65,057 Tom. ........ .. . .............................. 8 4,560 $698,279 Pro Forrna Ad ustments ate 2 Dr. (CL) S( 75) See Notes to Unaudited Pro Forma Combined Condensed Balance Sheet. Pro Forma Combined s 39.213. 3.963 19,886 131,054 2,371 3.833 (4.277) ”.122 43,812 21 330,018 14.551 1,001 1.329 1.804 _ 12.369 11.881 147.101 ”2.165 (201.773) 1.446 6.696 73,359 $710,942 ' 31 Exhibit 2 (cont.) KRYLON, INC. AND SUBSIDIARY COMPANY THE BORDEN COMPANY AND CONSOLIDATED SUBSIDIARIES UNAUDITED PRO FORMA COMBINED CONDENSED BALANCE SHEET July 81, I965 (In Thousands of Dollars) L I A B I L I T I E S Pro Forma Ad‘ustments ote 2 Pro Forma , Krylon Borden Dr. (CL) Combined Cuaasnr LIABILmsS: Notes payable: Bank ................................................. .. .. s 250 ._ — s 250 Unconsolidated foreign subsidiary .............. - ........... -— 8 2.799 2.799 Accounts payable: - Trade a s sssssssssssssssssssss a aaaaaaaaaaa a s ssssssssssssss 786 ”.939 —’ 51.725 Other . . .............................................. -— 9.446 — 9.446 Accrued accounts: , - Taxes ............................................ 345 31,414 — 31.759 Payroll: andoommissions ................................ 100 12.565 — 12,665 Interest .............. . .................. -— 1,067 — 1,067 otm sssssssssssssss a sssss a o a o a sssssssssssssssssssssssss 133 7.930 — 8.063 Total current liabilities . . . . . . . . . . . .: ............. 1.614 116.160 -- 117.774 “NB-Tun Dear: . 275% debentures, due 1981 ................................... — 38.745 — 38,745 496% debentures. due 1991 .................................. . . -— 50.000 _ — 50,000 85% notes. dueI981 ............ —- 11.200 — 11,700 3%?!- note, due 1973 ......................................... — 950 — 950 R330": : . ‘ Deferred Federal taxes on income ............. . .............. 24 23.709 —- 23.733 IInns-231cc, etc. ....... . ....................................... - 7.899 — 7.899 s”‘i‘lflflmlnas' Egurrv: The Border: Company: capital stock—par value $3.75 per share: ‘ Authorized 32,0001!” shares ‘ Borden Pro Forma Issued ............... 24.9%.506 shs. . 25,225,506 shs. Less Treasury Stock . . 139,040 shs. 139.040 shs. Outstanding ......... 24,841,466 shs. 25,086,466 shs. — 93.155 8 (919) 94,074 cmnmon Stock—without par value ....... . ............... 368 — 368 ._ E'nPIOyeess stock purchase instalments ........................ -— 9,627 9.627 SWPIIIS : C-vitas ................................................. — 8's.sss (10.106) 95.691 E‘rned .. .. ..... . ...... . . . . .. ........................... . 2.554 260,749 2,554 260,749 Tour. ............... .. ........................... 3 4.560 3698.279 3 (8.103) 3710.942 ' = .See Notes to Unaudited Pro Forma Combined Condensed Balance Sheet. 32 For year ending Amount classified December 31 as intangibles 1958 . . . . . . . . . . . . . . . $ 1,370,715 1959 . . . . . . . . . . . . . . . 2,753,457 1960 . . . . . . . . . . . . . . . 4,809,041 1961 . . . . . . . . . . . . . . . 10 , 970 ,182 1962 . . . . . . . . . . . . . . . 21,335,455 1963 . . . . . . . . . . . . . . . 39,081,703 1964 . . . . . . . . . . . . . . . 64,109,766 1965 . . . . . . . . . . . . . . . 87,698,396 Some Unique S ituat ions No discussion on existing pooling-purchase accounting methods would be complete without an explanation of three unusual situations which have come to be described as (1) partial-pooling treatment, (2) bargain purchase, and (3) retroactive pooling. The Partial-pooling Treatment In those cases where the acquiring corporation gives up a signi" f1icant amount of cash or cash equivalent (such as notes and debentures) as Well as appropriate equity shares, accounting practice generally ques- tions using the pooling-of-interests treatment for the entire transac- tion- But the profession does allow either (1) purchase accounting for the entire transaction, or (2) purchase accounting for the cash portion and Pooling accounting for the stock portion. This second treatment, cmumolf‘lly referred to as a partial pooling, has come to be accepted in a wide Variety of combination situations. Example A. Diamond Alkali Company acquired 40% of the shares of Harte 5: Company, Inc., in May 1962 for cash. In September 1965, Diamond ac Quit—ed the remaining 60% of Harte's outstanding shares in exchange for 33 95 000 shares of $4.00 convertible Preferred Stock--Series B. Since the 1962 transaction was treated as a purchase and the 1965 transaction was treated as a pooling of interests, the entire combination arrangement was in effect a 40-60% partial pooling.1 Example 13. Emhart Corporation used the pooling-of—interests method for the 45% minority interest acquired in its January 1966 merger with Plymouth Cordage Company. The 55% interest was represented by Plymouth stock previously acquired and held by Emhart which had been treated for accounting purposes as a purchase. Thus, the combination was essentially a 55-45% partial pooling-“that is, 557. purchase, 45% POOIing treatment. Furthermore, the 55% portion was a "bargain pur- Chase," since the excess equity in net assets of the 557. purchased over the related cost was $1,312,444. This amount is being amortized by CrEdits to income over a ten-year period commencing with the year 1963 Example C. EVans Products Company acquired the capital stock of Rand Acceptance Corporation for 34,500 shares of common stock (adjusted f°r a 3-to-2 stock split). At the same time EVans acquired the assets and businesses of each of three enterprises affiliated with Rand for $8,224 ,000 cash. The acquisition of Rand was accounted for as a pooling of interests, while the concurrent acquisition of the three affiliates W as re'230rded as a purchase. \— 1Diamond Alkali Company, Aflgl gggogt 1965, "Notes to 1965 F1 Dane 181 Statements," Note 1, p. 38. Janna 2Emhart Corporation, NYSE Listing Application No. A- 23040, Cord ry 10,1966, pp. 1- 2; in connection with the merger of Plymouth a8 8e Company into Emhart Corporation for 327, 783 shares common stock. 313vans Products Company, NYSE Listing Application No. Ac22902, 34 Example D. Celanese Corporation of America acquired the OWner- ship equity of two corporations in November 1964, whose principal asset was the outstanding stock of Federal Enameling & Stamping Company, for 241,700 shares of common stock. Celanese Corporation also issued 58,779 shares of common stock for the acquisition of certain fixed assets em" ployed in the business of Federal. The exchange of common shares was treated as a pooling, while the acquisition of the fixed assets was given purchase treatment.1 The earliest partial poolings were transactions in which the combination was arranged through different procedures or steps. If there was a time interval between the cash purchase and the exchange of equity shares, accountants supported the theory that the "combination" really occurred at the later date. They concluded that the original cash investment should be accounted for as a conventional purchase; however, the exchange of stock could properly be accounted for as a pooling of interests, assuming other pooling characteristics were present. Because of this time interval factor, the pooling treatment fOr the last step'in the acquisition process was considered an accepta- ble accounting practice and not a violation of the ownership interests "Philosophy" as quoted here. M No‘Vendaer 29, 1965, p. l; in connection with the acquisition of Rand ‘Acceptance Corporation for 34,500 shares common stock (after 3-for-2 StoCksplit) and three affiliated enterprises for cash consideration of $8.224,ooo. 1 1Celanese Corporation of America, Prospectus dated March 11, 966:-"Notes to Financial Statements," Note 1, p. 32. 35 For accounting purposes, a purchase may be described as a busi- ness combination of two or more corporations in which an important part of the ownership interests in the acquired corporation or cor- porations is elhminated or in which other factors requisite to a pooling of interests are not present. Accountants have gradually shifted their position on this point. They now conclude that a time interval between the cash purchase and the exchange of stocks is not a necessary condition of a partial pool- In effect, both purchase and pooling accounting techniques can be ing . There applied in a single cash-stock business combination transaction. are known cases in which the pooling portion of a single transaction has been as little as 28 per cent. Obviously, this practice is incom- patible with the ARB No. 48 position that a purchase is present when an important part of the ownership interest in the acquired corporations is eliminated. The following quotation from a recent NYSE Listing Application is an excellent illustration of a partial pooling effected in a single transaction that successfully removed a significant amount of intangible assets from the consolidated balance sheet. The transaction was accounted for as 78% "pooling of interests" and 22% "purchase" based upon the percentage relationship of the <-‘-losing price of Mid-Continent's common shares on September 24, 1 965, (the last trading day prior to the date of the Agreements) and the cash consideration included in the purchase. . . . In cOnsolidation, 78% of the intangible was charged to capital surplus and 78% of C.T. & N. 's earned surplus was brought forward in con- 8Cltlidated earned surplus. The accounting treatment as outlined \— l REL-am ch Bulletin No. 48 (January 1957), par. 3- 2Howard L. Kellogg, "Comments on SEC Practice as to Pooling of Int Decgists." W. XI (New York: Touche, Ross, Bailey 5: Smart, e1- 1965), footnote 5, p. 39. American Institute of Certified Public Accountants, Accounting 36 has been reviewed by Lybrand, Ross Bros. & Montgomery, Mid- Continent's independent accountants, and meets their approval as being in accordance with generally accepted accounting principles.1 Another interesting example of a single transaction partial pool- ing is Witco Chemical Company's acquisition of Argus Chemical Corpora- tion in February 1966. Exhibit 3 presents the balance sheet pro-forms summary and adjustments for this business combination based on financial information reported to the shareholders of Witco in a proxy statement dated January 25, 1966. USing the proxy statement figures, here is a Summarized accounting entry for the 55% purchase-45% pooling treatment as recorded on the acquiring firm's books. Current assets . . . . . . . . . . . . . . . . $3,584,900 Investments and other assets . . . . . . . . . . 1,218,900 Property, plant and equipment-met . . . . . . . 2,710,200 Excess of cost over book value . . . . . . . . . 10,151,700 Charge against capital surplus . . . . . . . . . 133,000 Charge against retained earnings . . . . . . . . 88,400 Current liabilities . . . . . . . . . . . . . . . $ 4,672,700 Cash . . . . . . . . . . . . . . . . . . . 11,714,400 Common stockupar value . . . . . . . . . . . . . 1,500,000 The details of the "accounting treatment" as referred to in the proxy statement are quoted as follows: The estimated $11 ,714,383 ($12,642,000 less excluded assets in the approximate amount of $927,617) of cash to be delivered to Argus represent 55%, and the 300,000 shares of Witco common stock (Valued at $32 a share) represent 45% of the aggregate considera- tion being paid for the Argus business and net assets. The value as Signed to the Witco shares was determined for accounting pur- Poses by taking the closing price of the Witco common stock on the New York Stock Exchange on November 29, 1965, the day preceding the announcement to the public of the proposed transaction. Witco intends to account for the transaction as (l) a "pooling of \\——- A 1Mid ~Continent Telephone Corporation, NYSE Listing Application ”23016, January 14, 1966, p. 1; in connection with the acquisition ‘ 6: N. Telephone Co. for $305,053 cash and 44,800 shares common No. of C 37 12th hi t 3 WITCO CHEMICAL COMPANY, INC., AND ANGUS CHEMICAL CORPORATION Unaudited Pro Forma Combined Condensed Balance Sheet October 31, 1965 Witco Argus Chemical Chemical Company, Inc. Corporation A S S E T 5 Current assets: Cash, certificates of deposit and marketable securities ..... Receivables (net) ................................... . Inventories . . . . . .. .................................... Other current assets .................................... Total current assets ....................... .. Investments in athliates, associated and other companies (Note e) .......... . ..................... Property, plant and equipment at cost, less accumulated depre- ciation, depletion and amortization (Note c) ........... . Other assets (Note c) .................................... Excess of cost of investment in Argus over underlying book equity as of date of acquisition (Notes c and d) . . .. ...... LIABILITIES AND SHAREHOLDERS’ EQUITY Current liabilities .. ........ Long-term debt ......................................... Other liabilities ............... . ......................... Dcierrcdcredits .............. ’ ...... ......... Minority interest in a subsidiary company ................ . Shareholders' equity: Witco: Common stock, par value $5: 4,000,000 shares authorized, 2.626.561 shares issued, 2,617,761 shares outstanding (2.926.561 shares issued and 2,917,761 shares outstand- ing after acquisition) ........... . . . ..... . ........ . . Argus: Common stock, no par value, 200 shares authorized, 25 shares issued and outstanding.. .. Q’iu' ,u'plu’ OOOCOCOOOOIOOOOCOOIOOOOO0.00.00.00.00... Rmim amin‘. 00000000000000 .00.... 000000000000 .00.. Treasury stock ...... .. ...... ................... $12,054,800 S 278,200 20,220,400 1,903,000 16,983,400 1,250,300 976,400 153,400 50,235,000 3,584,900 9,582,300 915,200 31,670,000 2,710,200 1,615,200 1,231,300 $93,102,500 $8,441,600 == = $18,510,600 $3,866,900 18,801,000 574,300 233,800 - 3,510,600 231,500 54,200 — 41,110,200 4,672,700 13,132,800 — -— 117,800 133,000 -- 38,984,600 3,651,100 (258,100) ._ 51,992,300 3.768.900 $93,102,500 38.441.600 Pro Forma Adjustments Dr (Cr) (Note b) 3 10,000,000 (2) (11,714,400) (3) (727.000) (5) (65.000) (6) (9273300)“) 10.151.700 (3) 65.W0 (6) 3(10.000.000)(2) 152.700 (5) 574.300 (5) (1.500.000) (4) 64,800 (3) 53.000 (4) 133.000 (4) 927,600 (I) 1,497,900 (3) 1,314,000 (4) Pro Forrra Combincc. S 9.826.600 22.123.400 18,233.7‘1‘0 1.129.800 51,313,500 10,497,590 34,380,200 1.918.900 10.216.700 3108326800 === 14,632.800 38,896,200 (258,100) 53,270,900 3108326300 38 Exhibit 3 (cont.) NOTES TO UNAUDITED PRO FORMA COMBINED CONDENSED BALANCE SHEET (a) Principles Applied in Preparation of Pro Forma Combined Condensed Balance Sheet: The accompanying pro Inrma combined condensed balance sheet reflects the combining of the unaudited balance sheets oI Witco and Argus as 01 October 31, 1965, giving effect to the proposed acquisition of substantially all of the business and assets and the asumption of substantially all the liabilities of Argus. The cash portion 01 the proposed transaction is accounted for as a purchase and the stock portion as a pooling of interests. (b) Explanation oI Pro Forma Adjustments: 1. To eliminate assets of Argus not being acquired. 2. To give effect to the short-term borrowing by Witco of $10,000,000. Sec reference to “Financing Arrange- ments” in this Proxy Statement. 3. To give efiect to the disbursement of $11,714,400 for the purchase of 55% of substantially all of the net assets of Argus. The excess ($10,151,700) 01 the cash consideration over the book amount oi such assets is allocated to ‘Excess of cost of investment in Argus over underlying book equity as of date of acquisition." See Note (c) below. 4. To give effect to the issuance of 300,000 shares of Witco's common stock (par value $5 per share) for 45% of substantially all of the net assets of Argus. The difference between 45% of the stated value ($53,000) of Argus' common stock and the par value ($1,500,000) of Witco: common stock is charged to capital surplus to the extent available ($133, 000) and the balance ($1, 314 ,000) is charged to retained earnings. 5. To give cfiect to the payment of certain of Argus' debt. 6. To give effect to estimated expenses to be incurred in connection with the acquisition. (c) It is contemplated that a portion of the amount assigned to “Excess of cost of investment in Argus over under- lying book equity as 01 date of acquisition" will be allocated to patents, licensing agreements, investments in affiliates, property, plant and equipment on the basis of an independent appraisal, which, it is estimated will not be completed earlier than March 15, 1966. In view of this it is not practicable to estimate the amount to be so allocated. (d) Witco does not intend to amortize the “Excess of cost of investment in Argus over underlying book equity as of date of acquisition” remaining aiter allocation. It is the opinion of Witco that there is no indication of a limited life for - this intangible; hence Witco has no present intention of amortizing this intangible asset. (a) The pro forma combined condensed balance sheet should be read in conjunction with the other financial state- ments and notes thereto included elsewhere in this Proxy Statement. BOOK VALUE PER SHARE On October 31, 1965 the book value of Witco common stock was $19.86 per share. On such date ' 25 shares of common stock of Argus were outstanding, all of which were privately held. Per share data on the book value of the common stock of Argus is inappropriate. The pro forma book value per share for the common stock of Witco as of such date, after giving effect to the proposed acquisition, would be $1826 of which $3.50 per share results from the excess of cash consideration of cost of investment in Argus over underlying book equity as of the date of acquisition. Such amount will be subsequently adjusted alter the Argus assets acquired have been appraised. See reference to “Accounting Treatment” in this Proxy Statement. 39 interests" to the extent of the assigned value of the shares to be issued and (2) a purchase to the extent of the cash payment. With regard to the purchase, the 55% of the net assets of Argus will be recorded on the books of Witco, by allocation of cost, at fair value to be determined by an independent appraiser. The unal- located excess of the cash payment over the 55% of the net assets acquired by Witco amounting to $10,151,700, will be carried on the books of Witco, as "excess of cost of investment in subsidiary over underlying book equity as at date of acquisition." See Notes to 'Unaudited Pro Forma Combined Condensed Balance Sheet (b) 3--page 12 [second page of Exhibit 3]. It is the Opinion of Witco that there is no indication of a limited life for this intangible; hence Witco has no present intention of amortizing this excess. S. D. Leidesdorf & Co., Witco's independent public accountants, have reviewed and approved this treatment as being in accordance with generally accepted accounting principles.1 Several comments are appropriate. The value of $32 a share assigned to the 300,000 Witco shares issued in the exchange transaction was used for purposes of determining the purchase-pooling gatig_for the partial-pooling treatment. But the $32 figure is not the basis of the value assigned to the shares for purposes of gecording the transaction, since this would be the conventional purchase accounting. If purchase techniques were applied to the entire transaction, then the appropriate entry would be: Current assets . . . . . . . . . . . . . . . . . $ 3,584,900 Investments and other assets . . . . . . . . . . 1,218,900 Property, plant and equipment--net . . . . . . . 2,710,200 Excess of cost over book value . . . . . . . . . 18,473,100 Current liabilities. . . . . . . . . . . . . . . $ 4,672,700 Cash . . . . . . . . . . . . . . . . . . . . . 11,714,400 Common stock--par value . . . . . . . . . . . . 1,500,000 Capital in excess of par value . . . . . . . . . 8,100,000 Computations: Cash . . . . . . . . . . . . . . . . . . . . . . $11,714,400 Stock (300,000 shares @ $32) . . . . . . . . . . 9,600,900 Total purchase price . . . . . . . . . . . . . $21,314,400 less: Book value of net assets acquired . . . . 2,841,300 Excess of cost over book value . . . . . . . . §18,473!100 1Witco Chemical Company, Inc., Proxy Statement dated January 25, 1966: “Accounting Treatment," pp. 5-6. 40 Thus, the choice of partial-pooling treatment rather than pur- chase accounting for this exchange transaction had two main effects: (1) assets (excess of cost over book value) were reduced by $8,321,400 and (2) stockholders' equity was reduced by the same amount. This analysis shows that a partial pooling, in comparison with purchasing, can serve as an effective accounting technique in avoiding tangible asset write-ups and in keeping large amounts of goodwill and other in- tangible assets off the consolidated balance sheet. But, more importantly, careful examination reveals that the actual basis of accountability for the 300,000 common shares issued by Witco is $1,278,600, or $4.262 per share-"less than the par value of these shares, $1,500,000, or $5.00 a share. The following computation illustrates why this is the case. Book value of the net assets acquired . . $ 2,841,300 Recorded excess of cost over book value . . 10,151,700 Subtotal . . . . . . . . . . . . $12,993,000 11,714,400 less: Cash consideration . . . . . . . . . Recorded increase in equity accounts . . iLlaEZfiaéQQ. As a result of the partial-pooling treatment, regardless of the Par Value of the shares issued, the recorded increase in the stock- h°1 ders' equity for Witco in its cash-stock acquisition of Argus is $1’278,600. Since the total par value of the 300,000 shares issued is greater than this amount, Witco's capital surplus and retained earnings were Charged with the difference of $221,400. From outward appearances, one miSht suggest that the stock was issued at a discount in connection with the Argus acquisition, although it had a fair value far above the rec 0rd ed amount. At least this is exactly the net effect of recording 41 this combination as a partial pooling; accountabilities are reflected as :if the stock had been issued at a discount--$4.262 per share. This discussion of partial poolings would suggest that such a technique can be applied in a diversity of combination situations and stxill allow considerable flexibility for the buying and selling corpora- tixans as to the manner in which acquisitions are carried out. Manage- Inemlt appears to have a choice in accounting for business combinations ‘Wluere both cash and stock considerations are involved in the exchange truansaction. Partial pooling is now a generally accepted accounting Preactice, even for cash-stock exchanges effected all in a single transac- tion. But it is difficult to conclude how large the "purchase" element if! such a situation can be before a partial pooling does not apply be- cause there are many interesting exceptions to prevailing practices in tile business combination area. By way of hypothesis, the writer illustrates below approximate a‘Hcounting "standards" that practice follows currently in selecting the appropriate purchase-pooling technique where cash (or cash equivalent) is a portion of the purchase price. h t o Techgigue selected Comments 1ess than 25% pooling of interest no need to consider other techniques since pooling is easily available 257. to 75% partial pooling a pooling may be questioned more than 75% purchase the logic of a partial pooling may be questioned 42 The practices listed implicitly assume that the total purchase price is significantly larger than the underlying book values of the acnfuired net assets or capital stock and that the acquiring firm wishes tc> avoid the writing up of tangible assets and the recordings of good- will and other intangible assets. The Bargain Purchase In those cases where one company acquires the net assets or Capital stock of another company and the underlying book value of such assets or stock exceeds the acquiring unit's purchase cost, the business Ccnnbination is commonly referred to as a "bargain purchase." In account- 1113 for this type of a combination, accountants regularly disregard the chaling-of-interests concept, even when an evaluation of the attendant Circumstances surrounding the exchange transaction would have suggested th«Fatall pooling criteria are satisfied. Instead, accountants prefer tflle purchase treatment which commonly gives rise to a substantial credit rePresenting an excess of book value over cost. This excess in bargain F"1rchase cases usually has favorable effects on the acquiring firm's fidaancial statements, regardless of the alternative ways it may be handled. These include: (a) Set up as a deferred credit and amortized to income over an appropriate number of years. (b) Used to reduce specific tangible assets, such as plant, equip- ment, and inventories. (c) Used to reduce goodwill and other intangible assets. (d) Credited directly to retained earnings (a rarity). As Professor Jaenicke writes, . here the excess of book values over cost generally has the result of increasing annual income credits, either by means 43 of annual amortization of the excess as such from its position as some sort of deferred credit, or by means of reduced annual depre- ciation charges because of the allocation of the excess to tangible asset accounts. . . . Whether used to reduce tangible assets or set up as an amortizable deferred credit, the excess will increase annual net income after taxes depending only on the rate of annual depreciation of the tangible assets or the rate of annual amortiza- tion of the deferred credit, as the case may be.1 Various cases serve as illustrations of the first three alterna- tiJre ways that accounting practice handles the excess of book value over cost in bargain purchase cases. (a) (b) Bargain Purchase--Excess Credit Amortized to Income The transaction will be treated as a "purchase" and not as a "pooling of interests." . . . Southern contemplates, at this time, transferring to income over five years the excess of the sum of the capital stock and surplus accounts of Farmers, as at July 31, 1965, applicable to the common stock purchased by Southern over the sum of cash paid and common stock issued by Southern in the exchange. Southern's independent accountants, Arthur Andersen & Co., have reviewed and approved the foregoing accounting treatment as being in accordance with generally accepted accounting principles.2 The deferred credit resulting from the acquisition of Mueller, including the amount resulting from the above exchange of shares, is to be amortized to income over seven years. Bargain Purchase--Excess Credited to Tangible Assets In consolidation the excess of the net assets as shown on the books of Western Block Company over the purchase price will be applied as a reduction to the carrying amounts of certain specific \* 1 Henry R, Jaenicke, "Management's Choice to Purchase or Pool," Thxe Accounting Rgiesg, xxxvu (October 1962), 763. 2 Southern Nitrogen Company, Inc., NYSE Listing Application No. A“‘22743, September 20, 1965, p. 1; in connection with the acquisition of armers Cotton Oil Company for 7,213 common shares and $1,027,348 cash. 3United States Smelting Refining and Milling Company, proxy Eytatement dated August 27, 1965, under Notes to Pro-Forms Combined Bal- anee Sheet, in connection with the merger with Mueller Brass Co., Note 3, p. 16. 44 assets (principally property, plant, and equipment and inventories) of Western Block Company based upon present values. This account- ing treatment has been approved by Touch, Ross, Bailey & Smart, independent certified public accountants of the Company, as being in accord with generally accepted accounting principles. Huron's assets and liabilities, as shown on their books as of November 30, 1956, will be recorded on the books of the Company except that the plant account will be reduced so that the aggregate of net assets will be $4,500,000 (maximum). The audited financial statements of Huron at June 30, 1956, indicate net book assets of approximately $6,388,000.2 (c) Bargain Purchase--Excess Credited to Intangibles The acquisition of the said 276 shares will be accounted for as a purchase, wherein upon consolidation the excess of book-value over cost will be credited to the intangible "Excess of cost over net assets of companies acquired." The established practice of recording assets at the selling company's book values which exceed cost and amortizing the excess of book value over cost to income, as illustrated under alternative (a), is open to serious objection. Such a procedure overstates the buying enterprise's accountability for the economic resources which were pur- Chased. Since excess amounts are recorded in tangible asset accounts, it is likely that future depreciation charges (and cost of goods sold) ‘0111 be overstated too. The gradual transfer of the excess credit 1 American HOist & Derrick Company, NYSE Listing Application lie. Ar22992, December 28, 1965, p. l; in connection with the acquisition <>f western Block Company for 14,064 shares capital stock and cash con- 81 deration $131 , 004. 2Hercules Powder Company, NYSE Listing Application No. A-16656, NOvember 21, 1956, p. 2; in connection with the acquisition of the IinronMiilling Company for 100,000 shares common stock. 3United Financial Corp. of California, NYSE Listing Application ”We. A-22800, October 25, 1965, p. 2; in connection with the acquisition 53f the stock of United Savings and Loan Association for 79,764 shares of capital stock. 45 (deferred credit) to income represents an arbitrary and highly dubious method of offsetting inflated depreciation charges in the final determi- nation of periodic income. If such depreciation charges are not exces- sive, then the practice of amortizing the excess of book value over cost to income is unacceptable because net income may be overstated by the amount of the amortization. Although accounting practices for the handling of book value over cost in bargain purchases do vary considerably, the basic implica- tions are clear. If the "excess" is on the credit side in combination transactions, accountants willingly write down assets or set up deferred credits to be amortized to income. If the excess is a reverse situation where purchase cost exceeds book value, accountants generally are not willing to write up assets (both tangible and intangible) and to make appropriate depreciation and amortization charges to income. While such practices may be "generally accepted accounting principles," they do not seem logically consistent. Should not the accounting principles applied in usual business combinations be the same as in "bargain" situations? The inherent logic of the situation would argue that if a new basis of accountability arises for bargain purchase combinations, then a new basis of accountability arises for the usual types of business combina- tions, i.e., where the selling companies are acquired at a premium. From the point of view of responsibility accounting, it makes little dif- ference whether book value exceeds the purchase cost or purchase cost exceeds the book value. Apparently managements and accountants alike are not willing to accept the usual consequences of purchase accounting except in those 46 situations where the selling company is acquired on a discount basis. Here the effect of recording under the purchase treatment does present the financial statements in a more favorable light. If the "excess credit" is applied as a reduction of the asset accounts of the selling company, then future income statements are relieved of some of the charges that might have been forthcoming 1km' depreciation or amortiza- tion. The alternative practice of using the selling company's book values and amortizing the excess credit gradually through the income account also increases the combined income of the conglomerate enter- prise. The tro ti e Poolin If a specific business combination is originally accounted for as a purchase and then later is changed to reflect a pooling of inter- ests, this represents a unique accounting phenomenon called a "retro- active pooling." Especially notable in the years 1959-62, these retro- active changes are additional evidence of the confused state of mind in accounting for business combinations. Most writers discussing the retroactive situation emphasize that the revision arises not from a mis- interpretation of the original combination transaction but from the changing nature of the pooling-of-interests concept.1 The retroactive poolings indicate the unclear standards that delineate a purchase from.a pooling of interests. 'They highlight the LArthur R. Wyatt, A Critical Study of Accountinggfor Business W, Accounting Research Study No. .5 (New York: American Insti- tUte for Certified Public Accountants, 1963), p. 49. 47 intense pressure that some managements have exerted upon the accounting profession to accept business combinations as poolings of interests regardless of the attendant circumstances surrounding the combinations. Bot, as a consequence, such changes have probably undermined the integ~ rity of financial reporting and impaired the prestige of the accounting profession. Switching from purchase accounting to pooling-of-interests accounting also seems to violate the concept of consistency in account- ing, a concept which Moonitz interpreted as one of the basic postulates of accounting. Postulate C-3. Consistency. The procedures used in account- ing for a given entity should be appropriate for the measurement of its position and its activities and should be followed con- sistently from period to period.1 An evaluation of two particular retroactive pooling cases fol- lows to emphasize management's strong interest in handling business combinations as poolings of interests and to bring out the usual effect of this accounting phenomenon on corporate financial statements. c & o.--A t o of c Ch 1 Com.a W; R. Grace & Co. acquired the net assets of Hatco Chemical Company in 1959 for 126,000 shares of common stock. 'These shares repre- sented 2.7 per cent of the shares outstanding after the combination, definitely below the 5-10 per cent presumptive limitation of Accounting Reseagch figlletin No. 48. Hatco was made an operating division and the exchange transaction was recorded as a purchase. The value placed on k 1Maurice Moonitz, The Basic Postulates of Accounting, Accounting iResearch Study No. 1 (New York: American Institute of Certified Public ACcountants, 1961), p. 53. 48 the stock for accounting purposes was $43.00, based on the approximate average price of the company's stock on the New Yerk Stock Exchange during the period of negotiations.1 Briefly, the accounting entry was: Net assets of Hatco . . . . . . . . . . . . . . . $1,537,679 Excess of cost over book value . . . . . . . . . 3,880,321 Common stock--par value . . . . . . . . . . . . . $ 126,000 Paid-in surplus . . . . . . . . . . . . . . . . . 5,292,000 The excess of cost over the book value of the underlying net assets of Hatco was charged to goodwill. Although Grace hinted in the listing application that such goodwill would be amortized on a straight- 1ine basis to income, this was not done. Apparently Grace was undecided on this matter for in the Annual Report 1959 it stated: The excess of the market value of the 126,000 shares over the book value of the underlying net assets of Hatco acquired amounted to $3,880,321 and has been recorded as goodwill. . . . the basis for amortizing the Hatco goodwill will be determined after exper- ience indicates the inter-relationship of its business to that of the Company's other chemical operations.2 But in 1960 Grace definitely solved their problem of deciding Vflmat to do with the purchased goodwill. The purchase accounting treat- nmnat was retroactively changed to effect a pooling of interests. 'The Change was explained in the Annual Report 1960 as follows: In 1960 the Company reconsidered the circumstances surrounding its 1959 acquisition of the Hatco Chemical Company for 126,000 Shares of the Company's common stock and decided that it would be tnore appropriate to treat the combination as a pooling of inter- tasts than as a purchase. Hatco's retained earnings account has \— 1W. R. Grace & Co., NYSE Listing Application No. A-18322, guiy 7: 1959: p. 1; in connection with the acquisition of Hatco Chemi- a Company for 126,000 shares common stock. 2W. R. Grace & Co., Annual Report 1959, p. 27. 49 been retroactively combined with that of the Company, goodwill of $3,880,321 has been eliminated and capital surplus has been reduced by $5,526,531.1 In addition to the above-mentioned balance sheet changes, the pooling-of—interests treatment increased Grace's previously reported 1959 net income by approximately $443,000, or 9d per share. Although Grace disclosed this change in the notes to the financial statements, the auditors did not mention the change in their short-form report. If pooling accounting had been used at the time of the acquisi- tion, the net assets of Hatco would have been brought on the books of Grace at book values and Hatco's retained earnings would have been car- ried forward. Briefly, the accounting entry would have been: Net assets of Hatco . . . . . . . . . . . . . . . $1,537,679 Paid-in surplus . . . . . . . . . . . . . . . . . 234,000 Common stock-"par value . . . . . . . . . . . . . $ 126,000 Retained earnings . . . . . . . . . . . . . . . . 1,645,679 The $234,000 charge to paid-in surplus arises under the pooling- Of-interests treatment because Grace would have transferred the total balance of retained earnings of Hatco on July 24, 1959; a charge to Paixi-in surplus, therefore, would have been necessary to account properly for capital elements of the surviving corporation. & nc L o e -- 4&1 ition of Nozden Lgbgratgries Smith Kline & French Laboratories issued 110,194 shares of its common stock in exchange for the business and net assets of Norden Laboratories (Nebraska) in January 1960. These shares represented less \—— 1 Stat; WF'R- Grace & Co-i Annual ReportglgégJ under Notes to Financial emnents,'N'ote 1, p. 28. 50 than one per cent of the shares outstanding after the combination. This particular acquisition enabled Smith Kline & French to enter the field of veterinary medicine through an established organization. As to the accounting treatment for this exchange transaction, Smith Kline & French reported: The fair value of the shares issued has been credited to stated capital and the excess of the fair value of the shares issued over the net tangible assets of'Norden CNebraska) at date of acquisition, $3,659, 820, is being amortized er a ten-year period by equal charges to consolidated earnings. In December 1961, Smith Kline & French gave notice to the New York Stock Exchange that the accounting method applied in connection with the Norden acquisition was being changed to a pooling of interests in accordance with generally accepted accounting principles. Exhibit 4 illustrates some of the important details concerning the change. ‘The change was also explained in the Annual Repozt 1961 as follows: In 1961 the Company reconsidered its accounting treatment applicable to the 1960 acquisition of Norden Laboratories (Nebraska) for 110,194 shares of the Company common stock and decided that it would be more appropriate to treat the combination as a pooling of interests rather than a purchase. Accordingly, the 1960 financial statements have been restated in that Norden's retained earnings account has been retroactively combined with that of the Company, the excess of the fair value of the shares issued over net tangible tassets at date of acquisition, $3,659,820, has been eliminated, and the excess of the stated value assigned to the shares issued over 'the stated capital of Norden has been charged to earnings retained 1J1 the business. The amortization of the excess of investment Cfllarged to earnings in 1960, $365,982, has been restored.2 \— N 1Smith Kline & French Laboratories, Anngal Report 196 , under Otes to Financial Statements, Note 4, "Norden Laboratories (Nebraska)," P- T1]_- No 2Smith Kline & French Laboratories, A. e-o 1961, under P t:§ to Financial Statements, Note 1, "Change in Accounting Treatment," Q 51 Exhibit 4 SUPPLEMENT TO PRIOR LISTING APPLICATION TO A $2622 NEW YORK STOCK EXCHANGE iimbhzg'i'gf SMITH KLINE SI FRENCH LABORATORIES NOTICE OF CHANGE OF ACCOUNTING METHOD IN CONNECTION WITH THE ACQUISITION OF NORDEN LABORATORIES Number of shares issued Number of stockholders and outstanding of record 14,641,504 13,086 (as at November 30, 1961) (as at November 30, 1961) __I J Castro: or ACCOUNTING Martian: Smith Kline 8: French Laboratories (the "Corporation") hereby gives notice to the New York Stock Exehange that the accounting method applied in connection with the Corporation's acquisition of all of the business and assets of Norden Laboratories (“Norden”), as set forth in the Corporation's Listing Application No. A-18692 dated December 22, 1959, has been changed from a purchase as therein reported to a pooling of interests of Norden with the Corporation. This change was made in accordance with generally accepted accounting principles. The Listing Application contains the following statement: “The Corporation has valued the business and assets (subject to liabilities) to be obtained from Norden at $5,509,700, which is the average fair market value of the shares to be issued to Norden during the period of negotiation prior to the date of the Agreement and this amount will be credited to the common stock account. The excess Of such amount over the book value of the net assets of Norden will be shown as goodwill on the books of the subsidiary which will hold the Norden assets and Operate the Norden business and will be reflected on the consolidated balance sheet as an intangible which will be amortized Over a period in conformity with generally accepted accounting principles.” ' BY reason of the change from purchase treatment to pooling of interests, the quoted statement is hereby deleted. The net book value of the prOperty and assets which were acquired will be shown on the books of the corporation as the value of its investment in the Norden assets. The asset and liability accounts at the amounts shown On the books of Norden will be carried forward (subject to appropriate reclassifications, if deemed necfssary, to place the accounts on a uniform basis) and the earnings retained in the business of N orden will be am“liar-1y carried forward. The excess of the stated value assigned to the Corporation's shares issued in the transaction over the stated capital of Norden will be charged to earnings retained in the business. The new uitalirrmnt will be given efiect more pro tugzc and will be shown in the Corporation’s consolidated financial state- merit; for its fiscal years ended December 31, 1960 and 1961 to be published in its annual report for 1961. The Board of Directors of the Corporation on November 16, 1961 authorized the accounting entries neces- :ary to change the accounting treatment of the transaction with Norden after reconsidering the circumstances u{rounding the transaction, which included (a) the equity interests in Norden continue as such in the Corpo- “hon andflb) there has been a.continuity of the business and management of N orden. ‘ 52 Exhibit 4 (cont.) The Corporation's auditors, who reviewed and approved the accounting treatment as being in accordance with generally accepted principles of accounting, are Peat, Marwick, Mitchell & Co., Philadelphia, Pennsylvania. The issuance of the 110,194 shares of the Corporation's common stock in exchange for the property and assets of Norden was authorized by the Board of Directors of the Corporation on November 19, 1959; the exchange was consummated on January 12, 1960. OPINION OF COUNSEL In the opinion of Messrs. Ballard, Spahr, Andrews & Ingersoll, Land Title Building, Philadelphia, Pennsylvania, the additional 110,194 shares of common stock of the Corporation covered by this Supplemental Application, as issued and delivered in accordance with the resolution of the Board of Directors of the Corpo- ration referred to above, remain unchanged by the change in accounting treatment from a purchase to a pooling of interests and remain validly issued, fully paid and non—assessable, with no personal liability attached to the ownership thereof under the laws of the Commonwealth of Pennsylvania, the state of incorporation of the Corporation and the state in which the Corporation’s principal office is located, other than the statutory liability of all shareholders of Pennsylvania business corporations for wage claims and the like up to the value, as defined in the statute, of the shares owned, such liability being conditioned upon the bringing of suit for such salaries and wages within six months after the same become due. Morris Cheston, a director of the Corpo- ration, is a member of the firm of Ballard, Spahr, Andrews 8: Ingersoll. SMITH KLINE & FRENCH LABORATORIES By: Howm E. MORGAN Tamra 53 The important effects of this retroactive pooling for Smith Kline 6: French were tor (a) remove permanently over $3.6 million of assets from the balance sheet; (b) reduce reported stockholders' equity about $3.3 million; (c) increase 1960 reported earnings per share from $1.64 to $1.67. Other cases in which a retroactive pooling treatment followed tlie purchase accounting of the original transaction include the follow- iaag combinations: Ammrican.Machine & Foundry Company's acquisitions of the W. J. Voit Rubber Corporation and the J. B. Beaird Company, Inc.; Aluminum Company of America's acquisition of Rome Cable; Raytheon Company's acquisition of Sorenson & Co., Inc.; Reichhold Chemicals Ccnnpany's acquisition of Alsynite Company of America;‘Universa1 Match COrporation's acquisition of Sleight & Hellmuth, Inc.; and Riegel Paper Corporation's acquisition of Bartelt Engineering.1 An earlier case of a Icetroactive pooling where the size criteria was slightly above 1e 0 's guideline of 5-10 per cent for the acquired company Was Food Machinery and Chemical Corporation's acquisition of Buffalo 15nectro-Chemical Co. in 1952.2 All of these cases of retroactive change W‘31-11d support the contention that nnnagements were unwilling to accept tile= usual consequences of purchase accounting. There are probably thI‘ee main reasons why managements and accountants have increasingly acc-epted the pooling-of-interests concept in accounting for business combinations . \— 1Samuel R. Sapienza, "Distinguishing Between Purchase and Pool- 1:18;" The Jomal ofi Acgogntgggy, CXI (June 1961), 35-40. 2W'yatt, op. cit., p. 53. 54 (a) The reluctance to recognize purchased goodwill and other intangible assets which generally result from using the purchase method and the accompanying amortization of such intangibles in conformity with the policy expressed in Accounting Research Bulletin No. 43, Chapter 5. (b) The pressure on corporate managements to maintain and increase earnings per share from year to year. (c) The desire to avoid the discrepancy between reported busi- ness earnings and taxable earnings which results from purchase account- ing, since the amortization of any excess in stock acquisitions repre- _, sents a charge against revenues not deductible for income tax purposes. When managements and accountants realized that the pooling Criteria set out in ARB No. 48 were indeterminative and subjective, they did not hesitate to initiate retroactive changes that created more f<'=lVorable financial results.1 Thus, the actual effect of both Afl No. 43 (1953), Chapter 5, and Ag no. 48 (1957) was to allow even wider latitude in determining the treatment of a given business combination than had previously existed.2 The retroactive poolings of the 1959-62 period are convincing evidence that accounting practitioners were not certain of the distinction between a purchase and a pooling of interests. Nevertheless, acOllountants were willing to deviate significantly from basic accounting s'i-I‘l‘ndards and recommended criteria and to implant their own notion of desirable practices in this area. \— 1For example, a pooling will show a better rate of return on assets on a pro-forms basis than a purchase if the selling company is aCQuired at a premium. 2Wyatt, op. cit., p. 38. 55 Some variations of Pooling and Purchase Accounting The main types of combination accounting treatments have been illustrated, but several variations Of pooling-purchase methods remain to be explained. Two are: Pooling treatment, with retained earnings (earned surplus) of the acquired company capitalized. Purchase treatment, with the systematic amortization of the excess of cost over book value to retained earnings. The carrying forward of the combined retained earnings of the constituents as the retained earnings of the resultant corporate entity represents one of the basic features of a pooling of interests. Agg, No. 48 clearly states that the retained earnings accountscfi the consti- tuents should be merged in a pooling combination, except to the extent otherwise required by law or appropriate corporate action. Yet occasion- ally business combinations are accounted for in a manner, as wyatt suggests, where "the assets were 'pooled', while the earned surplus was 1 . 'purchased'." Two quotations serve as examples of this treatment. The assets and liabilities of Formica will be carried forward on the books of the Company at the amounts recorded on the books of Formica. The par value of the Acquisition Common Stock issued as consideration therefore will be credited to capital stock and the excess of the net assets, on the closing date, over such par value will be credited to capital surplus.2 The acquisition of the Company's (Speer Carbon Company) busi- ness and assets by Airco is to be treated as a pooling of interests for accounting purposes in accordance with generally accepted k 1Wyatt, op. ci;., p. 29. A 2American Cyanamid Company, NYSE Listing Application No. A-l6202, ‘Spr11.2, 1956; in connection with the acquisition of Formica Company for 73,592 shares of common stock, p. 3. 56 accounting principles. . . . The common stock account of Airco will increase by an amount equivalent to the sum of the par value of the Company's common stock, paid-in surplus of the Company, and (as required by certain provisions of the Airco Certificate of Incorporation) the retained earnings of the Company as of the date of acquisition.1 While this type of combination accounting treatment may not represent a "true" pooling of interests, for all practical purposes it has similar effects on corporate financial statements. Whether the acquired unit's retained earnings are capitalized or carried forward in a pooling combination, the total assets and stockholders' equity of the surviving company remain the same. Such a distinction between contrib- uted capital and retained earnings on the books and balance sheet of a typical corporate enterprise is generally useless for purposes of finan- cial statement analysis. Logically, if a combination is deemed to be a pooling of inter- ests, the retained earnings of the acquired company should be permitted to survive, since a new basis of accountability does not arise. The Very connotation of the term "pooling" implies a commingling of interests,2 so that all or substantially all of the equity interests in Predecessor companies should continue undisturbed, as such, in the sur- ‘Viving entity. Capitalization of the acquired company's retained earnings, how- eVemy does not consistently reflect the pooling concept as to stock- holders' equity accounts. Should the acquiring unit be reluctant to add \____ J 1Air Reduction Company, Incorporated, Proxy Statement dated “15’ 18, 1961; concerning the acquisition of Speer Carbon Company, p. 7. C 2Samuel R. Sapienza, "Pooling Theory and Practice in Business 0mInitiations," The Accounti Re iew, XXXVII (April 1962), 273. 57 the acquired entity's retained earnings to its own, then pooling treat- ment could be questioned. Such capitalization may be suggestive of the applicability of purchase accounting, since in a business combination which is clearly a purchase none of the retained earnings of the acquired company is carried forward. The "pooling treatment, with retained earnings capitalized" is additional evidence that accountants are confused as to the distinction between a purchase and a pooling of interests. Where a business combination is treated as a purchase of assets, usually there arises the question of what to do with any excess of fair value of assets acquired over their book value. If the purchase price is substantially in excess of the best estimate of the present value of tangible and specific intangible assets being acquired, it is necessary to record "goodwill." Since the write‘off of goodwill at date of acqui- sition is now a questionable practice for purposes of generally accepted accounting principles, this item may be amortized over a period of years against revenues, or carried at cost until such time as it appears to have a limited life. Occasionally, however, such purchased goodwill has been accounted for in a manner different than these customary treat- ‘ments, i.e., where it is systematically amortized as a special charge after reported net income for the year. Such a treatment avoids reduc~ ing reported earnings per share and still gradually eliminates the Carrying cost of goodwill on successive balance sheets. Exhibit 5 iillustrates this treatment for the Gillette Company on its combined 1Jutome and retained earnings statement for the years 1956 and 1957. 58 Exhibit 5 GILLETTE COMPANY AN ILLUSTRATION WHERE GOODWILL WAS SYSTEMATICALLY AMORIIZED AS A SPECIAL CHARGE, 1956-57 Year ended Year ended December 31, December 31, 1956 1957 Net income before Special charges $31,544,304 $25,940,570 Special charge to amortize goodwill 2,817,366 2,628,255 Net income after special charge, transferred to U.S. retained $28,726,938 $23,312,315 earnings Source: Gillette Company, Annual Reports 1956 and 195 , p. 19. Exhibit 6 shows how Gillette has written off its goodwill and other intangibles from 1949 to 1961 with respect to purchased patents and trademarks and goodwill arising from four business acquisitions. Exhibit 7 shows the effect of the write-off to retained earnings treatment on the reported earnings per share of common stock for Gillette for six years 1953-58. If Gillette had not written off any of the purchased goodwill arising from acquisitions (see Exhibit 6) but had followed the "purchase without amortization" treatment instead, then the 1961 balance sheet would have reported "Goodwill, Patents, and Trademarks" of approximately. $39,752,000, rather than only $604,000 as it did. Note that over $39 nmillion of purchased goodwill was written off either to paid-in capital Or'tn retained earnings during the 1949-58 period. Gillette followed a Policy of "systematic amortization" for the cash acquisitions of the 59 Exhibit 6 GILLETTE COMPANY WRITE'OFF OF GOODWILL AND OTHER INTANGIBLES,1949-6l (in thousands of $) $1,136 of Year Auto Paper Harris Purchased Strop Tbni Mate Research Patents & Company Company Companies Labs. Trademarks 1949 $15,303 $ 8,000 -- -- -- 1950 -- 1,631 -- -- -- 1951 -- 1,006 " -- ~- 1952 -- 2,156 -- -- -- 1953 -- 2,983 -- -- -- 1954 -- -- - - -- -- 1955 -- -- $ 653 -- -- 1956 -- -- 2,632 $185 $ 6 1957 -- -- 2,628 -- 66 1958 -- -- 1,971 -- 66 1959 -- -- -- -- 123 1960 -- -- -- -- 135 1961 -- -- -- -- 136 'Total $15,303 $15,776 $7,884 $185 $532 Where charge paid-in retained retained retained income was made capital earnings earnings earnings statement Balance Dec. 31, 1961 -- -- -- -- $604 Source: various prospectuses and annual reports of Gillette (“Impany. ‘The preferred terminology, paid-in capital and retained earn- 11188, has been used in this exhibit although Gillette did use "capital surplus" and "earned surplus" on its balance sheet. 60 Exhibit 7 GILLETTE COMPANY EARNINGS PER SHARE OF COMMON STOCK BEFORE AND AFTER SPECIAL CHARGES, 1953-58 Before After Year Special Charges Special Charges Difference 1953 $2.18 $1.80 $.38 1954 2.77 2.77 -- 1955 3.13 3.06 .07 1956 3.40 3.10 .30 1957 2.80 2.51 .29 1958 2.97 2.76 .21 Source: Various prospectuses of Gillette Company. Toni Company and Paper Mate Companies, but such amortization bypassed the income statement since it was reported as a Special charge after annual net income. Practically speaking, the goodwill which arose from these two acquisitions was amortized systematically to Gillette's retained earnings.account. The purchase treatment with systematic amortization of the ex- cess to retained earnings is logically inconsistent and unsupportable for purposes of sound accounting theory. ‘This rare treatment is actual- 1y not too far removed from.the practice of writing off goodwill at the date of acquisition. If there has been some compelling reason to bring Purchased goodwill into the accounts in the first place, then either an inmmfliate write-off or a gradual write-off of this goodwill to paid-in ‘Japital or to retained earnings nullifies the fundamental accounting aninciple requiring substantially all charges to go through the income 61 account. As one writer maintains, . . when purchased goodwill is being amortized according to a systematic plan, a charge to current operations is the only type of charge which is consistent with the definition and meaning of goodwill and the functions of accounting. ‘Thus, the "purchase with amortization to retained earnings" technique used by Gillette is a clever piece of conservative balance sheet accounting, which also relieves income of periodic charges for the amortization of goodwill. The recording of purchased goodwill implies that it represents the cost of a valid and consumable asset. Further- more, any willingness to amortize gradually the recorded goodwill not only suggests that the asset has a limited term of existence (therefore classified as a type (a) intangible according to Bulletinino. 4 , Chapter 5), but also represents an orderly and logical disposition of the cost of that asset. Accordingly, such a cost should be amortized against the income expected to be realized from that asset. As walker suggests, Since purchased goodwill is, by definition, the present worth of an anticipated future income stream, logic dictates that the cost be written off against the income over the period for which the excess earnings are expected to be realized. Finally, the purchase treatment with systematic amortization of the excess to retained earnings can be considered a departure from generally accepted accounting principles, mainly as a result of the first sentence of paragraph 5 of Bulletig Ho. 5;, Chapter 5. M 1George T. walker, "Why Purchased Goodwill Should Be Amortized (“1 a Systematic Basis," The Jogzngl 9f Agcggntangy, XCV (February 1953), 21n5. 21 id., 213. 62 The cost of type (a)intangiblesshould be amortized by system- atic charges in the income statement over the period benefited, as in the case of other assets having a limited period of usefulness. Summar From the study of alternative pooling-purchase accounting prac- tices, the following conclusions may be drawn: 1. While there are two basic theories of accounting for business combinations--the purchase doctrine and the pooling-of-interests con- cept--accountants are not clear as to the underlying distinction between them. Purchasing implies a new basis of accountability for assets, possibly based on the cost or fair market value of what consideration the acquiring company gives up in the exchange, or the appraisal value of what is secured, or some composite of these values. Pooling sug‘ gests a commingling of ownership interests, where the surviving economic entity continues to have the same assets, equity interests, and manage- ment as did the several entities before combination. 2. The distinction between a "purchase" and a "pooling of inter- ests" is important. ‘Under the latter accounting treatment, the acquir- ing unit in a business combination is not faced with the problem of accounting for the "excess of purchase cost over book value of assets acquired," because the assets and capital elements of the nonsurviving company are carried forward on the books of the surviving company at book‘values. 1American Institute of Certified Public Accountants, Accounting Rgsgazch Bulletin.flo. 43, Chap. 5, par. 5. 63 3. .Many business combinations are accounted for as poolings-of- interests, although they do not come under the pooling precepts as promulgated in A33 mo. 58. By using the pooling approach in accounting for business acquisitions and mergers, corporate managements are not held accountable for the fair value of the assets acquired and the capital stock issued therefore. Pooling—of—interests accounting, in effect, fails to account for all costs of buying a business.1 4. There is a very definite relationship between the popular use of the pooling treatment and the present rules for dealing with intangi- ble assets, as promulgated in ARB No. 43, Chapter 5. A closer look at these rules will follow in Chapter III. 5. The established criteria, such as relative size, continuity of ownership and management, alteration of voting rights, and others, are not sufficiently objective as standards in determining whether the pool- ing treatment ought to be allowed for a particular business combination. Such criteria conceal the real issue! Should corporate management be held accountable for any excess of fair value of assets acquired over their book value at the date of the combination? 6. The failure of accountants to establish determinate pooling criteria has led to an array of combination accounting practices, all embraced in the term "generally accepted accounting principles." These alternative pooling-purchase accounting practices produce widely vary- ing differences in a company's financial position and earnings, 1Leonard Spacek, "The Treatment of Goodwill in the Corporate Balance Sheet," Ihg_Jgg;ggl_g£_Aggggn;§ngy, GXVII (February 1964), 39. 64 especially for the asset values recorded and stockholder equity values carried forward into subsequent financial statements. 7. The existing variety of combination accounting practices allows too much inconsistency and diversity in financial reporting. The dif- ferences that result from alternative pooling-purchase practices require thorough study and analysis to improve the general understanding and usefulness of corporate financial statements. 1Wyatt, Op. cit., p. 103. CHAPTER III BACKGROUND The Growth of Business Combinations Business combinations have played a dominant role in the economic expansion of the United States. During recent years the number of mergers and acquisitions of business entities has continued at a high level. According to the Federal Trade Commission, a significant spurt in merger activity is apparent during the 19603. Data on a series of mining and manufacturing acquisitions, kept by the Commission annually since 1940, indicate that the number of mergers and acquisitions in the five years 1960-64 runs about 30 per cent over the total for the 1955-59 period.1 According to a survey by W. T. Grimm & Co., a Chicago-based financial consulting firm specializing in acquisitions, corporate merger activity set a record in 1965 with a total of 2,125.2 Private sources expect mergers and acquisitions to reach 2,400 in 1966.3 An exact count of all business combinations is practically im- possible to compile. Note from Exhibit 8 the increasing trend in merger 1"Merger Tide is Swelling," Business Week (May 29, 1965), p. 27. 2 "Mergers Set a Record Last Year With 2,125, Consulting Firm Says," The wall Stgegt Jougnal, January 28, 1966, p. 12. 3"Mergers: Everybody wants to Get Bigger," Newsweek, April 25, 1966, p. 72. 65 66 Exhibit 8 MERGERS AND ACQUISITIONS“-MANUFACTURING AND MINING CONCERNS ACQUIRED, 1949-64 Year Number Year Number 1949 126 1957 585 1950 219 1958 589 1951 235 1959 835 1952 288 1960 844 1953 295 1961 954 1954 387 1962 853 1955 683 1963 861 1956 673 1964 854 Source: Statistical Abstgnct of the united Stgtgs, 1965, p. 503; Federal Trade Commission records. Data limited to actions reported by Moody's Investors Service and Standard & Poor's Corporation, so that many smaller acquisitions are not reported. The data only in- clude partial acquisitions when they comprise whole divisions of other companies. activity for manufacturing and mining concerns as reported by the Federal Trade Commission during the period 1949 to 1964. This exhibit shows that merger activity for these types of concerns accelerated at a rapid pace starting in 1955. Between 1950 and 1954, for example, an average of 285 mergers and acquisitions occurred each year. Between 1955 and 1959, this average increased to 673 per year. Presently, based on an average of 873 a year between 1960 and 1964, the level of merger activity is higher than at any time during the past thirty years.1 In addition to the absolute increase in merger activity, the Commission released merger statistics showing that an increased number of 1Federal Trade Commission, Annual Report 1965, . 39. 67 acquisitions were made by large companies between 1955 and 1964. For example, in 1955 companies with assets of $100 million or more made 16 per cent of the recorded acquisitions, while in 1964 this size group accounted for almost 25 per cent of the merger activity.1 An analysis of merger activity should include more than the mere counting of the number of acquisitions and mergers that take place. The statistics on 720 "large" (defined as acquired firms with assets of $10 million or more) mergers are presented in Exhibit 9 to show both the Exhibit 9 ACQUISITIONS 0F LARGE MINING AND MANUFACTURING CORPORATIONS WITH ASSETS OF $10 MILLION AND OVER, 1948*64 Year Number Value (in millions) 1948 4 $ 64.6 1949 5 66.8 1950 4 154.8 1951 9 201.4 1952 13 326.5 1953 23 678.6 1954 36 1,450.2 1955 68 2,156.0 1956 59 2,069.6 1957 49 1,458.9 1958 39 1,118.5 1959 63 1,949.6 1960 62 1,708.3 1961 60 2,144.6 1962 71 2,179.7 1963 65 2,791.0 1964 _29, 2,784.3 Total 720 $23,303.4 Source: Federal Trade Commission, Annual genogt 1965, p. 40. Its information is based on a report on The Scone of the Cnggent Merge; Mo e t, prepared in 1965 for the Senate Subcommittee on Antitrust and Monopoly, which also gives the Bureau of Economics as a source. Ibid. 68 number of acquisitions of firms of this size and the value of the acquired assets. Based on the dollar value of the acquired assets in- volved in these large acquisitions, a significant rise in merger activ- ity is apparent after the year 1953. Takeovers of large firms with assets of more than $10 million definitely are mounting; there were 91 such deals in 1965, as compared with an average of 64 for the years 1959-63.1 To gain an insight into merger and acquisition activity by indus- try class, Exhibit 10 gives the pertinent data for the six leading indus- try groups of manufacturing concerns for years 1957-64. According to Federal Trade Commission data, the chemical industry in 1964 ranked second among industry groups in level of merger activity, with approxi- mately 14.5 per cent of the acquisitions and mergers for manufacturing concerns 0 Exhibit 10 MERGERS AND ACQUISITIONS-'MANUFACTURING CONCERNS ACQUIRED FOR SIX LEADING INDUSTRY GROUPS, 1957-64 Industry Group 1957 1958 1959 1960 1961 1962 1963 1964 Electrical machinery 62 59 82 113 122 113 109 116 Chemicals 46 58 76 68 86 108 78 103 Machinery, except elec. 79 71 91 77 87 73 88 72 Food & kindred products 40 51 69 61 73 56 67 69 ”Transportation equipment 41 49 65 67 47 56 46 56 Textiles & apparel 26 23 46 53 51 59 62 55 Source: Statistical Apatrac; pf the Dnitad Statea, 1965, p.504; Federal Trade Commission records. 1"Mergers: Everybody wants to Get Bigger," op. cit., p. 72. 69 More reliable and complete data on merger activity in recent years is included in a study by the Select Committee on Small Business of merger actions of the 500 largest industrial and 50 largest merchan- dising firms for the eleven-year period, 1951-61. Clearly, the most merger-prone industry group during this period was dairy products; but the committee's study found that a substantial number of acquisitions took place in other industries, such as paper and allied products, in- dustrial chemicals, petroleum refining, aerospace, electrical equipment, motor vehicles, and textile-mill products.1 Exhibit 11 (compiled from Exhibit 11 NUMBER OF ACQUISITIONS OF 500 LARGEST INDUSTRIALS BY INDUSTRY AND PER FIRM; 1951-61 Average ‘Number of number of SIC firms among ‘Number of acquisitions NMmber Industry 500 largest acquisitions per firm Waters: 202 Dairy products 7 462 66.0 260 Paper and allied products 26 213 8.2 281 Industrial chemicals 25 204 8.2 291 Petroleum refining 32 193 6.0 372 Aerospace equipment 23 170 7.4 361 Electrical equipment 20 160 8.0 371 ‘Motor vehicles and equipment 20 160 8.0 220 ‘Textile-mill products 18 110 6.1 Othe; aelected industgiea: 283 Drugs 16 71 4.4 284 Soaps, detergents, and cosmetics 6 33 5.5 1Select Committee on Small Business, House of Representatives, 87th Congress. Staff Report: Mezgega and Supezconcentration, Apguiai- tions of 500 Lapgeat Industrial and 50 Laggast Megahandiaing Finns (Washington, November 8, 1962), pp. 23-25. 70 Table 8 of the committee's study) focuses on certain merger patterns for these industries and the selected industries of direct concern to this dissertation (chemicals, cosmetics, and drugs). Exhibit 11 shows that the third most active industry was indus- trial chemicals, which recorded some 204 acquisitions by 25 leading com- panies--or an average of 8.2 per firm. In this exhibit the SIC numbers in the first column represent the Standard Industrial Classification group numbers as developed by the Office of Statistical Standards of the Bureau of the Budget and published in 1957 in its "Standard Industrial Classification Manual." This study will be concerned mainly with com- panies classified under SIC group numbers 281, 283, and 284.1 Appendix A lists the company breakdown for the three industries. As shown in Appendix A, five major chemical companies each acquired 11 or more firms during the eleven-year period, 1950-61, and another 12 firms acquired from 6 to 10 companies each. Especially active leading drug companies would include Chas. Pfizer & Co., Rexall Drug & Chemical Co., Sterling Drug, Inc., and warner‘Lambert Pharmaceu- tical Co.--a11 with 6 or more acquisitions. The two leading cosmetics firms, Procter & Gamble Co. and Colgate-Palmolive Co., were also active participants in mergers and acquisitions. 1Exact descriptions for these SIC group numbers are: No. 281-- industrial inorganic and organic chemicals; plastic materials and syn- thetic resins; synthetic rubber and other man'made fibers, except glass. No. 283--drugs. No. 284--soaps, detergents, and cleaning preparations; perfumes, cosmetics, and other toilet preparations. In general, each company is classified on the basis of its major line of activity. In cases where a company has no single line of activity or product which is dominant, the classification must necessarily be somewhat subjective. 71 As business combinations are maintaining a record-setting pace, the merger movement of the 19508 and 19603 poses problems for the accounting profession. Selected companies in the chemical, cosmetic, and drug industries have a pronounced and interesting history of cor- porate growth through acquisitions and mergers. Chemical companies, in particular, have joined forces in order to exploit joint interests and garner "captive" sources of raw materials.1 Typically, the recent merg- er movement has involved piecemeal acquisitions designed to strengthen a competitive position, to diversity into new markets, and to keep abreast of the rapidly developing technological changes initiated by world War II.2 Furthermore, the larger and older firms in a wide spec- trum of industries have not been idle, themselves making significant, selective, and huge mergers. Economic evidence suggests that the postwar merger movement cuts across traditional industry lines to reveal a striking trend toward sUperconcentration. This movement reflects the pervasive rise of the c“Inglomerate corporation--an entity possessing advantages in magnified fOrrmover smaller rivals, particularly as to control over product mar- klats, access to capital markets, and accessibility to new government research and development grants.4 Economic evidence also indicates this M 1Select Committee on Small Business, 0p. cit., p. 43. 2Arthur R. wyatt, A Critical Study of Acconnting for Business CC’ bi atio , Accounting Research Study No. 5, American Institute of Certified Public Accountants, 1963, p. 2. 3Select Committee on Small Business, op. cit., p. 43. 41bid., p. 44. 72 accelerating merger movement has had a pronounced impact on corporate financial statements and accounting reporting practices. 'Trends in Accounting for Businesa Combinations Although the concepts presented in Accounting Research Bulletin N@g_4§ were developed over a long period of time, the distinction be- tween a purchase and a pooling of interests is a relatively recent development. It is useful to review briefly relevant pronouncements since 1944 of both the American Institute of Certified Public Account- ants (formerly the American Institute of Accountants) and the Securities and Exchange Commission. Agcounting Research Bulletin No. 24, published in December 1944-- recognized that it was acceptable practice to write-off goodwill against either paid-in capital or retained earnings, although it discouraged such charges to paid-in capital. Accounting Series Ralease R0. 50, issued in 1945 by the SEC-- held that the write-off of purchased goodwill to paid-in capital was contrary to sound accounting principles, and that it was prefer- able to make periodic charges to income. Accounting Research Bulletin No. 40, published in September 1950--gave the accounting profession a guide with respect to busi- ness combinations. As the first official pronouncement on the subject, four tests were provided (continuity of equity interests, relative size, continuity of management, and similar or comple- mentary activities) to describe those combinations where a "pooling of interests" was normally involved, otherwise a "purchase" combina- tion was presumed to exist. Aaconnting Research Rulletin No. 43, Chapter 5, issued in 1953-- held that purchased goodwill should not be written off to retained earnings immediately after acquisition, nor should such intangibles be written off against paid-in capital. Furthermore, it advocated that those intangible assetsvflth a limited term of existence should be amortized by systematic charges in the income statement over the estimated remaining period of usefulness. Intangibles not amor- tized systematically should be carried at cost until an event has taken place which indicates a loss or a limitation on the useful life of the intangibles. 73 Acgounting Reaearch Bulletin R0. 43, Chapter 7, Section C, issued in l953--was a revision of Bulletin No. 40 and held that any adjustment of asset values or of retained earnings which was in con- formity with generally accepted accounting principles in the absence of a combination would be equally so if effected through a pooling of interests. A co ti e e ch ulletin o. 8, issued in January 1957-- superceded chapter 7(c) of Bulletin me. 43 and was the third attempt of the committee on accounting procedure to express clearly a concept of a "pooling-of-interests" business combination. Brief- ly, this revision reiterated the various criteria set forth in earlier bulletins and modified the relative-size criterion. Most importantly, it clearly emphasized that when a combination was deemed to be a pooling of interests, a new basis of accountability did not arise. Opinion No. 6, Status of Accounting Research Bulletins, issued in October 1965--emphasized that the criteria set forth in Bulletin No. 48 are not necessarily literal requirements and that treasury stock may be used to effect a "pooling of interests." Prior to 1954 the accounting treatment followed in acquisitions auad mergers was uniform in certain respects whether consideration given was cash or stock. Because it was permissible, according to AR___B__N9_.__2_4_, tC’ write-off purchased goodwill against retained earnings (earned sur- E3113s), future income statements were relieved of any charges for the EDccess of purchase cost over value assigned to net tangible assets acquired. There was no need to use the poolihg-of—interests approach fflr stock acquisitions or mergers, since the direct write-off of the excess to retained earnings resulted in carrying forward the acquired aSSets on about the same basis (book value) as if the combination had been recorded as a pooling. Exhibit 12 shows specific examples of this treatment for selected chemical and drug companies during the period 1951-53. Apparently Accounting Series Releaae Ho. 50 was somewhat success- ifill iridiscouraging the practice of writing off goodwill to capital 74 .oaw: uoEuow mug menu Honumu mama udouuso mu“ we hemaaoo wcwuasoom ocu mo mam: ecu page ouoz. .moucmaaoo wcgufisoom one mo muuoaou Hoodoo maoaum> "wousom Hue mmoH mousse musmmouu .oeH .mowummam oomphuxm .osH .HHounoznc0mmumnoam 20$ 23 same Eases a menace .m .n .8 a Hands .naeo mmo.m Nmma menace aoEEoo mammaou ocuunz. .oo .Euwsm uuonamqnuocumz ofl $3 sane - 833323 .< .u .> .8 .526 a was Saxon ooo.m Hmma moumnm coEEOO .oaH “mamoaaoco moaaumsm .auou mamoaamcu uaochom odm.H HmmH moumnm :ofiEoo muodvoum.asammawwz maaumz .oaH .mamaaoo w xoumz «mm.m HmmH moumnm coEEoo .oaH .Noa moon mm>o_Hmoo ho mmmoNMnIHZMZH Hmaafioc mnu um wouuoaou ouo3 muommm manawamuaw pocuo cam HHHBmoow use» memos :c: em .moacmaEOo xam onu mo muuoaou amends maowum> "wousom H .eomH H .moma N .NomH a .eaaa m .Haas a .meaH H .oaaH anon H .maaa amaasoem no .az mwo.o~o.mm oaw.oo<.o¢ emo.aam.¢u ooo.wwH.oH mom.oNH.Ns wen.mm~.0m moma mmo.omo.m~ Hwo.mao.mm 0H5.Hwn.ow ooo.ww~.o~ CNN.BmH.H¢ nom.m-.wm «omfi mmo.o~o.m~ ~¢N.moo.cw o-.~on.o~ ooo.mw~.o~ wwa.mmn.om Nmeawmoamm mama mmo.oNo.mN oqm.mdw.w mmm.H¢w.mH ooo. awdfiaoc memos :s: caxs .qmmfi .H muwacmh HHaScoow mcwuwunofiw moanauaoomav .ou o>aHoEHmmuouwwHoo moanmmgr .mummwm oapamcmu has on woumooHHm uod mg mdam> xoon um>o moaua mmmcouom mo mmwuxm ecu umcu mmasmmm manna mapfi "ouoz 82 mwo.o-.na aHm.oom.eHH oao.aae.mma ooo.oww.q~ nom.e-.~e man.ma~.mma mama mNo.ONN.na Hme.maa.aoH oHe.Hmn.o~ ooo.oww.e~ ONN.NmH.He nam.mm~.mm some mNo.o~a.m~ Nem.mon.oa oka.usn.oN ooo.owm.<~ mwa.ame.om ~m<.m~o.mm mean «No.0Na.mN o<~.m<~.on mma.saw.aa ooo.eaw.am mmm.mme.m~ NwH.oNs.<~ «ems amn.0sa.a~ Nan.mea.mm Nem.maa.na ooo.oa~.n~ wu~.-e.w~ oea.maa.aa Home one.oHa.e~ ma¢.4a¢.~ omm.mmo.mH som.eu~.- ama.maa.w~ ama.aww.ma coma amn.oHa.q~ mea.ma~.~ «ma.oam.ma Nmn.mmm.w zoo mozHgoom oq< .mmHzamzoo me mom mammm<_mgmHuzgazH #H uwnwaxm 83 companies have been converted to purchases based on market values of the stock consideration on dates of agreement to combine. Exhibit 15 gives the important details about the respective business combinations. For comparative purposes, Exhibit 14 assumes that Colgate-Palmolive stopped its practice of amortizing purchased goodwill on January 1, 1954, rather than on January 1, 1961, as actually done. A liberal interpreta- tion of ARR R0. 43, Chapter 5, would have allowed this since the amorti- zation of type (b) intangibles was regarded as within the discretion of the company and not obligatory.1 A study of Exhibits 13, 14, and 15 shows that the pooling-of- interests concept was successful in keeping sizable amounts of goodwill and other intangibles off the corporate balance sheets. Possibly an- other consequence of pooling accounting in these cases was to prevent the upward adjustment of the inherent value of the tangible assets of the acquired companies. One company, Richardson-Merrell, Inc. (formerly Vick Chemical Company), never used the pooling method although it had several stock acquisitions in 1956 and 1958. ‘The other five companies were definitely late in taking full advantage of the pooling concept. Jaenicke's case study of St. Regis Paper indicates that this company began using the pooling method in December 1956.2 The Flintkote Company had its first pooling of interests in 1957.3 Based on his search of 1American Institute of Certified Public Accountants, 0 . cit., par. 7, p. 39. 2Henry R, Jaenicke, "Management's Choice to Purchase or Pool," Thaiapcounting Rayiew, XXXVII (October 1962), 759. 3Samuel R. Sapienza, "Business Combinations--A Case Study," The Acconnting Rayiew, XXXVIII (January 1963), 93. 84 .mwumSm sanoo mo mocmsmmw man up kHoHOm wouoommo mums mcoaumnanaoo wmocausn nonuo one mo HH< .oumu :oamuo>eoo um xooum coaaoo coda vouuo>coo ma xooum mouuomoua moesmmm noguwaanaoo mcHHooa menu pom sowuouauu ouamr .moaamaaoo mdauaavom mo meoaumowamao wnaumaH wwwz new muuomou Hansen msoaum> "coupon H.a n.m~s ~.ra .oo Saracens .oo ananz.aoanaam mama a.~ o.moH rm.a .oo anaeronm team nauseous ream .ams< moms m.~ m.m n.o .oo nonsense esea mnaenoanau .ou a panama .naao «one N.N e.Hn w.m .00 a namaon .4 .n .00 rename a naaaoam «one N.w m.w o.H .aaH ..ou Haoasaro aaoaaan .00 a panama .aaao mane a.H m.n a.~ .oaH ..oo a asaaaaaz .M,.o .oo a nanamm .aaro Name m.¢. m.N m.o .osH .meoaonowm uoxoonuoxuaam .00 w Honwmm .mmnu mead m.a w.n a.s .aaH .aaaaaenm .00 a unnamm .aaao Head N.a k.m~ n.m .00 a manger; masons. .00 s panama .aaao Home m.a H.0H w.H .oo esea acreage are. .00 a panama .aaro Home m.N o.H «.0 .uGH .moauoumuonmq onofiw .00 w nouamm .mmso Homa m.a a.H 4.0 .aaH .aaaaouanonaa aasaa.saae .00 a panama .aaao Hana nasaa m.e m.~a a s~.a .aaH .aaanoaanonaa averages .00 naaaoeaam-aeawsoo oeaa oaam> zoom AmeoaHH«E_aav Goauouwuo mammaoo wouasvo< hnmmfioo wcuuwsvo< use» ou umou onaw> xoom anew mo mamz mo mamz. mmwsuufim ng m>AHMHmM mo ofiumm umoo masseusm wo mmooxm iirlilll ma-oaas .memmamazu no nozHaooe_zmmauHms 2a chsazmgmzH mmaomamW ma oneness 85 stock listing applications over the span from 1950 to 1960, Sapienza observed "a marked increase in the tempo of poolings after 1957."1 Chemical companies have especially been early users of the pool- ing-of-interests concept. One of the first examples of a pooling is the 1946 merger of Celanese Corporation of American and Tubize Rayon Corpora- tion.2 This merger transaction probably served as a guide to the com- mittee on accounting procedure in drafting the first pronouncement on business combinations, Accounting Research Bulletin No. 40, issued in September 1950.3 Below are listed some poolings of leading chemical con- cerns during the years 1955-57. Apgniring Company--Agguired Cpnpany Effectiye Dates Hooker Electrochemical Co.--Durez Plastics & Chemicals, Inc. April 1955 Olin-Mathieson Chemical Corp.--Blockson Chemical Co. June 1955 Monsanto Chemical Co.--Lion Oil Co. Sept. 1955 American Cyanamid Co.--The Formica Company April 1956 Stauffer Chemical Co.--West End Chemical Co. Sept. 1956 Hooker Electrochemical Co.--Oldbury Electro- Chemical Co. Nov. 1956 Union Carbide Corp.--The Visking Corporation Dec. 1956 Dow Chemical Co.--The Dobeckmun Company August 1957 M.— 1 m., 92. 2See William M. Black, "Certain Phases of Merger Accounting," 1 o A o , LXXXIII (March 1947), 214-20, which discusses the merger (pooling) of Celanese Corporation of America and Tubize Rayon corporation. 3See Edward B. Wilcox, "Business Combinations: An Analysis of HerSets, Purchases, and Relating Accounting Procedures," Jo l of °°° a c , LXXXIX (February 1950), 102-107. He discusses the pooling of Celanese Corporation of America and Tubize Rayon Corporation. In wee, this article was followed by A counti e e h ullet n O . Wilcox was a member of the Committee on Accounting Procedure Which approved Rullerg No. 49. Lamp 86 For the most part, all of these eight poolings were larger trans- actions and involved the use of voting capital stock of the acquiring company. 'Typically, the purchase price varied from two to four times the book value of acquired assets. The point to be emphasized here, however, is that after publication of ARB No. 43, Chapter 5, with its untenable methods of handling acquisition goodwill, these leading chemical companies were quick to take full advantage of the "pool- ing-of—interests" concept to avoid capitalizing goodwill and other intangibles. A review of stock listing applications and annual reports over the span from 1954 to 1965 shows that many chemical companies utilized the pooling concept exceptionally early to prevent upward adjustments of asset values and to keep goodwill off the balance sheet. One particular drug company to take early advantage of the pool- ingrof-interests technique was warner-Lambert Pharmaceutical Company. After its formation in 1955 by the merger of the Lambert Company and warner-Hudnut, Inc. (which was treated for accounting purposes as a pooling of interests), warmer-Lambert used the pooling concept twice during 1956 under somewhat disputable circumstances. Size criterion (based on com- Nane of acquired conpany Considerarion mon shares) Emerson Drug Company of Baltimore City cash and common shares 11.1% Nepera Chemical Co., Inc. preferred and common shares 7.2% Cash represented about 22 per cent of the total purchase price 111 the Emerson Drug acquisition. Based on fair values of the stock con- sixiergtion, the $4.50 cumulative (nonconvertible) preferred stock used 87 in the Nepera acquisition was 47 per cent of the purchase price. During 1959 and 1960, Warner-Lambert purchased and retired all of the shares of preferred stock from the holders for $7,070,200 cash. ‘Using the pooling treatment for these two acquisitions was dubious because an important part of the ownership of the acquired corporations was eliminated either before or after the combination. Nevertheless, pooling treatments were allowed and Warner-Lambert was able to remove from its consolidated balance sheet about $12.6 million of "excess of purchase cost over book value." If Warner-Lambert had consistently used the purchase-without- amortization method in accounting for business acquisitions since 1955, the amount reported on its 1965 Statement of Financial Position as "goodwill and unamortized cost of patents--resulting from corporate acquisitions" would have been about $162 million, rather than only about $9.3 million as actually reported. In discussing goodwill that results from acquiring going businesses in which the purchase price exceeds the carrying values of the net tangible assets acquired, warner-Lambert's 1964,4nnna1 Repor; mentions that "the goodwill so acquired is not amortized since the companies are expected to retain or increase their value."1 The statistics given in Exhibit 16 would seem to bear out the general hypothesis that accounting for business combinations has changed in recent years. 'The exhibit is based on a careful review of 124 busi- ness acquisitions and mergers made by the companies possibly to be \h. 1 . 1warner-Lambert Pharmaceutical Company, 1244ppnnna;_ngpgrrg 'Financial Review," p. 21. 88 Exhibit 16 BREAKDOWN OF 124 ACQUISITIONS AND MERGERS, 1956-65 Number of Poolings Acquisitions Burchasas of Lnrarests ‘Year and Mergers ‘NUmber Per Cent 'Number Per Cent 1956 15 9 60.0 6 40.0 1957 8 7 87.5 1 12.5 1958 5 4 80.0 1 20.0 1959 12 9* 75.0 3 25.0 1960 ‘_1 .44 57.1 _§_ 42.9 1956-1960 47 32 70.2 15 29.8 1961 17 7 41.2 10 58.8 1962 11 4 36.4 7 63.6 1963 12 3 25.0 9 75.0 1964 19 4 21.1 15 78.9 1965 n: _g 11.1 ' _1_§_ 88.9 1961-1965 77 20 26.0 57 74.0 1956-1965 124 53 42.7 71 57.3 *This exhibit includes W. R. Grace's retroactive pooling as a Purchase treatment in 1959. 89 selected for this dissertation study (see Appendix B) where stock was used as important consideration for the transaction. The information is compiled from over 100 New York Stock Exchange listing applications filed by the respective chemical, cosmetic, or drug companies during the ten-year period 1956-65. A considerable amount of timely information about business acquisitions and mergers can be obtained from these list- ing applications. As Exhibit 16 shows, the selected companies used the purchase doctrine more frequently than the pooling—of-interests concept from 1956 to 1959. But after 1959 these same companies began increasingly to use the pacling technique, until recently substantially all combinations effected solely by the issuance of equity shares (either preferred or common) are considered as poolings of interests. Based on its wide acceptance after 1960, it seems safe to say that the pooling-of— interests accounting treatment has come of age, regardless of the rela- tive size of the constituent companies or the presence of other so- called relevant factors. .As extracted fromflExhibit 16, the number of poolings whose relative size criterion is below 5 per cent is as follows: 1956 ‘1 1961 7 '1957 1 1962 3 1958 0 1963 8 1959 1 1964 10 1960 3 1965 13 ”This listing, including W. R. Grace's retroactive pooling as a pooling- of-interests treatment in the year of the change, stresses the rapid demise of the relative size criterion that took place after 1959. Per- haps it shows how arbitrary and invalid the 5-10 per cent rule is as a 90 specific standard for presuming that a purchase, rather than a pooling, exists. While the discussion centers on trends in combination account- ing practices for a sample of chemical, cosmetic, and drug companies, it should be emphasized that most of the conclusions set forth in this study are likely to apply to companies in an array of industries, such as paper, electronics, food, electrical equipment, machinery, textiles, and apparel. An examination of many listing applications, prospectuses, and annual reports over the period 1956 to 1966 suggests that the prob- lem of accounting for business combinations is generic to all companies with an active history of growth through acquisitions and mergers. Examples of practices of disregarding the necessary criteria that set off pooling from purchasing are easily found.1 As Wyatt writes, Our review of the combinations consummated during the 1958-60 period, along with a consideration of the combinations of the earlier periods, leads to the conclusion that the nature of a business combination was lacking in clarity by the end of 1960, both as to the concept itself and as to the practical classifica- tion of the various combinations.2 e d P l hed the C Each year the American Institute of Certified Public Accountants (hereafter referred to as AICPA) publishes a survey of the accounting aspects of the annual reports of 600 industrial and commercial 1See Samuel R. Sapienza, "Pooling Theory and Practice in Busi- ness Combinations," The Acconnting Rayiey, XXXVII (April 1962), 268-78. Also see Chapter 16 by the same author in.Modern,chounting'Theory, Morton Backer, ed. (Englewood Cliffs, N: J.: Prentice-Hall, Inc., 1966), pp. 339-65. 2wyatt, op. cit., pp. 37-38. 91 corporations under the title Accounting Trends and Techniques. Since 1960 one of the subjects analyzed is the accounting for business combina- tions. Exhibits 17 through 20 summarize the nature of such information as disclosed in recent report years. Note from Exhibit 17 that over the four-year period from 1960 to 1963 approximately 55 per cent of the business combinations reported were purchases and 45 per cent were poolings of interests. It is diffi- cult to estimate the extent that cash and stock were used as considera- tion for these combinations, but generally the vast majority of those involving substantial consideration were effected by exchanges of equi- ties and therefore treated as poolings of interests. In recent years, however, cash deals are gaining popularity, thereby explaining why an increasing percentage of business combinations have received purchase Exhibit 17 BUSINESS COMBINATIONS REPORTED, 1960-65 lPurchases Poolings of Interests Year Number . Per Cent Number Per Cent 1965 -- -- 84 -- 1964 -- -- 67 -- 1963 97 68.3 45 31.7 1962 36 53.7 31 46.3 1961 48 48.0 52 52.0 1960 66 9.6 67 50.4 1960-63 4-year average 54.9 45.1 Source: Accounting Trends and Technigues, AICPA, from sections on Business Combinations, 15th-20th eds., 1961-66, an annual cumulative survey of the accounting aspects of the annual reports of 600 industrial and commercial corporations. Statistics were not disclosed before 1960 report year. Number of purchases was not disclosed in the 1964 and 1965 report years. 92 treatment--68 per cent in the 1963 fiscal year. According to a survey and analysis by W. T. Grimm & Co., 67 per cent of the total acquisitions and mergers in 1965 were for cash. Grimm released the following details on cash and stock acquisitions for the years 1964 and 1965.1 Cash Deals sgogg Deals Cash-stock heals Year Total Par Cent Total Rer Cent Total Per Cent 1964 1,248 64 624 32 78 4 1965 1,424 67 616 29 85 4 One possible explanation for the increase in cash deals is that the growing impact of the depreciation recapture statutes of the Inter- nal Revenue Code seemstx>have triggered an increase in transactions in- volving the sale of assets for cash rather than stock.2 Another possi- ble reason for more cash deals is that there has been an increase in the number of foreign acquisitions. It is likely that foreigners would prefer the use of cash and debt instruments rather than ownership equi- ties in selling corporate interests for several reasons--marketability, effect on country's balance of payments, income tax factors, and such. From Exhibits 18, 19, and 20 the following trends in pooling accounting can be observed. 1. Since 1962 the number of companies reporting poolings of inter- ests has increased. Furthermore, companies reporting poolings are 1W. T} Grimm & Co., "Merger Review--l964 and 1965," studies on corporate merger activity released by the Grimm organization, a finan- cial consulting firm specializing in corporate acquisitions, Chicago, Illinois, 1964 and 1965. 2Ibid., explained by Willard T. Grimm, president of the firm, 1965. 93 .wcHHoom emu ou uoowmo o>wuomouuou o>am 09* .oa-mras ..ana ream sauna .mcowumcamaoo mmmcamom co mcoauoom 80pm .oum smouswam .mummw maoa>oum Hmuoa weaumumom Hoz moacmaaoo wcaumumom mowammaoo zmom m>HHauwumaaoo saucy co mucmaoumum Hmaucmcwm wcaucomoum mmacmmEoo ca muaoaouwum Hmaucwcah wcfiucmmoum onchEoo m." Own—«nunfl mHmmmmHzH mo mUZHAoom UZHHMONMM mqu«uoommo ofimoon mnaaooa onu.umo% ecu ooqam nos .umom uuoaou moma one ca oomoHomHo uo: mmB coaumEuomca csooxwoun mans .moumo¢H ..mco coma usuna .wcowumcwnaoo mmoofimsm do mcoauomm scum .onafiw neocommoa no code muommm man uchmucN mo moahu cwmuuoo muaao use muommm macawcmuca mo momma coeaoo umoe one muooamou umNH maan .001nmma ..mmo cuomucuaa .muomm< macwwcmucH co wcowuoom Scum . ost> NmuoH caocm mchcumm oaoucH umow was» uoz chNaoz OouNunoamcD uoz OoeNmqu omuucu ou OOMWOco momma ost> OONNNNOE< OZOHHONHHNQZ< nz¢_onH¢§N¢s Hmmmm mgzer cent interest of DearborntAqua-Serv, Inc., for common shares. (PT) , A careful study of these examples will indicate that the pooling treatfinent is considered acceptable for some partial acquisitions, i.e., Where the buying enterprise acquires the remaining minority interest of \— 1Note that a PT after any one of the examples means the transac- tio n received a pooling of interests treatment. 105 the selling company for equity shares. Such practices are closely related to the partial-pooling situation described in Chapter II which involves a diversity of conditions under which pooling accounting has been applied. Like the partial poolings, these practices have no logi- cal basis for support if the minority interest transaction is viewed as a bona fide exchange of assets and/or equities between independent parties. 2. There seems to be an increasing trend in the number of foreign acquisitions. The Grim Company reported that about 9 per cent of 1965 nuzrgers involved the purchase of foreign corporations.1 Examples for 1964-65 are: a. Chas. Pfizer & Co. acquired Bridge Colour Company, England, for cash. b. warner-Lambert Pharmaceutical Company acquired Laboratories S.A.M., Belgium, for cash. c. Procter & Gamble Co. acquired Rei-Werke A. G., West Germany, for caSh. d. W. R. Grace & Co. acquired Rexolin Chemicals Aktiebolag, Sweden, for cash and stock. (PT) e. Chas. Pfizer & Co. acquired Propas Company, Canada, for cash. f. Celanese Corp. acquired British Paints, Ltd., England, for <3étsh. g. W. R. Grace & Co. acquired the Con-Spec Companies, Canada, for cash and stock. (PT) \\_— 1W. T. Grimm & Co., 0 . cit., Merger Review--l965. 106 h. Pet Milk Company acquired C. V. Gebroeders Pel of Leiden, Holland, for cash. 1. Richardson-Merrell, Inc., acquired Laboratories Picot S.A., Mexico, for cash. j. Control Data Corporation acquired waltek Ltd., Hong Kong, for stock. (PT) These examples affirm the fact that the pooling-of—interests treatment is now acceptable for foreign acquisitions where the consider- ation for the exchange is substantially in the form of equity shares. Evenla.small portion of cash in the exchange transaction (perhaps up to 25 per cent) will not void the pooling treatment. 3. There seems to be an increase in the use of treasury stock for lnlsiness combinations. Furthermore, since about 1962, it has been Obeserved that the accounting profession has permitted the pooling treat- merxt for business combinations effected through the use of treasury Sttnik shares, although the net effect of the completed transaction is to ac"Illire the company for cash. Examples of recent "treasury stock pool- 14188" are: a. Gillette Co.--Sterilon Corp., 1962 b. Johnson & Johnson-”Stim-U-Dent, Inc., 1963 Rohn1& Haas Co.--Warren-Teed Products Co., 1963 Miles Laboratories, Inc.--Lab-Tek Plastics Co., 1964 O- O Rohu1& Haas Co.--Whitmoyer Laboratories, Inc., 1964 Union Carbide Corp.--Neisler Laboratories. Inc., 1965 American Cyanamid Co.--Preem Company, 1965 Johnson & Johnson--Eastern Magnesia Talc Co., 1965 H-D‘OOr-hm Warner-Lambert Pharm. Co.--Texas Pharmacal Co., 1966 Warner-Lambert Pharm. Co.--General Candy Corp., 1966. L—lo o 107 The use of treasury stock rather than unissued stock in effect- ing business combinations is no longer a rarity and its use in whole or in part does not prevent the pooling-of—interests accounting treatment. In his December 1962 article in The Journal of Accountancy, Jaenicke commented on the use of treasury stock as consideration for business acquisitions and speculated that: . . the profession, desirous of permitting the pooling treat- ment as often as possible, may attempt to justify the pooling treat- ment on the basis of the issuance of common shares regardless of their source.1 He could not have been more correct in his speculation. At prwesent accountants, and the SEC staff, do not question the use of com- umnm treasury shares for pooling purposes. Practice now justifies treas- Hr)? stock poolings, R. C. Lauver explains, "on the theory that this technique has the same net effect as separate transactions to accomplish, fllrst, the acquisition and retirement of treasury stock and, second, the iSamance of previously unissued shares to effect the business combina- ticnm."2 A treasury stock pooling, in effect, gives the management of thebuying company an opportunity to acquire a business for cash and yet clefirerly avoid the requirement of accounting for the excess of cost over book value which arises in the usual direct cash acquisition. The eress is written off to retained earnings at the time when the treasury Shares are retired. This shall be illustrated by examining the treasury ._._‘~‘________ 1Henry R. Jaenicke, "Ownership Continuity andm mg ," The “9-13na1 of Accountancy, CXIV (December 1962), 59. XL. 2R. C. Lauver, "The Case for Poolings," The Accounting Review, ‘I‘ (January 1966), 74. 108 stock pooling of warner-Lambert Pharmaceutical Company and Texas Pharma- cal Company early in 1966.1 . 360,000 treasury shares Consideration for acquisition . Market value at date of agreement . . . . . . $14,000,000 Cost basis of treasury shares . . . 10,800,000 Book value of acquired company . . . . 2,240,000 Entries under pooling concept: Cost of common treasury stock . . $10,800,000 Cash . . . . . . . . . . . . . . . . . $10,800,000 (purchase of 360,000 treasury shares at $30 per share) Common stock--par value $1 $ 360,000 Retained earnings . . . . . . 10,440,000 Cost of common treasury stock . . $10,800,000 (retirement of 360,000 shares of treasury stock) Net assets of acquired company . $2,240,000 Common stock--par value $1 . . . . . . . . $ 360,000 Paid-in capital in excess of par value . . . 1,140,000 740,000 Retained earnings carried forward . (acquisition of the net assets of Texas Pharmacal Company for 360,000 shares of treasury stock) A combined entry for the entire transaction would be: 1§et assets of acquired company . . . . $2,240,000 . . . . . . . 9,700,000 Iletained earnings . . . . . $10,800,000 Cash . . . . . . . . . . . . . . . . . Paid-in capital in excess of par value . . . . 1,140,000 N— 1Warner-Lambert Pharmaceutical Company, 1965 Annnal Report, H Fin“incial Review," p. 18. On December 31, 1965, the company held in leasury 624,833 shares of its common stock at a cost of $29.59 per the t :- :fiar‘e — For this illustration we assume the cost basis is $30.00 per arwa - Net assets of Texas Pharmacal Company were $2,136,375 on Septem- b er 53(3.. 1965. The amount used for the above illustration. $2.240:0002 gzgresents a reasonable estimate of book value of the net assets at illusnber 31, 1965. Any difference between the figures used in this t:Jr:ation and actual amounts is immaterial and does not change the und e1;— 1 Ying analysis . 109 Engries under purchase doctrine: $10,800,000 Cost of common treasury stock . Cash . . . . . (purchase of 360, 000 treasury shares at $30 per share) $10,800,000 $ 2,240,000 11,760,000 Net assets of acquired company Excess of cost over book value Cost of common treasury stock . .$10, 800, 000 Paid- in capita1--from treasury stock transactions . 3,200,000 (acquisition of the net assets of Texas Pharmacal Company for 360,000 shares of treasury stock) For those accountants holding the View that the true "acquisi- tion cost" of the acquired company's assets is the cost basis of the treasury shares used as consideration in the exchange (not the market Value of the shares on the date of acquisition), the appropriate account- 1113 entry would be: llet assets of acquired company $2,240,000 iExcess of cost over book value . . . . . 8,560,000 Cost of common treasury shares . . . . . . . . . $10,800,000 Accountants have every reason to be skeptical of the treasury Stoek pooling practice. When the combination transaction is viewed in its (entirety, the practice generally gives the same results as the "pur- Chase with the immediate write-off of the excess to retained earnings method, a treatment which most accountants have not sanctioned since 1953 - Where treasury stock of the buying enterprise is the consideration \— it 1For example, Colgate-Palmolive Company used this treaunent when (Hful‘chased the outstanding stock of S. M. Edison Chemical Company, Inc. treme311018) on January 15, 1960, in exchange for 33, 838 shares of common book lll'y stock. The excess of the cost of the treasury stock over the $WIEB‘VValue of the net assets of the acquired company amounted to ‘(3 ,000 and was recorded as goodwill. See Colgate-Palmolive Company, Ttunxl. , "Notes to the Financial Statements," p. 20. 110 used in a business combination, the recorded values of the properties on the acquired company's books cannot be assumed to express "acquisition cost" to the buying enterprise. 4. There seems to be a marked increase in the use of convertible preferred stock as a form of consideration for business acquisitions and As one source suggests, "they are the hot new trend in cor- mergers. porate acquisitions." The issuance of such convertibles in exchange for the common stock of the firm it is buying does offer the acquiring company some advantages. Besides giving the acquiring company more flexibility in making the purchase, these securities generally allow the 'buyer to pay more, on paper, for a going concern than it could afford if it paid cash.2 It is difficult to ascertain just why and how much more a buying firtn is willing to pay on paper (by the issuance of equity shares) for a going concern than it would pay if it paid cash. A purchase price is generally arrived at as the result of negotiation, where many factors are considered in reaching an agreement. Some of these factors, such as time :Eorm of consideration involved, are not readily susceptible to eval- uation. One may have misgivings in using the market price of the stock (“1 tile day of the agreement for value purposes, but there is usually little else to go on. Also on such convertible preferred deals, as one broker says, H the aIrithmetic is delightful."3 'Usually the acquired company's profits ‘_\—-— l"Mergers: Everybody Wants to Get Bigger," op. cit., p. 74. 2Ibid 111 are greater than the preferred dividend requirements. Therefore, with- out changing another thing, the acquiring company's profits per share will increase by the profits of the bought-out company that remain after the preferred dividends have been paid. If the buyer's common stock continues to sell at the same price-earnings ratio that existed before the acquisition or merger, price appreciation will likely result subse- quent to the combination.1 Although the element of ownership continuity is averted to some extent where preferred stock is issued in a business combination, its use will not prevent the pooling treatment. Even in combinations accom- Plished by the use of nonconvertible preferred stock, a purchase trans- auztion should not be assumed, for the absence of the convertible feature does not prevent the pooling treatment. As Jaenicke writes, The general conclusion here can be little other than a state- ment to the effect that it now appears that neither the issuance of preferred stock in whole or in part, nor any features of the preferred issue, will prevent a pooling-of-interests accounting treatment. A review of 189 acquisitions and mergers as reported in stock lidsting applications from August 1965 to March 1966 disclosed 32 (17 per cerrt) which involved the use of preferred stock. Preferred and common shares: Purchases 2 Poolings 9 Preferred shares: Purchases 4 Partial pooling 1 Poolings 16_ Total 32 ._‘~‘~_‘_______ lIbid. 2Jaenicke, op. cit., p. 59. 112 Two of the purchases and the one partial pooling combination in- volved a significant amount of cash as consideration, so pooling treat- ment would have been questionable. 0f the four remaining purchases, three were bargain purchase situations, where purchase treatment is desirable because of enhancement of subsequently reported earnings. In the one remaining preferred stock acquisition, the purchase price only slightly exceeded the acquired firm's book values, so that handling the transaction as a purchase had no significant effect in the consolidated accounts. Thus, the conclusion is warranted that management's choice to purchase or pool in combinations involving the use of preferred stock is ruat based on the ownership continuity feature, but is primarily made on the:basis of selecting that method which has the most favorable effect Or: the resultant financial statements. Discussion on Important Trends An evaluation of trends in the business combination area suggests thait the concept of a pooling of interests is still developing. The in- erwaase in partial acquisitions, the expansion through foreign acquisi- tiJJns, and the growing use of cash, treasury stock, and convertible pre- ferred stock are important trends that have definite implications for present and future combination accounting practices. For example, stirictly speaking, partial acquisitions are not business combinations; EUD‘] yet the accounting profession is beginning to treat them as if they we‘re. Today the presence of a significant minority interest outstanding subsequent to the acquisition does not prevent a pooling of interests. ain‘__‘________ 1Ibid., p. 62. Also see Samuel R. Sapienza, "Pooling Theory and 113 Furthermore, pooling has taken on international dimensions, in that American companies now actually "pool" with companies operating all over the world. The use of treasury stock in whole or in part does not forestall the pooling treatment, although the net effect of the com- pleted transaction is to acquire a business for cash. Nor does the presence of cash as a significant portion of the consideration (general- ly up to 25 per cent of the purchase price) prevent a pooling of inter- es ts. Finally, the recipients of stock in a pooling-of-interests combi- nation are allowed to sell off to outside parties a significant portion 015 their stock interest without destroying the pooling treatment for the business combinations.1 Although all of these practices seem contrary to the spirit of E No. 448, they have become acceptable by the account- 11‘13 profession and are now embraced in the term "generally accepted e,ccounting principles." Clearly, corporate managements are not willing to face the usual consequences of the cash-equivalent purchase doctrine in accounting for business acquisitions effected by the issuance of 3h ares of stock. The pooling concept has permitted accountants to record acquired aS'sfiits without regard to fair value and ignore the problem of accounting for any excess of fair value of assets acquired over their book value, but it has not solved the problem of accounting for business combina' tions, In fact, as Spacek suggests, it has compounded it. Presently: \— igactice in Business Combinations," The Accounping ngiew, XXXVII (April 62) . 273-74. In 1Howard L. Kellogg, "Comments on SEC Practice as to Pooling of 1381;83:93th W, XI (New York: Touche, Ross, Bailey & Smart, camber 1965), 35-36. 2Spacek, op. cit., p. 38.' 114 the cash-stock form of the consideration used to effect a given business acquisition seems to determine the alternative purchase-pooling account- ing treatment applicable to the combination transaction. If the assets acquired at the time of a particular business combination are the page regardless of the form of consideration involved--cash, other assets, notes, or stocknthen it is logically inconsistent to have different accounting practices for cash and stock acquisitions. For purposes of responsibility accounting, the initial amount assigned to all types of prOperties (tangible and intangible) acquired by a specific enterprise at the time of a business combination should be "acquisition cost." This is in accord with the so-called "generally accepted cost principle," as stated in a leading accounting textbook: Subject to generally recognized exceptions, and excluding caSh and receivables, cost is the preper basis of accounting for assets and expenses, and accounting records should reflect acquisition costs and the transformation, flow, and expiration of these costs. Even though the acquisition cost concept has undergone several modifications over the years (for example, the lower of cost or market rule for inventories), it is still fundamental to most accounting t1’leories of value and of income. Considerable support can be found in the accounting literature for such a concept. In the 1957 Revised State- meut by the American Accounting Association, much emphasis is placed on the concept of "acquisition cost" in valuing nonmonetary assets, such as 1rl‘rentories, plant, long-term investments, and deferred items. \— 1H. A. Finney and Herbert E. Miller, Principles of Accounting: W (6th ed.; Englewood Cliffs, N. J.: Prentice-Hall, Inc., 965), p. 142. 115 Assuming a free market, acguisition cost expressed in the bar- gained price of an asset is presumed to be a satisfactory quantifi- cation of future service expectations at the time of acquisition. Bargained price is the objective and determinable result of a com- pleted transaction, and it tends to reflect the unique relation of the asset to the entity at the time of the transaction. Accounting Research Study No. 3 states that "the initial basis of measurement for items of plant and equipment is acquisition cost or the equivalent."2 The study also stresses that intangible items (patents, cOpyrights, research and development costs, goodwill, and the like) should "probably be carried at acquisition cost in the absence of compelling evidence that their value is markedly different." Here is the real dilemma in accounting for business combinations. At: present, accountants use two different concepts of "acquisition cost" irl accounting for the acquisition of a business. If a combination is effected by means of cash, other assets, or notes, accountants record tile: cost of the prOperties acquired on the basis of the money value of tries cash, other assets, or notes given up as consideration in the ex- Here cost, in effect, means cash or its equivalent. Change . But if equity shares are used to effect a merger or acquisition, however, and the transaction is deemed a pooling of interests, \— Committee on Concepts and Standards Underlying Corporate Finan- gi‘al Statements, "Accounting and Reporting Standards for Corporate Finan- a1 Statements, 1957 Revision," in Accounting and Reporting Stnndards . O . ‘ 1.1 {1 t au'1t‘ :1d.’ ‘ e'_9' t.‘ e : :7 d ,D- ' o EEEEJEEL (American Accounting Association, 1957), p. 4. Italics mine. obert T. Sprouse and Maurice Moonitz, A Tentatiye Set of Broad 2 R ‘2‘) ti P i ci les for usi e s E te e , Accounting Research 3 (New Ybrk: American Institute of Certified Public Account- Study No. ants . 1962), p. 32. 3 Ibid., p. 36. 116 accountants record the cost of the properties acquired at the same values as those existing on the acquired company's books. Cost in this case means "amounts as carried on the books of the acquired company," without regard to current values of the acquired properties or the cash equivalent value of the equities given up in the exchange. As Account- ing Research Study No. 7 suggests, Where two or more previously independent entities merge or otherwise combine in such a manner as to constitute a pooling of interests, the new entity inherits the bases of accountability of the constituent entities. The above principle is incompatible with another statement on components of cost as expressed in the same study. If the consideration employed in acquiring properties is in the form of the capital stock of the buying enterprise, the par A fair or stated value cannot be assumed to express actual cost. measure of actual cost is the amount of money which could have been raised through the issue of the securities for cash.2 Both statements expose the two different cost concepts now accepted in accounting for business combinations. The real issue is nC>t2 one of establishing criteria to differentiate between a purchase and a Fkooling of interests. The important question is: Should different cost concepts be allowed in accounting for business combinations depend- 1‘15! (on whether a business is acquired for cash or stock? ‘Unless there are good reasons to support the position that a business combination effected by the issuance of equity shares should not disturb existing __n___~_—_______ 1Paul Grady, Inventory of Generally Accepted Acconnting Princi- $if5§§1_ for Business Enterprises, Accounting Research Study No. 7 (New 1: American Institute of Certified Public Accountants, 1965), Prin- ci ‘ht: Ple E-4, p. 67. 21bid., p. 254. 117 accountabilities, the usefulness and comparability of a series of suc- cessive financial statements for a specific reporting enterprise can be questioned. Regardless of the cash-stock form of consideration used to effect the combination, should not all of the costs of acquiring a business be fully accounted for to the corporate stockholders and creditors? CHAPTER IV METHODOLOGY Review of Two Case Studies In order to evaluate the impact of pooling and purchase account- ing on corporate financial statements, it was necessary to select some actual companies for analysis. A logical starting point seemed to be those companies in industries known to have in recent years an active history of growth through business acquisitions and mergers. Such, an approach was taken by Jaenicke in his case study of St. Regis Paper Com- Party.1 Although he suggests that St. Regis was chosen at random, never- theless there were several good reasons for his selection of this parti- CUIar firm. First, the company had a pronounced history of growth through co“lbination and was active in the use of the pooling and purchase con- cepts. Second, the company used its own common stock as the principal means of achieving these combinations. Finally, the company was listed \— 1 enry R. Jaenicke, "Management's Choice to Purchase or Pool," H W, XXXVII (October 1962), 758-65. Jaenicke's study 8 ctoncerned with accounting effects of alternative treatments on finan" or St. Regis Paper Go. over the period 1947-60. The (3:31 information f InDenny had 29 acquisitions but only 6 received pooling accounting treat- m ail-1'18. He converted these 6 to purchase treatments with fifteen-year 01‘tization and made an analysis of the effects on six financial ratios f “1‘ the period 1957-60. 118 119 on a major stock exchange and therefore more complete financial informa' tion was available relative to the various business combinations. Sapienza took a similar approach in his case study of the Flint- kote Company.1 This company had rapid growth during the five-year period 1956-60 mainly as a result of 16 acquisitions, of which 9 re- ceived pooling treatments. After converting the poolings to purchase treatments with amortization against revenues based on the company's average rate and making an analysis of the effects on three selected financial ratios, Sapienza concluded: Important financial differences of interest to stockholders arise from a consistent application of the pooling method as con- trasted with a purchase technique. . . These results appear likely: (1) Significant undervaluation in assets exists in terms of market appraiSal at the time of exchange. (2) Earnings ratios tend to overstate managerial efficiency in operations. (3) The debt to equity ratios tend to worsen with a consistent application of the pooling technique.2 Both studies supported the general conclusion that pooling-of- irlterests accounting reflects an improvement in operating statistics in financial statements which may not be warranted. Neither study, how- e3’irr, measured completely the impact of alternative pooling-purchase a‘5-‘-<=ounting techniques on the underlying financial statements and invest- theI'M: analysis. By converting all poolings to purchases (with amortiza- tfl<>t1), both studies compared two alternative ways a company's financial s tatements can be presented. \—————— A 1Samuel R. Sapienza, "Business Combinations--A Case Study," The cecu ti view, xxxvm (January 1963), 91-101. bee Zlhlés. 101. In this article the author does not explain what Ineans when he amortized by the "company's average rate." 120 The first way is a mixture of methods--as actually reported-- where both the pooling and purchase concepts are followed depending primarily on the form of payment used to effect the business acquisi- tions. The other way is to treat all business combinations as purchases and systematically amortize the excess of cost over book value against income on an appropriate basis. But these two ways simply do not consider the other alternative practices in the area of business combination accounting. Because it is not entirely clear in financial circles that capitalization of purchased goodwill and its subsequent amortization result in more meaningful in- come data, some accountants prOpose the direct write-off to retained earnings of the cost of goodwill at the date of the combination, regard- less of the form of consideration involved-“whether cash, debt, or stock. Remember that a "treasury stock pooling" situation allows management to a<-‘-quire a business for cash and, for all practical purposes, amounts to the "purchase with immediate write-off" treatment. Other accountants believe that the purchase treatment is proper for both cash and stock acquisitions, but they insist that no systematic mortization policy should be followed for any excess of fair value of a sSets acquired over their book values. Chapters II and III have stressed the popularity of this "purchase without amortization" treatment. Clear- 13; ’ a study of the effects of alternative pooling-purchase accounting 1: reatments on financial statements should consider, within reason, the e R18 ting variety of combination accounting practices. The alternative w ays 0f accounting for business combinations and of presenting the 121 resultant financial statements will be described later in this chapter. The case studies of St. Regis and Flintkote provide only a convenient starting point for purposes of this study. Empirical Approach to the Study The initial task was to select several industries for purposes of the study. It was decided that the industries selected should be popular with investors. Assuming that the corporate return on invest- 'ment was an important performance standard for investors, ten well- defined industries known to have active histories of business combina- tions were selected and ranked according to their return on invested capital in 1 964.1 Return on Industry Invested Capital Industry Rank Pharmaceuticals 16.3% lst Soaps, cosmetics 14.7 2nd Chemicals 12.1 6th Appliances, electronics 11.9 7th Office machinery 11.4 10th Apparel 11.0 11th All Industry Median 10.5 Food and beverage 9.8 15th Paper and wood products 9.6 17th Petroleum refining 9.0 20th Textiles 8.6 let The next step was to look more closely at those industries per- Fo7‘1‘Ining better than the median. A review of the industry classification 3 3"'~‘3t:em.used by Standard & Poor's Corporation showed that the appliances \—_— 1Th Fo tune Di ecto , "The 500 Largest U.S. Industrial Corpora- t Alfons” tables on Return on Invested Capital for the Industry Medians, 8118:: 1965, p. 21. 122 and electronics grouping was not a well-defined industry. It soon be- came apparent that the leading three industries--pharmaceuticals, cos- metics, and chemicals--have a high degree of homogeneity in Operations and have been good quality investments over the years. In the final analysis, there were no good reasons for not choosing these three industries. The next step was to select for the study a list of companies from within those industries. The following requirements were estab- lished. l. The companies chosen must be listed among the top 500 industrial companies by The Fortune Directory, August 1965. 2. The companies selected must have had their common stock shares traded on the New York Stock Exchange for the ten-year period 1956-65. 3. The companies selected must be classified as Chemicals, Cosme- tics, and Drugs as based on the classification system published by Standard & Poor's Corporation, Nevember 1965, in the Security Owner's grock Guide. 4. The companies selected must be considered as high quality invest- ments. For purposes of the study, an.A+, A, or A- stock ranking by Standard & Poor's as of November 1965 satisfied this requirement. Based on the above requirements, thirty companies were selected. The list is included as Appendix B. The next step was to review New York Stock Exchange listing applications for the thirty selected companies over the periods 1956-65. Over one hundred pertinent listing applications were examined and selected data of 126 business acquisitions and mergers were compiled. 123 Excluding two partial poolings, Exhibit 16 in Chapter III gives a break- down of the purchase and pooling treatments used for 124 acquisitions. Having reviewed all pertinent listing applications, an examina- tion was made of annual reports, proxy statements, and various prospec- tuses of the thirty companies. In most instances, the disclosure of information about business combinations accounted for as poolings of interests was reasonably adequate. 0n the other hand, the disclosure of information about the purchase accounting treatments was generally inadequate. The lack of information about allocation and amortization practices was discouraging and placed definite limitations on the study. In fact, without the information as reported on the listing applica- tions, proxy statements, and the forms 10K filed annually with the Securities and Exchange Commission, important details necessary for certain calculations and adjustments could not have been obtained. Even with these details it was necessary to introduce certain assumptions and estimates. On the basis of the investigation of the indicated information, eight of the thirty companies studied were selected for detailed case analysis. These eight companies comprise the heart of the empirical section of the study. These firms were chosen because they seemed to satisfy best the central objective of the study, i.e., to determine the effects of pooling and purchase accounting treatments on the presenta- tion and interpretation of corporate financial statements. Appendix C lists the eight companies selected. Appendix D lists the business acquisitions and mergers for these eight over the time period 1951-65. For purposes of the case analysis a ten-year period from 1956 124 through 1965 was used, but appropriate adjustments to financial state- ments under each of the alternative combination accounting treatments also considered mergers and acquisitions occurring during the years 1 951 -55 . Briefly, the alternative ways of accounting for business com- binations and of presenting the resultant financial statements are d escribed here . 1- W. "pool ings of interests ,' All business combinations were treated as ' regardless of the form of consideration in- VOlved. Such a treatment requires the immediate write-off to retained earnings of the cost of goodwill and other intangibles created in the case of a cash acquisition. This practice was acceptable prior to the issuance of ARB No. 43, Chapter 5, in 1953. 2. Mixture, as reported. All business combinations were treated e3'Eactly as recorded by the acquiring company at the time of the acqui- S ition or merger. In effect, no adjustments were made to the annual financial statements. Since each company had many purchases and at 1east one pooling treatment (considering the "purchase with irmnediate wri te-off" technique as a pooling treatment), all of the companies actLlally followed a "mixture" of combination accounting methods through- on t their respective histories of acquisitions and mergers. At present, 125 the typical enterprise follows a mixture of purchase and pooling con- cepts in accounting for business combinations depending predominantly on the cash-stock forms of consideration used to effect the combinations. 3. Purchase without Apprtization. All business combinations were treated as purchases but with no systematic amortization policy followed for any excess of fair value of assets acquired over their book values. The excess of purchase price over the book value (or value assigned to the net tangible assets acquired) is carried at cost as a permanent in- tangible asset on the balance sheet. For cash deals, this treatment is somewhat similar to the observed practice of recording some foreign acquisitions in an "investments, at: cost" account. Of course, under this "investment" treatment all of the acquired assets (includingthe element of excess of cost over book value) are buried together in the LInvestments account. Celanese Corporation, for example, used this treatment in October 1965 when it purchased for approximately $48,500,000 suhstantially all of the outstanding shares of British Paints (Holdings), Ltd_1 4. Purchase nith Anortization. All business combinations were tI‘eated as purchases, with the systematic amortization of the cost of acquired intangibles in the income statement over an appropriate number of years. Of the eight firms selected for case analysis, only one (Colgate-Palmolive) actually amortized the cost of goodwill and other gerleIl‘al intangibles by annual charges to operations, a practice which the \\____ 1Celanese Corporation of America, Annqu Report 1965, "Notes to C Gasolidated Financial Statements of 1965 ," Note 3, p. 31. 126 company discontinued in 1961. Nevertheless, it should be stressed that an examination of listing applications for the thirty companies given in Appendix B did reveal several other firms (such as W. R. Grace & Co., .American Cyanamid Company, and Air Reduction Corporation) which amor- tized the excess of cost over value assigned to net tangible assets of tnasinesses acquired over various time periods from five to forty years :for certain business combinations. Expanding upon the approach used by Jaenicke and Sapienza in tileir respective studies of St. Regis Paper and Flintkote, the study paroceeded with detailed case analysis for each of the companies. It was necessary to make adjustments to financial information under each of tlle alternatives in order to establish what would have resulted had the rfeporting enterprise treated acquisitions and mergers differently than it actually did. In determining the amount of the difference between Cost and book value to be capitalized in the process of converting the POOIings to purchases, the value assigned to the shares given as consid- ercation was based on the closing market price of such stock on the date of the agreement between the constituent corporations; from this value was subtracted the net worth of the acquired company as of its last audited balance sheet prior to the combination. In all cases the result- ing difference turned out to be a debit figure and was treated as though it Were capitalized as an intangible, with a like amount being added to the acquiring firm's capital surplus. Both ichibit 15 in Chapter III and Appendix E give important particulars about the respective pooling comb inations . Under alternative 4 (the purchase with amortization treatment), 127 intangibles were amortized over a ten-year period on a straight-line basis. Practically speaking, it is impossible to say that any selected time period is a proper one, for estimating the appropriate amortization rate depends on assumptions and judgments about the nature of goodwill and its useful life. As ARE NO. 43 suggests, the pattern for amortiza- tion of intangibles should be based on "all the surrounding circumstan- <:es, including the basic nature of the intangible and the expenditures currently being made for development, experimentation, and sales promo~ tion."1 If it is notoriously difficult to evaluate the very nature of goodwill. (remembering that all too frequently "goodwill" includes unallo- cated costs of tangible assets and specific intangibles which do not bel ong in the account), then it is equally difficult to establish 0a systematic and rational basis for the allocation of the cost of goodwill. While it is apparent that any treatment accorded the disposition °f SOOdwill is subjective and arbitrary, some basis had to be selected-- if only to show the consequences of such amortization procedures on finaInitial statements. In the previously mentioned study of St. Regis Paps—‘1‘, Jaenicke chose a fifteen-year period mainly to be on the conserva- tlve Side.2 Another author contends that "there are sound reasons to amortize the excess debit, if one exists, over the same period of time that expected earnings [of the acquired company in the combination] were capitalized, regardless of whether income is available to absorb the \- fied 1Committee on Accounting Procedure, American Institute of Certi- Public Accountants, Apconnring Rgsearph and Terninology Bulletins (fi nal ed.; New York, 1961): Chapter 5: par. 7’ P' 39' 2Jaenicke, op. cit., p. 760. 128 charge."1 Thus, the selection of a ten-year amortization period for purposes of this study implies a ten per cent rate of capitalization at the time of the business combination-“which perhaps is realistic in an economic sense. Such an amortization term would appear reasonable if accounting standards as recommended by Paton and Littleton are followed. . . . the cost of goodwill or other general intangibles should be absorbed by revenue charges during the period implicit in the computation on which the cost incurred was based; . . .2 The selection of a ten-year amortization plan could be unreason- able when judged in the light of a recomendation by the Committee on Accounting Procedure in accounting for intangible assets. Where the intangible is an important income-producing factor and is currently being maintained by advertising or otherwise, the period of amortization should be reasonably long. ' In the final analysis, although practices in this area do vary considerably, the study selected a ten-year amortization period prima- r1137 because a review of many stock listing applications over the span from 1954 to 1965 showed that this particular term of goodwill amortiza- tion is a prevalent one. Conparatiye Analys is To compare the results of the four alternative pooling-purchase a ccounting treatments on financial statements and to evaluate the \_______ St lsamuel R. Sapienza, "An Examination of AICPA Study No. 5-- andards for P0011118," h Accounti e iew XXXIX (July 1964), 584—85. 2W. A. Paton and A. C. Littleton, An Introduction to Corporate A (451° tin t nda d , American Accounting Association Monograph No. 3 e7|:‘1can Accounting Association, 1940), p. 66. 3Committee on Accounting Procedure, op. cit., p. 39. 129 changes in investment analysis resulting therefrom, a computer program for financial statement analysis was used. This program was developed at the Graduate School of Business Administration, University of Califor- It computes eighteen ratios commonly used by finan- nia at Los Angeles.1 The ratios cial analysts and compounds growth rates for selected items. are grouped into six functional classes: liquidity ratios, efficiency ratios, profitability ratios, price ratios, capital structure ratios, and miscellaneous ratios. In addition, the program calculates and prints out a series of per share data for the analyst which has been adjusted for all stock splits and stock dividends. It also calculates tZhe mean ratio for the entire number of years for each of the eighteen financial ratios.2 Appendix F reproduces the details concerning the fit'lancial ratios and growth rate items. The computer program for financial statement analysis produces tthree pages of output for each company. Since the present study con- siders four alternative pooling-purchase accounting treatments, a given company's financial statements can be presented and analyzed in four different ways. For the eight companies analyzed this actually means there were ninety-six pages of output, considering all of the alterna- tiVes. While it is not practical to include all of the pages of output resulting from these case studies, for illustrative purposes Appendix G gives eight pages of output for one of the selected companies, \———— «11 1David K. Eiteman, "A Computer Program for Financial Statement 61 aéysm’" '- 1 1 0 1: XX (November-December 1964), ‘ 8. 111“ 2In this dissertation study, for example, the mean ratio for the A!) Q‘year period 1957-65 was calculated for each financial ratio. See pendix G for mean ratios of Chas. Pfizer & Co. , Inc. 130 Chas. Pfizer & Co., Inc. Pfizer was chosen because it not only had a pronounced history of growth through business acquisitions but also be- <:ause it was active in using both the pooling and purchase concepts. CHAPTER V THE IMPACT OF ALTERNATIVE COMBINATION ACCOUNTING PRACTICES ON FINANCIAL STATEMENTS AND INVESTMENT ANALYSIS It is apparent that accounting practices fashioned for business mergers and acquisitions are rather arbitrary, largely ignoring the criteria set forth in.Agpppnring_Rpngnrpnrflnllerrn_flpr_4§_and the underlying nature of the exchange transaction. Accountants themselves are not certain of the distinction between a purchase and a pooling of interests. ‘When faced with the problem of accounting for the "excess of purchase cost over book value of assets acquired," management and accountants alike have favored pooling over purchase accounting whenever possible. ‘The obvious lack of a reliably consistent basis for choosing between methods has led to an array of combination accounting practices, each possessing the stamp of general acceptability. Earlier chapters have shown briefly how alternative pooling- purchase accounting treatments produce widely”varying differences in an enterprise's financial position and earnings. ”This chapter evaluates the consequences of alternative combination.accounting practices on con- ventional financial statements and investment analysis for selected comr Penies in three industries--chemicals, cosmetics, and drugs. Perhaps a atlldy of the effects of alternative treatments on the presentation and interpretation of corporate financial statements not only will show that 131 132 it is logically inconsistent to allow different accounting practices (using different concepts of acquisition cost) for cash and stock acqui- sitions, but also will disclose the one best method of recording the combining of business enterprises. Effect of Alternatiyes on Financial Data Exhibits 25 and 26 have been prepared to reflect the effect of alternative combination accounting practices on certain financial data for four drug companies. The information in these exhibits will be referred to many times in the ensuing discussion. Pooling concept. Under this approach business acquisitions have been treated as if they were poolings of interests. 'The cost of good- will and other general intangibles created in the case of cash acquisi- tions has been written off to retained earnings. Prior to the issuance of ABE No. 43, Chapter V, in 1953, this practice was acceptable account- ing (see Exhibit 12). Both Leonard Spacek and Robert C. Holsen favor thismethod.1 Whether called the "purchase with immediate write-off of excess" technique or the "pooling of interests" method, generally both treat- ments produce the same effect on financial statements. Accountants may object to this inference; they may claim that the term."excess" is being misinterpreted. It is the excess of purchase cost over the fair yalue 1Leonard Spacek, "The Treatment of Goodwill in the Corporate Balance Sheet," Ine_Jpnrna1_pfrnpppnnranpy3 CXVII (February 1964), 35~40; Robert C. Holsen, "Another Look at Business Combinations," a section included in Arthur R” wyatt, A Criticgl Study of Accountingyfor Business Combinations, Accounting Research Study No. 5 (New'Ybrk: AICPA, 1963) pp. 109-114. 133 of the assets acquired rather than the excess of purchase cost over book value that they believe should be charged to retained earnings at the date of the acquisition or merger. First, any portion of the excess which is attributable to tangible assets and specific intangibles must be assigned; therefore, only the remaining portion (if any) that is truly attributable to goodwill may be accounted for as a reduction of the equity of the acquiring corporation. While ARE No. 58 states clearly that adjustments of asset values are appropriate for pooling combinations, accountants do not write up assets (either tangible or intangible) in connection with a pooling of interests. In fact, accountants frequently do not write up the book ‘values of the tangible assets acquired when using the purchase approach. Often they merely charge the excess of purchase price OVer book value of the acquired assets to a catch'all account entitled "cost in excess of book amount of net tangible assets of businesses acquired." Since accoUntants today do not often record upward adjustments for tangible assets acquired by combination, would they do so in the future if the practice of writing off purchased goodwill to retained earnings became a "generally accepted accounting principle," as it was before 1953? Possibly here is the greatest weakness of any proposal that pur- chased goodwill should be charged against retained earnings at the date of the acquisition. Accountants may use the term "goodwill" to describe the entire excess of cost over book value of assets acquired, with little reference to the underlying nature of the excess. Such a goodwill account could easily become a depositary for specific asset items that actually do not belong in the account--a convenient place to hide upward 134 adjustments of tangible asset values. By writing off to retained earn- ings the entire excess of purchase cost over book value without regard for the fair value of the absorbed company's specific assets at the time of the combination, accountants will carry forward asset values into the acquiring firm's accounts on the same basis (book value) as if the com- bination had been treated as a pooling of interests. Tax aspects of the nontaxable type of business combination only tend to encourage the pooling assumption since any write-up of tangible asset values by the buying firm cannot be depreciated for income tax computations. Accounting for the nontaxable type of combination as a purchase augments continuing differences between reported and taxable business earnings. Practical tax accounting considerations definitely favor the pooling concept. From.Exhibits 25 and 26 it is obvious that material differences in financial data do result from management's choice to purchase or to pool. 'The use of pooling is appealing as it offers balance sheet con- servatism and avoids the difficulties of accounting for the excess debit. ‘The pooling technique gives financial statements a certain sense of form and uniformity since all of the assets of the surviving company are recorded at the book amounts previously carried by the constituent com- panies. Therefore, the future financial performance of the surviving enterprise will be directly comparable to the combined past records of the merged companies.1 But using the prior book values as the basis of accounting recognition disregards the valuation and bargaining activity 1A. N3 Mosich, "Impact of Merger Accounting on Post‘Merger Finan- cial Reports,"inanagemenr_Anppnnring, XLVII (December 1965), 23. 135 Exhibit 25 1965 FINANCIAL DATA FOR FOUR.DRUG COMPANIES (in millions of dollars) Mixture Purchase Purchase Pooling as without with Company and Item Concept reported Amortization Amortization Enigtol-Myers Total assets $168 $193 $322 $295 Common equity 118 143 272 245 Net income before taxes 65 65 65 50 Net income to common 33 33 33 18 i er 'Total assets 489 534 607 559 Common equity 293 338 411 363 Net income before taxes 96 96 96 85 ‘Net income to common 53 - 53 53 42 h d on-Me ell 'Total assets 132 174 175 151 Common equity 107 149 150 126 Net income before taxes 42 42 42 38 Net income to common 20 20 20 16 e - e t Total assets 252 262 429 345 Common equity 138 147 314 230 Net income befOre taxes 72 72 72 56 ‘Net income to common 37 37 37 21 136 Exhibit 26 1965 FINANCIAL DATA FOR.FOUR.DRUG COMPANIES (comon equity per share-'adjusted data) Mixture Purchase Purchase Pooling as without with Company and Item Concept reported Amortization Amortization Eriatol-Myers Earnings $ 2.64 $ 2.64 $ 2.64 $ 1.43 Dividends 1.32 1.32 1.32 1.32 Cash flow 2.96 2.96 2.96 2.96 Book value 9.36 11.34 21.55 19.45 Average market price 83.50 83.50 83.50 45.19* ghgg. Egizer Earnings 2.69 2.69 2.69 2.11 Dividends 1.30 1.30 1.30 1.30 Cash flow 3.58 3.58 3.58 3.58 Book value 14.71 17.00 20.67 18.25 Average market price 62.38 62.38 62.38 48.95* Richardson-Merrel 1 Earnings 3.54 3.54 3.54 2.84 Dividends 1.00 1.00 1.00 1.00 Cash flow 4.22 4.22 4.22 4.22 Book value 18.58 25.89 25.97 21.84 Average market price 70.25 70.25 70.25 56.23* Hameziambert Earnings 1.60 1.60 1.60 .90 Dividends .90 . .90 .90 .90 Cash flow 1.87 1.87 1.87 1.87 Book value 5.98 6.39 13.60 9.95 Average market price 37.94 37.94‘ 37.94 21.33* *Assumes that the market price of each company is directly related to earnings and that the 1965 average price-earnings ratios for the companies remains unchanged, i.e., at 3L6, 23.2, 19.8, and 23.7 times earnings, respectively. This assumption is likely invalid because price-earnings ratios are highly unpredictable. ”It..- IIcv I . tea 137 between the constituents and ignores completely the actual exchange transaction without which the combination could not be effected. Note from Exhibit 25 that the consistent application of the pool- ing technique for both cash and stock acquisitions causes significant undervaluation in asset and equity values reported in subsequent finan— cial statements. The effect is to omit accountability for the current value of acquired assets existing at the time of the exchange and to retain historical cost figures for post—merger reports of the pooled entities. While historical cost data may be acceptable and significant to the acquired enterprise prior to the business combination, such data should not automatically be recognized as acceptable and relevant to the enterprise which emerges after the combination. Generally book values are relevant to no other enterprise but the one which originally incurred such cost.1 Keeping in mind that the objective of accounting is always to present meaningful and useful financial statements, the purchase price or fair market value of the consideration given in exchange at the time of the combination is usually a far more significant figure to the pur- chasing entity than the existing book value of the predecessor company. There is nothing inherent in the pre—merger carrying values on the acquired company's books that guarantees their usefulness as a basis of accountability for the acquiring company. If a seller's book value figures are virtually insignificant as a basis of accountability for the acquiring company, it appears that the pooling approach to business combination accounting violates the 1Public utility accounting would be a major exception to this statement. 138 American Accounting Association's primary standard of relevance. This is one of the four basic standards mentioned in Chapter I that this study shall use as criteria in evaluating the acceptability of alterna- tive accounting methods. Past acquisition costs on the books of the selling enterprise generally are inferior to current market prices as a measure of the cost or "sacrifice" involved in acquiring a going concern. Because the pooling technique essentially ignores the new exchange value (purchase price) created by the business combination transaction, it can hardly be said to provide financial information that is relevant for 1 investment decisions. Mixture, as reported. At present, business combinations effected through the use of assets and debt instruments are accounted for regular— ly under the purchase concept, but combinations involving an exchange of equity shares generally are treated as poolings of interests. Because the form of consideration used in acquiring a going concern determines the appropriate combination accounting technique, the typical reporting enterprise follows a mixture of methods in accounting for acquisitions and mergers over its history of combination growth. Most accountants would agree with the proposition that the type of consideration involved in acquiring a business does not cause the book value of the acquired company to become more relevant to the acquir- ing company in giving information to creditors and stockholders about the financial position of the reporting enterprise. The fact that purchase price for a cash or stock acquisition typically varies from three to lAmerican Accounting Association Committee to Prepare a State- ment on Basic Accounting Theory, A Statement of Basic Accounting_Theory (American Accounting Association, 1966), p. 33. 139 six times the book value of the net assets of the absorbed entity lends considerable support to this proposition. Clearly, if the book value of an acquired company is irrelevant in the case of a cash purchase, then the book value is equally irrelevant if that same company were to be acquired by means of a stock transaction. Except for the difficulties of establishing a suitable value for the shares issued in a stock trans- action, the excess of purchase cost over book value in a stock acquisi— tion is fundamentally no different than in a cash acquisition. Furthermore, once the exchange price has been established in a business combination, the allocation of the total price to various assets is no different when stock is used than when cash is used to acquire the selling company. Thus, for allocation practices under pur- chase accounting, the standard of verifiability applies just as easily to stock acquisitions as to cash acquisitions. When consideration for a business combination is in the form of equities, the shares of stock used to effect the exchange are merely sub- stitutes for cash or other assets, notes or bonds. The actual cost of the new properties acquired by the buying entity in a stock acquisition is best measured by the cash equivalent value of the securities trans- ferred in the exchange, i.e., the amount of money which could have been raised through the public issue of the securities.1 The fact that shares rather than dollars are involved in the exchange does not change the accountant's function of quantifying the business combination activity in 1W. A. Paton and A. C. Littleton, An Introduction to Corporate Accountigngtandards, American Accounting Association Monograph No. 3 (American Accounting Association, 1940), p. 28. 140 terms of money-equivalents. When viewed from the point of View of the buying party, meaningful quantification of data in terms of implied cash costs (bargained prices) for noncash forms of consideration is desira- ble to improve the measurement process in accounting and to increase the usefulness of financial information. If a series of successive finan- cial statements for a Specific entity are to possess comparability and Significance, there is no logical basis existing in accounting theory for a continuation of the mixture of methods currently being followed for business combination accounting practices. Purchase without amortization. Under this approach both cash and Stock business combinations have been treated as purchases with no system- atic amortization policy adopted for the excess of purchase cost over bOOk value. Previous chapters stressed that the practice of carrying 800dwill and other related intangibles as an unamortized asset on the balance sheet is acceptable for cash or stock acquisitions and seems to be increasing in its application. Note from Exhibit 25 that the consistent application of this method has its greatest impact on successive balance sheets by causing sizable accumulations of goodwill and other general intangibles. Amounts 1reported on the balance sheet for total assets and stockholders' equity are larger than under any other alternative combination accounting treat- metlt: . But now accountabilities are based on the current value of the acquired assets existing at the time of the business acquisition regard- less of the cash-stock form of consideration used to effect the exchange. \— 1American Accounting Association Committee to Prepare a Statement QSDKWBasic Accounting Theory, op. cit., p. 12. In this statement the com- ttee suggests that "the accounting function emphasizes meaningful quan- ’& glfication represented by numbers to increase usefulness." 141 As long as the excess of purchase cost over fair value of net tangible assets of businesses acquired is carried on the balance sheet as an asset, as if its value is being maintained, the amount reported as stockholders' equity does reflect perhaps an amount that should be recognized in the determination of total invested capital. Furthermore, if the intangibles have been acquired at a cost and there is reasonable evidence that their values are being maintained by current expenditures, a continuing policy of nonamortization of such intangibles may be appro- priate. As Hendriksen stresses, Amortization should occur only when there are indications of limited existence, and a write-off should be made only when there is evidence of loss of value. The same principles should apply to intangibles. A general license to amortize and write them off over arbitrary periods does not lead to responsible accounting. The result is an understatement of net income during the amortization period and a perpetual understatement of assets in subsequent periods. The practice of continuing to show this excess as an asset on the balance sheet after the circumstances that created it no longer exist may be open to serious objection. This practice could mislead creditors and stockholders who wish to accumulate information about the financial activities of a business enterprise as a basis for the formulation of many business decisions. Carrying goodwill and related intangibles as unamortized assets infers that the present level of corporate earnings are still related to the original cost of the intangibles; but the longer that time elapses, the weaker this connection becomes. Practical diffi- culties in establishing a sound basis on which the expense for a single period or longer can be calculated, however, indicate that the general 1Eldon S. Hendriksen, Accountigg;Theory (Homewood, Ill.x Richard D. Irwin, Inc., 1965), p. 344. 142 practice of expensing the costs of maintaining intangibles with no amortization of capitalized intangibles may be the most appropriate or at least the most expedient method of accounting for purchased goodwill and other unlimited-term intangible assets.1 Paton and Littleton advocate that amounts expended for goodwill and other general intangibles are essentially no different from that of any asset subject to depreciation. Such amounts represent committed investments to be recovered in the future just as much as do Specific investments in tangible assets. Paton and Littleton believe the prac- tice of not amortizing the cost of goodwill by periodic charges against revenues is fundamentally unsound. They state: The cost of goodwill included in the purchase price of a going concern is essentially the discounted value of the estimated excess earning power-~the amount of the net income anticipated in excess of income sufficient to clothe the tangible resources involved with a normal rate of return. Thus purchased goodwill represents an advance recognition of a debit for a portion of income that is expected to materialize later. It follows that the amount expended for goodwill should be absorbed by revenue charges--during the period implicit in the computation on which the price paid was based-~in order that the income not paid for in advance may be measured.2 Purchase with amortization. Under this last approach the excess of purchase cost over book value arising from business acquisitions and mergers has been absorbed by revenue charges over a ten-year period. 1Ibid. Perhaps it should be stressed that this discussion on the amortization of intangible assets is concerned with type (b) intan— gibles (those without limited life). If an intangible is identified as type (a), this study accepts the generally accepted accounting principle that "the cost of type (a) intangibles should be amortized by systematic charges in the income statement over the period benefited," as pre- scribed by ARB No. 43, Chapter 5, par. 5. 292. cit., pp. 92-93. 143 Although the period is selected arbitrarily, the policy of amortizing goodwill and other intangibles by charges to operations has many propo— nents in accounting literature. One writer contends that a difference of opinion about the exact period which should bear the charge is an inadequate reason for failing to charge the intangible against any period.1 From the information in Exhibits 25 and 26 it is clearly evident that an amortization policy with respect to goodwill arising from busi- ness acquisitions does have important consequences on selected financial data. Especially note the probable effect on earnings to common stock- holders. When the intangible increment in asset values is amortized, in the case of Bristol4Myers Company the result is a reduction in reported common earnings from $33 million to $18 million, or from $2.64 to $1.43 per share. Such a difference here in reported earnings is obviously a strong inducement to any management to avoid the purchase—with-amortiza— tion method in accounting for business acquisitions and mergers. Under the assumption that the market price of a company's common stock is directly related to earnings, and that the 1965 average price- earnings ratio for Bristol-Myers would remain unchanged at 31.6 times earnings, the purchase-with-amortization treatment would cause the average market value of Bristol-Myers common shares to decline to $45 per share (from an average of $83.50). Although stock prices do not necessarily follow predictable price-earnings patterns, it seems likely that the policy of amortizing the cost of purchased goodwill to 1Gordon M; Hill, "Wanted: Solutions to Three Major Technical Problemm," The Journal of Accountancy, C (August 1955), 44. 144 operations would have a potentially depressing effect on the market value of the buying enterprise's stock. This in turn could have an unfavorable effect on an enterprise's cost of raising additional funds. If the lower earnings per share is accompanied by a probably lower market price of stock, the cost of raising equity funds may be much higher under purchase-with—amortization accounting than under other combination accounting treatments. The cost of borrowing could also dif- fer as a result of the lower earnings reported when using the purchase- with-amortization method. But since creditors and their financial analysts place great importance on the concept of cash flow in apprais— ing a firm's debt capacity, it is more probable that the cost of raising additional funds through borrowing is not significantly affected by the particular pooling-purchase accounting treatment used. As Exhibit 26 illustrates, an enterprise's cash flow (measured roughly by adding non- cash expenses to net income) is the same for each combination accounting method because the amortization charges under purchase-with-amortization accounting are noncash deductions. Exhibit 27 shows more completely the impact of amortization on earnings per share for two companies over the period 1957-65. By includ- ing dividends and dividend payout ratios, this exhibit discloses the enormous fluctuations in dividend—income per share relationships that result from the practice of arbitrarily amortizing the cost of intangi- bles to operations. When based on data as reported in the financial statements, for example, the payout ratios for Warner-Lambert are reasonably stable near the mean of 52.4 per cent. With amortization of the intangible 145 Exhibit 27 SELECTED DATA FOR.ALLIED CHEMICAL AND WARNER-LAMBERT, 1957-65 Earnings Earnings per Dividend per Dividend Dividends share as Payout share with Payout per share reported Ratio Amortization Ratio 1 c 1 1957 $1.47 $2.14 68.6% $2.02 72.9% 1958 1.47 1.67 88.1 1.54 95.2 1959 1.54 2.47 62.6 2.34 65.9 1960 1.76 2.52 70.0 2.39 73.7 1961 1.76 2.31 76.4 2.18 80.8 1962 1.72 2.15 80.3 1.14 151.3 1963 1.79 2.72 66.0 1.69 105.9 1964 1.77 3.02 58.4 2.06 85.5 1965 1.89 3.14 60.1 2.19 86.4 1957-65 Mean 70.0% 90.8% W 1957 $0.39 $0.91 42.8% $0.74 52.6% 1958 0.50 0.94 53.0 0.77 64.5 1959 0.53 1.02 51.8 0.85 61.9 1960 0.55 1.03 53.2 0.87 63.3 1961 0.57 1.10 51.7 0.93 60.9 1962 0.63 1.20 52.4 0.50 124.9 1963 0.71 1.24 57.0 0.53 132.3 1964 0.75 1.41 53.5 0.67 112.6 1965 0.90 1.60 56.3 0.90 100.2 1957-65 Mean 52.4% 85.9% Note: Data are based on the actual number of shares of common stock outstanding at the end of each fiscal year and has been adjusted for stock dividends and stock splits. Slight discrepancies between data and payout ratios are likely to exist because computations have been rounded off. 146 investments, however, these ratios are much higher and vary widely about the mean of 85.9 per cent. In some years the payout percentages exceed 100 per cent which implies that part of the dividend disbursements were a return of stockholders' prior retained earnings rather than a distribu- tion from periodic earnings. This immediately raises the question: Are decisions made by a financial analyst based upon his evaluation of these payout ratios improved as a result of amortization? While there is no easy answer to this question, it does appear likely that an analyst could draw misleading inferences from income data which reflect arbitrary write-off of type (b) intangibles. Current accounting practices are almost exclusively concerned with a monetary or 1 Advocates of this concept believe "earning power" concept of income. that the income statement should show as clearly as possible the mone- tary flows to the company's production and distribution activities over the fiscal year in order that meaningful comparisons can be made with prior years and with the performance of other companies. Accountants feel that reported "net income" is best measured by the difference be- tween gross revenues from the major operating activities of the enter— prise and applicable costs of a regular or recurring nature. Influenced by practical necessities, investors and their financial analysts have become accustomed over the years to reading financial statements based upon this earning power theory of income statement content. Emphasis on the earning power concept has been encouraged further by the increased 1For a discussion of the earning power concept of the income statement, see R. K” Mautz, "Emphasis on Reporting, NOt Calculation, Could Settle Income Statement Controversy," The Journal of Accountanqy, XCVI (August 1953), 212-16. 147 use of single-step income statements. When income calculations are identified primarily with monetary concepts, a company's cash dividends and reported earnings traditionally are bound together by real and definite economic relationships. Conse- quently, owners often use payout analysis to appraise the dividend-pay- ing capacity of the company and to assess the risk and future prospects of their investments. An accounting procedure which causes unreasonable divergence in dividend payout percentages (from a standard such as the mean) may be of dubious soundness by failing to provide financial meas— urements that facilitate intelligent decision—making by owners. Thus, the practice of assigning the costs of all intangible assets to time periods for matching with revenues of the time periods could be ques- tioned because it distorts the "normal" relation between dividends and earnings for a going concern and generally impairs the reliability of income data and payout ratios in judging the dividend-paying capacity of that enterprise. The accounting practice of amortizing intangibles which have no determinable date of expiration of life also may be unwarranted if ex- penditures are continually being made and charged against revenues to 1The earning power concept of the income statement is compara- ble to the American Institute's current operatingfperformance concept of net income (see Chapter 8 of ARB No. 43), where the principal empha- sis is upon the ordinary, normal, recurring operations of the entity during the current period. Accountants hold a considerable diversity of Views on this question of what items should enter into the determination of net income for the period. This study shall not undertake to find a concept of net income which is acceptable to all. Furthermore, past emphasis on the current operating concept of net income is likely to change as a result of the Accounting Principles Board Opinion No. 9 issued December 1966, which supersedes ARB No. 43, Chapter 8. 148 maintain their value. Here the practice would result in a "double charge" against revenues during the amortization period.1 Paul Grady also expounds this particular thought when he writes: Similarly, the charging off of unlimited term intangibles, such as goodwill, integration costs, etc., which are being fully maintained, would result in an understatement of cost of fixed assets and an overstatement of expenses.2 If the primary task of accounting is to present meaningful and useful financial statements, mandatory amortization of intangibles with- out limited life is not advocated. As long as (1) accounting remains based on the concept of a going concern and (2) outsiders insist on the earning-power concept for measuring periodic business income, the prac— tice of arbitrarily amortizing type (b) intangibles appears unacceptable. Such a practice could mislead a financial analyst in evaluating the past Operating performance of a business entity and in forming an opinion about its future potential. Since many intangible assets have no natural limited life and (are closely related to the economic value of the enterprise, usually there is no sound basis on which the expense of such intangibles for a single period or longer can be calculated. Where the intangible is «deemed an investment--possessing an important income-producing factor \Ja\U1¢~U:n>ha \JO\CDBJUJ¢~U1FJ u:o~o>esn>ua~4a~ vdra'drardcn*d*d *F * ranking fell. I 1arranking improved. S = ranking remained the same. 158 Exhibit 33 EFFECTS OF'ALTERNATIVE POOLING-PURCHASE ACCOUNTING TREATMENTS ON CASH FLOW'TO COMMON STOCK EQUITY FOR EIGHT COMPANIES, 1965 Mixture Purchase Purchase Pooling as without with Concept reported Amortization Amortization Warner-Lambert 32.5% 30.5% 14.0% 18.6% Bristol‘Myers 36.9 30.1 19.8 22.0 Allied Chemical 27.7 26.3 19.2 21.9 Diamond Alkali 24.8 23.3 20.8 22.4 Chas. Pfizer 25.6 22.3 18.1 20.3 Procter & Gamble 19.1 18.3 16.9 17.6 Richardson‘Merrell 24.3 17.1 17.1 20.2 Colgate-Palmolive 17.7 16.9 15.9 16.9 ‘HighrLow Spread 19.2% 13.6% 6.8% 5.5% Bgnkings based on o e erce t e Effect* warmer-Lambert 2 1 8 6 F Bristol-Myers 1 2 2 2 S Allied Chemical 3 3 3 3 S Diamond Alkali 5 4 1 1 I Chas . Pfizer 4 5 4 4 I Procter & Gamble 7 6 6 7 F Richardson-Merrell 6 7 5 5 I Colgate-Palmolive 8 8 7 8 S ranking fell. ranking improved. ranking remained the same. *1? I s 159 change enough to have a significant effect on financial analysis. Decisions made by a financial analyst are likely to be different depend- ing on the combination accounting method adopted. In these exhibits the effects on a company's ranking is based on a comparison between the "mixture, as reported" and "purchase-with-amortization" treatments. C1ear1y,the number of firms given a different ranking as a result of using the purchase-with-amortization approach is of significance. Of the eight companies, the following number were given a different ranking from that which they had before: Ranking Ranking Fell Improved Total Earning power 4 3 7 Return on capital 2 3 5 Return on common stock equity 3 4 7 Cash flow to common stock equity 2 3 5 Furthermore, when based on a comparison between the mixture as reported and the purchasedwithout—amortization treatments, there is a Similar significant change in rankings for the eight companies: Ranking Ranking Fell Improved Total Earning power 3 3 6 Return on capital 2 3 5 Return on common stock equity 3 4 7 Cash flow to common stock equity 1 4 5 In many cases there was a spread of two or more places between the companies' positions depending on alternative combination account- ing practices. With reapect to return on capital, for example, 160 Warner-Lambert ranked seventh under the purchase-with-amortization tech- nique, but it actually ranked second based on information as reported in the financial statements. It is interesting to note the companies whose rankings fell or improved by two or more places: Warner-Lambert . . . . . ranking fell 4 times. Bristol-Myers . . . . . ranking fell twice. Allied Chemical . . . . ranking fell once. Richardson-Merrell . . . ranking improved 4 times. Procter & Gamble . . . . ranking improved 3 times. Colgate-Palmolive . . . ranking improved twice. Diamond Alkali . . . . . ranking improved once. As might be expected, Exhibits 30 through 33 illustrate further that the companies which have an active history of large poolings are the ones which would be hurt most as to ranking by using the purchase- with-amortization method of accounting for business combinations. For example, Warner-Lambert ranked first in regard to the ratio of cash flow to common stock equity, but it ranked sixth after all poolings were con- verted to purchases with amertization. At the other extreme, Richardson- Merrell, a firm which used the pooling concept to the smallest degree, improved from fifth to first place in the ranking for rate of return on common stock equity. For all ratios, Exhibits 30 through 33 also illustrate that the high-low spread (difference) between the best and the worst ranking come pany is the largest under the pooling concept. This high-low spread becomes correspondingly smaller as one moves from the pooling concept to the mixture approach, the purchase-without-amortization method, and finally, the purchasedwith-amortization method. Such exorbitant 161 differences between these financial ratios that result from applying the pooling technique could indicate that such ratios are essentially invalid for analytical purposes. Although the evidence is inconclusive, this may suggest that the consistent gpplication of purchase accounting (with or without amortization) gives more reliable financial ratios and hence makes financial statements more meaningful. The ratios appear unreliable under the pooling concept (or mixture method) in the sense that they may not be accurately measuring what they are intended to meas- ure (evaluate managerial performance) and therefore could be invalid for purposes of making intercompany comparisons. The operations of the dominant company--the one continuing enterprise of paramount importance--do not need to be restated at the time of a business combination because the past costs incurred by it are as significant as before. But the historical cost transactions of acquired companies are unrelated to the operations of the buying enter- prise. These costs are essentially meaningless for future analytical purposes and generally have no inherent reporting value to the acquiring company. Such costs may not be representative of the service potential of assets acquired by the buying entity at the time of the combination if market value of shares given is substantially greater than book value of assets purchased. The "normal" significance of future reports of the dominant company can be distorted when historical cost data of acquired companies are injected into its record-keeping process. Furthermore, the significance of current value information at the time of a business combination does not depend in any way whatsoever upon the usual 162 criteria which are proposed as guidelines for distinguishing between a purchase and a pooling of interests.1 It should be stressed that useful analysis and interpretation of published financial data as a basis for decision-making by creditors and stockholders depend on the validity of financial statements. The results obtained from accounting records are no more reliable than the validity of the information that is put into them.2 Since ratios are normally computed directly from a company's financial statements, if inaccurate information is put into the accounting records, then the financial ratios calculated from resultant reports cannot themselves be accurate. Other Ratios Exhibits 34 through 36 are designed to illustrate important points on three financial relationships: 1. Funded debt to capital Interest coverage (or times interest earned) 3. Price to book value From an analysis of Exhibit 34, it is apparent that using a pooling approach in accounting for business combinations tends to increase debt as a per cent of total capital. Debt-to-capital relation- ships are more favorable (lower) under purchasing treatments. This 1WilliamlM. Parker, "Business Combinations and Accounting Val- uation," Journal of Accounting;Research, IV (Autumn 1966), 153. 2Louis Goldberg, An Inquiry Into the Nature of Accounting, American.Accounting Association Monograph No. 7 (American Accounting Association, 1965), p. 220. 163 result arises from the fact that pooling, relative to purchasing, simul— taneously understates the asset side and net worth section of the balance sheet. If the reported values for stockholders' equity are lower by reason of pooling accounting, then debt-to—capital ratios will worsen (be higher) with the consistent application of the pooling technique. Exhibit 34, for example, shows how debt-to—capital ratios are higher for Allied Chemical under the pooling concept than for other combination accounting practices. From 23.8 per cent in 1965 using the purchase-without-amortization method, the debt-to-capital ratio Exhibit 34 EFFECTS OF ALTERNATIVE POOLING-PURCHASE ACCOUNTING TREATMENTS ON DEBT-TO-CAPITAL RATIOS FOR THREE COMPANIES, 1962-65 ‘———'_ t —_‘ T 1962 1963 1964 1965 ALLIED CHEMICAL Pooling concept 28.2% 27.0% 26.7% 30.9% Mixture, as reported 27.3 26.1 25.6 29.8 Purchase without amortization 21.2 20.2 20.1 23.8 Purchase with amortization 22.1 21.7 22.0 26.6 COLGATE-PALMOLIVE Pooling concept 15.1 14.3 12.8 12.7 Mixture, as reported 14.5 13.8 12.3 12.3 Purchase without amortization 13.7 13.0 11.6 11.6 Purchase with amortization 14.2 13.6 12.3 12.3 DIAMOND ALKALI Pooling concept 21.9 21.8 27.3 25.0 Mixture, as reported 20.9 20.9 26.3 23.7 Purchase without amortization 19.3 19.3 24.5 21.6 Purchase with amortization 19.9 20.1 25.7 22.9 164 increases to 30.9 per cent using the pooling concept. As a result of this worsening ratio of debt to capital resulting from pooling, the capital market could require Allied Chemical to pay a higher rate of interest on future debt securities. While debt-to-capital ratios are relatively greater when combina- tions are accounted for on a pooling basis than under purchasing methods, accounting for such combinations under the purchase-with-amortization technique leads to unfavorable interest coverage ratios. Note from Exhibit 35 how "times interest earned" computations for Allied Chemical, Colgate-Palmolive, and Diamond Alkali are lower when amortization enters into the analysis. The differences in Exhibit 35 between interest coverage ratios with or without amortization may not be considered too significant for Exhibit 35 EFFECTS OF ALTERNATIVE POOLING'PURCHASE ACCOUNTING TREATMENTS 0N INTEREST COVERAGE RATIOS FOR THREE COMPANIES, 1962-65 (times interest earned) 1962-65 1962 1963 1964 1965 Mean L ED C CAL Purchase without amortization* 12.3 15.1 16.3 12.9 14.2 Purchase with amortization 9.2 . . . COLGATE-PALMDLIVE Purchase without amortization* 15.7 16.3 16.8 17.8 16.7 Purchase with amortization 15.0 15.5 16.1 17.1 15.9 D LI Purchase without amortization? 15.6 13.6 13.1 14.4 14.2 Purchase with amortization 14.2 12.3 12.1 13.0 12.9 *It should be noted that interest coverage ratios are the same using the pooling or mixture approach as they are under the purchase- without-amortization treatment. Colgate-Palmolive discontinued the prac* tice of amortizing goodwill in 1961. 165 purposes of financial analysis. All of these companies have large amounts of earnings available to meet interest requirements even when these earnings are reduced by amortization charges. Furthermore, as men- tioned earlier, most creditors, when appraising an enterprise's debt ca- pacity, place greater importance on cash flow statistics rather than on reported earnings. Thus, it is likely that the creditor decision-making process in evaluating a firm's interest-paying ability is not affected un- duly by management's choice of alternative combination accounting practices. An analysis of the data in Exhibit 36 makes it apparent that price-to-book-value ratios are affected substantially depending on which combination accounting practice is followed. Price-to-book-value rela- tionships unquestionably are highest when reporting practices consis- tently follow the pooling concept. Although book value is a statistic of questionable value, finan- cial analysts do measure a company's price-toAbookdvalue ratio in order to evaluate whether the current market price is in line with price-to- bookavalue relationships traditionally experienced by that company. Such a measure may be of some significance in appraising the degree of valuation risk associated with common stock investments. 1"Valuation" risk may be defined as the inherent price volatil- ity underlying common stocks as an investment media. Even though specir fic adverse developments do not occur within a company, an effective loss of principal can result because the company may fail to live up to the very favorable expectations implied by the market price and incor- porated into the optimistic valuation estimate. This dimension of val- uation risk appears quite frequently in connection with growth companies. See Douglas A. Hayes, Invesrmentg: Analysis and Management (New York: The Macmillan Company, 1961), pp. 548-50. EFFECTS OF ALTERNATIVE POOLDIG-PURCHASE ACCOUNTDIG TREATMENTS 166 Exhibit 3 6 ON PRICE-TO-BOOK-VALUE RATIOS FOR EIGIII‘ COMPANIES, 1965 (times) ' Mixture Purchase Purchase Pooling as without with Concept reported Amortization Amortization Bristol-Myers 8.92 7.36 3.87 4.29 Warner-Lambert 6.34 5.94 2.79 3.81 Chas. Pfizer 4.24 3.67 3.02 3.42 Procter 6: Gamble 3.72 3.57 3.31 3.47 Richardson-Merrell 3.78 2.71 2. 70 3 .22 Allied Chemical 2.07 1.96 1 .45 1.67 Colgate-Palmolive 1 . 94 1 .86 1 . 75 1 . 87 Dimnond Alkali 1 .49 1 . 38 1 . 22 1 . 31 High -Low Spread 7 . 43 5 . 98 2 . 65 2 . 98 W e 03 Effect* Bristols-Myers 1 l 1 1 S Warner-Lambert 2 2 4 2 F Chas . Pfizer 3 3 3 4 S Procter & Gamble 5 4 2 3 I Richardson-Menell 4 5 5 5 S Allied Chemical 6 6 7 7 F Colgate-Palmolive 7 7 6 6 I Diamnd Alkali 8 8 8 8 S *In this exhibit the effect on ranking is based on a comparison bt-I'tween the "mixture, as reported" and "purchase without amortization" treatments. F, I, and S have same meanings as in Exhibits 30 through 33. 167 A study of Chas. Pfizer, for example, during 1957-58 before the company began its active history of growth through acquisitions and mer- gers reveals that the firm's price-to-book-value ratio traditionally deviated slightly about 2.8. But observe what has happened to this price-book value relationship in recent years depending on the pooling- purchase accounting technique followed: Mixture Purchase Purchase Pooling as without with Year Concept reported Amortization Amortization 1961 3.98 3.83 3.06 3.20 1962 3.68 3.55 2.85 3.02 1963 3.92 3.57 2.85 3.09 1964 3.59 3.15 2.53 2.81 1965 4.24 3.67 3.02 3.42 1961-65 Mean 3.88 3.56 2.86 3.11 Note how following the purchase-without-amortization treatment fOr Chas. Pfizer gives the M price-to-book-value ratios that are Very much in line with ratios previously experienced by that company. Clearly, the consistent application of purchase—without—amortization accounting results in price-to-book-value ratios that correlate best With historical price-book value relationships normally maintained by the enterprise. The analytical significance of price-to-book-value relationships appears to be misconstrued when the pooling'concept is used - Exhibit 36 also discloses that the high-low spread between the ratios of the eight companies is largest tmder the pooling approach to business combination accounting. Such extreme differences between these price"t<)--book--value ratios that result from applying the pooling 168 technique could suggest that such ratios are essentially unreliable for sound analytical purposes. Although the evidence is not conclusive, the study finds price-to-book-value ratios most valid as an analytical tool for investor decision-making in appraising valuation risk when business combination accounting practices consistently apply the pur- chase-without-amortization me thod. Effect of Alternatiyes on Growth Rate Apalysis Growth rate analysis is regarded as a practical aid to stock valuation and investor decision-making. By studying the historical growth rates of earnings per share, dividends per share, and other finan- Cial data a shareholder may be able to determine the future prospects of his investment and value his stock investment in relation to its appar- ent future prospects. Growth rate statistics also assist stockholders and creditors in measuring the past effectiveness of the management to Which they have entrusted their investments. An investigation of the effects of pooling and purchase accounting on growth rate analysis Should help determine whether any particular combination accounting tireé'rtment renders financial statements more meaningful. Exhibit 37 gives growth rates per annum for selected companies for three financial items: (1) net income to common, (2) net sales. and (3) book value per coumon share. From the exhibit it is apparent that growth rates for book value per share vary widely depending on "hi-ch combination accounting treatment is adopted. The book-value grOWth rates that result by reason of pooling accounting are lower and definitely out of line in comparison to the other growth rates. In fact: com Dari—sons between the growth rates for net income to conunon, net sales, 169 Exhibit 37 COMPARISON OF GROWTH RATES FOR SELECTED COMPANIES, 1956-65 (growth rates per annum) Net Boo a1 er Sh e Income Purchase Purchase to Net without with Pooling Common Sales Amortization Amortization Concept Bristol-Myers 21.8% 16.0% 16.7% 15.1% 10.1% Chas. Pfizer 12.0 13.2 14.0 12.7 9.3 Warner-Lambert 14.3 11.9 13.8 11.3 6.4 Richardson-Merrell 12.4 10.5 12 .1 10.0 8.8 Allied Chemical 8.7 6.4 6.5 5.1 1.5 Colgate-Palmolive 4.6 6.3 4.7 4.0 3.4 and book value per share under the purchase-without-amortization method seem to possess the best correlative characteristics. If there is any Significant connection between a firm's growth in earnings, sales. and bOOk value per share, this relationship is severely distorted when that firm consistently follows the pooling concept in accounting for business ac-ncern-generally are bound together by a real and definite 170 Exhibit 38 GROWTH RATE ANALYSIS FOR FOUR SELECTED COMPANIES, 1956-65 Growth Rate Correlation per annum Coefficient as per cent with Time Eris pol -Mygrs Cash flow per share 16.3 0.9929 Dividends per share 18.4 0.9945 Earnings per share 18.6 0.9953 Earnings per share (A)* 14.2 0.9479 Egichgrdson-Merrell Cash flow per share 11.3 0.9786 Dividends per share 11.4 0.9417 Earnings per share 11.5 0.9653 Earnings per share (A) 9.2 0.9493 Mae; Cash flow per share 9.5 0.9917 Dividends per share 8.2 0.9787 Earnings per share 8.6 0.9794 Earnings per share (A) 5.1 0.8896 C o 1 gate ~2g1mol iyg Cash flow per share 4.2 0.8646 Dividends per share 4.9 0.9435 Earnings per share** 3.6 0.7499 Earnings per share (A) 2.1 0.4778 *(A) means that the analysis reflects amortization charges over a t e n-year period . **These data for Colgate-Palmolive reflect minor amortization ciharges to operations in the years 1956, 1959, and 1960. 171 relationship.1 Each respective correlation coefficient should be used to measure the validity of the indicated growth rate per annum. Note from Exhibit 38 that each company's growth rate for earn- ings per share is comparable to cash flow and dividend growth rates as long as the income figures do not reflect amortization charges. But when goodwill and related intangible assets are amortized by periodic charges, growth rates for earnings per share are lower and at variance with cash flow and dividend growth rates. Note also how each company's correlation coefficient is lowered as a result of amortization, suggest- ing that the indicated earnings per share growth rate is less reliable in measuring past management effectiveness and in predicting the future prospects of the company. The accounting practice of arbitrarily amor- tizing the costs of type (b) intangible assets may be questioned because it fails to provide meaningful growth rate statistics for earnings per Share (in comparison to other growth rates) that facilitate intelligent decision-making by investors. The lower earnings that result from such amortization may produce a statistical bias in income information con- tained in external general purpose reports. If there is a choice be tween biased and unbiased information, presuming that other standards haVe been met, the unbiased information is preferable.2 _— 1Support for such a statement is felt unnecessary because this onomic pattern generally accepted by professional financial Professors Weston and Brigham suggest further that cash flows htly better relationship to dividends than do earnings, but ering the exact nature of the relation requires more exhaus- See J. Fred Weston and Eugene 1.8 an ec :nalysts. are a slig Sat discov F v; 8 tudies than have been made to date. win righam: mrgginance (2nd ed.; New York: Holt, Rinehart and in Egon. 1966), pp. 445-49. Analysis of the eight selected companies 18 study supports the views of the financial analysts. ment 2American Accounting Association Committee to Prepare a State- on Basic Accounting Theory, op. cit., p. 11. CHAPTER VI SUMMARY AND CONCLUSIONS The accounting treatment of business combinations must fall into one of two categories, either as "purchases" or as "poolings of interest." Under each category a variety of recording practices have been held to be in accordance with generally accepted accounting prin- ciples. Some business combination accounting practices, such as "partial poolings," actually overlap into both categories. The existing variety 0f pooling-purchase accounting treatments permits so much inconsistency in financial reports that they often become confusing and misleading. The established criteria--such as relative size, continuity of Ownership interests, alteration of voting rights, and others--are grad- ually being reduced to a minor role in deciding between a purchase or POO ling application. These criteria are not sufficiently objective as Standards in determining whether the. pooling treatment ought to be allowed for a particular business acquisition or merger. Many account— ants are not certain of the distinction between a purchase and a pool- ing of interests; nevertheless, they have deviated intentionally from basic accounting standards and implanted their own notion of desirable practiCes in this area. 172 173 At present, the decision to purchase or to pool is influenced more by the subjective attitudes of management than by the criteria of AccountingrResearch Bulletin No. 48 or sound accounting theory. Where a significant portion of the consideration used to effect an acquisition is in the form of equity shares, there now are no insurmountable bar- riers preventing management from adopting the pooling treatment if such a treatment is desirable and likely to give the most favorable financial impression. But when companies are allowed to choose whichever method is to their own advantage, confidence in the independence of the public accounting profession is weakened. The financial statements of a business enterprise with an active history of acquisitions and mergers are affected substantially by the consistent application of different business combination accounting treatments. The manner in which business combinations are recorded has important consequences on selected financial data, on many financial ratios, and on investment analysis. Alternative pooling-purchase accounting procedures may, for example, affect (l) asset and equity values carried forward into subsequent financial statements, (2) the level of reported earnings, (3) efficiency ratios, (4) profitability ratios, (5) dividend payout ratios, (6) interest coverage ratios, and (7) growth rate analysis. Much of the business combination controversy is centered in legal and tax considerations, neither of which is a proper criterion for evaluating the true merits of the issue. Economic substance, rather than legal form or tax considerations, should be the primary determinant of the accounting recognition for the business combination exchange 174 transaction.1 SEC practice as to pooling of interests should be rejected because it appears to be adhering more to the legal aspects of the transaction than to the economic realities. At the time of a busi- ness combination, a careful process of investigation, evaluation, and reporting of results should be required to reflect as accurately as possible the fair value and true nature of the assets acquired. Conclusions Based on the findings yielded by this study, the following con- clusions are deemed warranted. With these conclusions a rational approach to business combination accounting procedures is suggested to improve the general usefulness of conventional financial statements. In develOping a logical body of accounting principles and procedures appli— cable to mergers and acquisitions, the study has tried to adhere to the four basic standards (relevance, verifiability, freedom from bias, and quantifiability) for the best communication of financial information to interested parties outside the reporting enterprise—~primarily stock- holders, other investors, and creditors. 1. One of the minimum requirements of accounting is that its proce- dures are carried out consistently from a particular point of view.2 In substance, most business combinations are acquisitions of one or more 1Donald E. Kieso, one of the conclusions in his dissertation entitled "The Development of an Accounting Concept of Business Combina- tionsf' unpublished Ph.D. dissertation, University of Illinois, Urbana, 1963. 2Louis Goldberg, An Inquiry into the Nature of.Accounting,.Ameri- can Accounting Association monograph No. 7 (American Accounting Associa- tion, 1965), p. 47. 175 going concerns by a dominant enterprise. Accountability for such acqui— sitions should reflect the point of view of the continuing enterprise-- "the entity which produces the activity."1 2. For the dominant enterprise, fundamentally, business mergers and acquisitions are simply one of several alternative methods of attain- ing the objective of business expansion. Often management finds it more economical to acquire an established business than to attempt to develop one by its own efforts and expenditures over a period of years. In effect, assets of acquired companies should be regarded as additions to the facilities of that dominant enterprise. 3. The purchase price of a going concern represents a capital investment from the point of view of the acquiring enterprise. To pro- mote sound and informative financial reporting, most business combina- tions should be accounted for as purchases in the context of an invest- ment decision, for in this way financial statements present fairly the enterprise's financial position and results of operations. From the point of view of the dominant "buying" enterprise at the time of a busi- ness combination, the purchase treatment (relative to pooling) requires a complete and realistic accounting for the additional capital invested by it to acquire the selling company. The general reliability of a reporting enterprise's financial information for interpretive purposes is not improved by the consistent application of the pooling concept in accounting for business combinations. LArthur R. Wyatt, A Critical Study of.Accounting:for Business Combinations, Accounting Research Study No. 5 (New York:.American Insti- tute of Certified Public Accountants, 1963), p. 72. 176 4. The pooling-of-interests technique is incompatible with the investment concept of a business combination. In general, pooling-of- interests accounting should be discontinued because it fails to account for all costs of buying a business. It is common knowledge in business that going concerns are bought and sold at amounts widely divergent from book values. Recorded values of properties on the books of the acquired company are generally irrelevant to the investment decision and should not be assumed to express the total cost of the acquisition to the buy- ing organization. Furthermore, when vendors' book values exceed acqui- sition cost as in a bargain purchase, the accounting practice of setting up the excess of book value over cost as a deferred credit and amortizing it to income is unacceptable. The excess credit in this type of business combination generally should be applied as a reduction to the carrying amounts of specific assets (principally property, plant, equipment, inventories, and intangibles) of the selling company based upon current values of the assets acquired. 5. The significance and meaning of information presented in the financial statements of a dominant enterprise are distorted when meaning- less historical cost data of acquired companies are injected into its record-keeping process. Empirical evidence in this study demonstrates that many financial ratios are made invalid and lack significance by reason of applying the pooling technique. Useful analysis and interpre- tation of accounting reports as a basis for intelligent decision-making by outsiders was found more reliable when business combination account- ing practices consistently followed the purchase-without-amortization method. 177 6. Accounting Research Bulletin No. 48 should be revised or with— drawn.. In practice it does not provide any equitable means of distin- guishing purchases from poolings. New criteria should be established that make the distinction between a purchase and a pooling of interests rest on differences of economic substance. .Any revision of ARB No. 48 must justify from an economic viewpoint why a new basis of accountability should not arise at the time of the business combination. The position taken here is that only those mergers which have the characteristics of a "genuine corporate marriage" should be allowed to be treated as pool— ings of interests.1 7. There is no logical basis existing in accounting theory for a continuation of two different concepts of "acquisition cost" in account- ing for business combinations depending mainly on the cash—stock forms of consideration used to effect the combinations. The type of considera- tion used in acquiring a going concern should not determine the purchase or pooling treatment applicable to the business combination transaction. 8. When consideration for a business combination is in the form of ownership equities, the shares of stock used by the acquiring corpora- tion to effect the exchange are merely substitutes for cash, other assets, notes, or bonds. The acquisition cost of properties acquired by the buying enterprise in a stock transaction is best measured by the implied cash cost of the securities issued by the purchaser in the 1This study also accepts the pooling treatment for a business combination between two legally separate but formerly related entities. See Wyatt, op. cit., recommendation No. 2, pp. 105-106. This study defines a genuine corporate marriage as that type of business combina- tion situation in which Wyatt recommends the application of the "fair- value pooling" concept, pp. 81-86. 178 exchange, i.e., the amount of money which could have been raised through the public issue of the securities.1 The cost of treasury stock given for a business acquisition is not a proper basis for determining the pur— chase price unless this cost happens to represent the fair value of the stock given up in the exchange. 9. It usually takes from six to eight months to consummate a merger or acquisition. Generally, the value assigned to any shares given as consideration should be based on the average market price of the stock for a period of 60 to 90 days prior to the date of the agreement between the bargaining constituents, rather than the closing market price of the stock on the date of the agreement. In this way combination transactions in which exact quantification is not apparent may be recorded at purchase prices that are reasonable approximations of exchange prices. The results of this study suggest that such a manner of valuation for owner- ship equities adequately meets the standard of ggantifiability that the AmericanflAccounting Association Committee recommends as one of the cri- teria to be used in evaluating the acceptability of potential accounting information.2 10. After establishing the purchase price of a business combination, part of the acquisition cost should be assigned or allocated to current assets, prepaid items, tangible fixed assets, and sundry assets on a reasonable basis--at amounts representing the fair value of such assets LW. A. Paton and A. C. Littleton, An Introduction to Corporate Accountingg§tandards, American Accounting Association.Mbnograph No. 3 QMmerican Accounting Association, 1940), p. 28. 2American Accounting Association Committee to Prepare a State— ment of Basic Accounting Theory, A Statement of Basic Accounting Theory (American Accounting Association, 1966), p. 8. 179 at the time of purchase. Any amount remaining may be considered to represent the investment in intangibles. Tax aspects of the exchange transaction should not dictate allocation procedures for purposes of financial reporting. The main objective in allocating the purchase price of a business combination is "to spread the cost realistically over the assets purchased so that financial position will be fairly stated and, upon realization of the assets purchased, income will be reflected in a reasonable manner" (italics mine).1 11. The investment in intangible assets should not be charged against retained earnings at the date of the acquisition. The amount of capital devoted to the enterprise is materially understated because of the arbi— trary write-off of intangibles. Generally, such a practice distorts the value of assets (as bundles of service-potentials) relating to future periods and overstates an enterprise's efficiency and profitability ratios. 12. Although most intangible assets are unique and difficult to eval- uate, the cash (or its equivalent) which is invested in patents, goodwill, formulas, trademarks, and similar intangibles is just as Egg; as the cash ‘which is invested in visible implements of production and distribution such as land, buildings, and equipment. Intangibles are valid capital assets of economic significance to the usual business enterprise. Where intangibles are acquired by the issuance of securities, or purchased for cash and other consideration, they should be accorded the same accounting recognition as tangible assets. \— 1William L. Gladstone, "Tax A8pects of the Allocation of Pur- Chasfia Price of a Business," The Journal of.Accountancy, CXXII (October 1966) , 37. 180 13. Present accounting procedures for intangible resources are con- fusing. Many of the intangible costs incurred in the normal operations of an enterprise (e.g., research and development costs, advertising expenditures, engineering and promotional costs) are recorded as ex- penses in the year they are incurred. Other intangible costs are either (1) written off immediately against retained earnings, (2) deferred and amortized by systematic charges in the income statement over a period of years, (3) carried at cost as a permanent asset on the balance sheet, or (4) never accounted for at all by reason of the pooling treatment. In accounting for intangibles the profession has instituted, as Dwight R. Ladd suggests, "truly a procedure for every taste."1 14. From an accounting standpoint, there is little difference between the costs of internally developed intangibles and the costs of intangi- bles acquired from another company. Both represent investment expendi- tures from the point of view of the acquiring enterprise to maintain or improve its competitive position in business affairs. Both types of intangible expenditures are likely to benefit the enterprise beyond the normal operating cycle of the business. Ideally, all intangible costs incurred by a specific business enterprise should be capitalized (recog- nized as assets), and then, as AccountinggResearch Study No. 3 recommends: "Intangibles" of limited term should be amortized as production cost or expense over their estimated service lives. Unlimited-term items should continue to be carried as assets, without amortization.2 lContemporary Corporate Accountingrand the Public (Homewood, 111.: Richard D. Irwin, Inc., 1963), p. 148. 2Robert T. Sprouse and Maurice Moonitz, A.TEntative Set of Broad Accounting Principles for Business Enterprises, Accounting Research Study No. 3 (New York: American Institute of Certified Public Account- ants, 1962), p. 36. 181 15. In accounting for intangibles, conservatism should not be the only governing factor. The desirable objective is clear--that there should be a proper matching of these costs with the future revenues to which they relate. Present accounting practices (with some noteworthy exceptions) of expensing immediately self-developed intangibles, capitalizing permanently the costs of externally acquired intangibles when purchased for cash, and omitting entirely such intangible assets when acquired by the issuance of equity securities are obviously incon- sistent. This study suggests that such accounting does not properly match costs and revenues. When costs and the related benefits are im- prOperly matched between fiscal periods, management performance and accountability for results of operations are obscured.1 16. One important characteristic of most intangible assets is the high degree of uncertainty regarding the value of the future benefits to be received.2 Accounting for research and development costs presents a difficult problem because most of such expenditures cannot be identified with specific products or projects on any practicable basis. Many intan- gibles which do not have a natural limited life are a component part of the economic value of the enterprise. Often the rights, conditions, claims, or privileges received in an intangible investment can be asso- ciated with specific tangible assets, but unlike the tangibles they can- not be transferred to alternative uses. The costs of some intangibles, 1Arthur Andersen and Co., Agcountigg gnd gepgzting Problems of the Accognting Professiog (2nd ed.; Chicago: Arthur Andersen and Co., October 1962), p. 93. 2Eldon S. Hendriksen, Agcognting Theory (Homewood, 111.: Richard D. Irwin, Inc., 1965), p. 337. 182 such as patents, trademarks, and trade names, are joint costs. 17. Even though there are difficult problems in the valuation of intangibles, this is not sufficient reason for failing to account proper- ly for such assets. The costs of internally developed intangibles should not be deferred to future operations unless there is a reasonable expectation that they will be recovered.2 But where the cost of organi- zation, secret processes, integration, trademarks, going concern, good- will, and other unlimited-term intangibles are encountered in a lump-sum purchase of an operating company, generally there is no sound basis on which the expense for a single period or longer can be calculated. In such cases, the intangibles may be properly carried in the accounts at unamortized cost until it becomes reasonably evident that their value has been permanently impaired or that their term of existence has become limited.3 18. At the time of a business combination, a careful process of eval- uation is required to determine as closely as possible the exact nature of the intangible assets acquired. Any portion of the purchase price that can be reasonably identified with limited-term intangible fixed assets (such as patents, copyrights, and fixed-term franchises) should be amortized over their estimated period of usefulness. Only unlimited- term intangibles may be carried as assets without amortization. The 11bid., p. 338. 2Arthur Andersen and Co., op. cit., p. 93. 3American Institute of Certified Public Accountants, Accounting Research Bulletin No. 43, Chapter 5, pars.6 and 8. With reference to type (b) intangibles: "those having no such limited term of existence." 183 practice of arbitrarily amortizing the costs of type (b) intangible assets is not advocated. For many profitable and highly successful compa- nies, such a practice results in a double charge against revenues during the amortization period. Empirical evidence in this study shows that many financial ratios become meaningless as a result of arbitrary amorti- zation of intangibles. General license to amortize unlimited-term intan- gibles as production cost or eXpense over arbitrary periods makes finan- cial statements less reliable to outsiders using them for analytical purposes. 19. If the task of accounting is to present meaningful and useful financial statements, mandatory amortization of unlimited-term intangi- ble assets is unacceptable. Where the intangible is deemed an inVest- ment, possessing an important income-producing factor and having no determinate life, and the policy of the enterprise is to maintain fully the value of the investment by high-quality products or services and by continued advertising, research and development, and other maintenance expenditures (which are charged to current operations), the cost of the intangible investment should not be amortized against revenues or writ- ten off to retained earnings "unless and until there is permanent impair— ment in earning power" (italics mine).1 Recurring appraisal of the intangible asset would then be the primary requirement for proper accountability. If conditions develop after the investment which indi- cate that the unamortized intangible has become valueless, or that its value is unrelated to the present level of corporate earnings, or that 1Paul Grady, "Accounting for Fixed Assets and Their Amortiza- tion," The Accounting Review, XXV (January 1950), 12. 184 its life will terminate, it should be written off by charges in the income statement in accordance with the recommendations of Accounting Principles Board Opinion No. 9 (issued December 1966). Pertinent sen— tences from this opinion are quoted: Extraordinary items should, however, be segregated from the results of ordinary operations and shown separately in the income statement, with disclosure of the nature and amounts thereof.1 Examples of extraordinary items, . . . include material gains or losses (or provisions for losses) from . . . (c) the write-off of goodwill due to unusual events or developments within the period, It is the Board’s opinion that the reporting of per share data should disclose amounts for (a) income before extraordinary items, (b) extraordinary items, if any, (less applicable income tax) and (c) net income--the total of (a) and (b).3 20. The practice of understating intangible assets, particularly for well-established businesses, should not be tolerated. 'Many intangible assets belong on the balance sheet where their true nature can be dis- closed. Tangible and intangible.fixed assets should be classified separately. The costs of both limited- and unlimited-term intangibles should be reported as separate items on the corporate balance sheet. For illustrative purposes, the following balance sheet presentation for intangible assets by Diamond Alkali Company on December 31, 1965, repre- sents an acceptable manner of disclosure. lAccounting Principles Board, Opinion No. 9, Reportingithe Results __Of Operations (New York: American Institute of Certified Public Account— ants, December 1966), par. 17. 21bid., par. 21. 31bid., par. 32. 185 Intangible Assets Patents, trademarks, formulae, processes, etc., at cost, less amortization . . . . . $1,582,884 Excess of cost over value of net assets of companies acquired since 1960 . . . . . 7,616,040 $9,198,924 The amounts as reported, however, are of dubious soundness because Diamond Alkali had several poolings since 1960 (see Appendix D). Naturally, details about the acquired companies, amortization rates, and other matters which may require disclosure could be given in notes accom- panying the statements. Final Comments on the Pooligg;of—Interests Concept As stressed in paragraphs 3 and 4 of the conclusions, most busi- ness combinations are investments by a dominant enterprise and the pool- ing technique is incompatible with this "investment” concept. But are there any instances in which the pooling-of—interests concept and its related accounting treatment are sound and should be applied in prac- tice? Wyatt recognizes that pooling-of-interests accounting is accept- able when no substantive changes occur because of the combination of "formerly related entities."1 Such a view is sound because a business combination between related enterprises is not an actual exchange trans- action between genuinely independent parties which establishes a new basis of accountability (acquisition cost). Nor should such a combina- tion be viewed in the context of an investment decision, if no exchange IWyatt, op. cit., pp. 105-106. m g was.-- . .. transac: mergers should combini siderat Any ev may re» tance t tUally acCoun« of thi’ C0“ priSeS tially existi HGSS C VEIUe 186 transaction was involved. The position taken in this study (see paragraph 6) is that those mergers which have the characteristics of a genuine corporate marriage should be allowed to be treated as poolings of interests. The firms combining need not be formerly related before a combination merits con— sideration as a pooling of interests. If a business combination is effected through the use of resid- ual ownership equities and the constituents are relatively the same size, a problem arises in determining which company is the dominant enterprise. Any evaluation of the attendant circumstances surrounding the combination may reveal that there is no one continuing enterprise of paramount impor- tance through which economic activity takes place. In this case, concep- tually, the dominant entity of accountability and center of interest for accounting analysis and reports cannot be identified. Wyatt was aware of this problem when he wrote: . identification of the entity of accountability in a combination transaction is a crucial problem.1 When the resources of two separate and "equal" business enter- prises are merged, Wyatt concluded that the resultant entity was essen- tially a "new" enterprise--one materially different from either pre- existing business. Under such conditions, he recommended that the busi- ness combination be accounted for by a method to be known as the "fair- value pooling" concept.2 The underlying reasoning for his recommendation is: 11bid., p. 69. 21bid., pp. 81-86. 187 In combinations which result in an essentially new enterprise there may be nothing inherent in prior carrying values to warrant their continued usage subsequent to the combination. Rather, it is possible that the assets of the resultant entity should be accounted for based on their "cost" to the new entity. Since the accounting unit is, in effect, a new entity, cost to the entity would involve a determination of the fair value of the assets contributed to the future use of the entity.1 Yet it must be stressed that the fair-value pooling concept definitely entails a departure from the established cost basis of accounting. Accounting deals primarily with the effect on a specific enterprise of its completed exchange transactions with other enterprises or individuals. Postulate B-3 of Accounting Research Study No. 1 sup- ports the assumption that a given enterprise constitutes the basis unit of accountability. Postulate B—3. Entities. The results of the accounting process are expressed in terms of specific units or entities. In a purchase type of business combination, the properties of the acquiring company do not need to be restated at the time of the acquisition or merger; only the assets of the acquired company are restated to recognize current values so that an adequate measure of new capital is obtained. But the significance of current value information at the time of a combination exchange transaction does not depend in any way whatsoever upon the ability to identify the dominant entity of accountability. .Although there may be nothing inherent in prior carry- ing values on the buying company's books to warrant their continued 11bid., p. 82. ZMaurice Moonitz, "The Basic Postulgges of Agcounting, Account- ing Research Study No. 1 (New York:.American Institute of Certified Public Accountants, 1961), p. 52. 188 usage after' the combination, generally accepted accounting principles require that the buying company's existing accountabilities should not be disturbed. As long as historical cost information constitutes the basis of prevailing theory and practice, accounting procedures must be carried out consistently from a particular point of view. When account-- abilities are reflected from the point of view of the acquiring enter- prise, the fact that the buying firm has been identified dictates that a new basis of accountability arises only for the acquired company. As stressed throughout this study, the initial amount assigned to all types of properties (tangible and intangible) acquired by a specific enterprise should be "acquisition cost." "Costs" (bargained prices) are the fundamental data of accounting; their recognition, measurement, and classification are indispensable requisites in the process of compiling relevant and dependable accounting data.1 Appar- ently, to an important degree, the acquisition cost concept is influ- enced by the concept of an enterprise. Because cost in accountancy implies a sacrifice made by a buyer to secure something of economic value, the generally accepted cost principle in accounting requires that a specific buying unit or entity be identified. It is difficult to say that a new cost basis, and therefore a new basis of accountability, must result from a business combination situation where no dominant "investing" enterprise can be identified. lPaton and Littleton, op. cit., p. 25. It should be stressed that the term "costs" is being used in its broadest sense. Broadly defined, cost is "the amount of bargained-price of goods or services received or of securities issued in transactions between independent parties." Ibid., p. 24. 189 For purposes of responsibility accounting, there is no relevant basis of acquisition cost at the time of a business combination when the given unit or entity of accountability cannot be determined. Meaningful standards of cost recognition in accounting require that an exchange transaction be viewed from the standpoint of a buying party. Cost, as a valid accounting concept, is the product of a buying transaction; so unless a buying company is identified there can be no proper cost deter- mination at the time of a business combination. In an exchange transac- tion in which the dominant entity is indeterminate, there can be no new basis of accountability because there is no buying organization with which to establish the initial recognition of acquisition cost. Where there is a reorganization merger of two "equals," implying a corporate marriage, it is difficult to establish which business enter- prise constitutes the most relevant center of interest for future accounting analysis and reports. Since there is no one "investing" organization, both business enterprises continue on in the surviving entity in form and in spirit. When an evaluation of the attendant cir- cumstances surrounding the combination clearly indicates that there is no one investing business entity, as in a genuine corporate marriage, accountabilities for the resultant entity may properly be reflected from the point of view of both enterprises prior to the business combination.1 1It is difficult to enunciate the essential attributes of a genuine corporate marriage, but the intent of the parties involved in a :merger is probably the most significant factor. The "criterion of effective control" over the assets, management, and ownership of the smerged entity, as advanced by Phillips, appears to be the best test for judging the underlying intentions of the parties to a business combina- tion. See Lawrence C. Phillips, "Accounting for Business Combinations," The AccountinLReview, X1. (April 1965) , 377-81. 190 Such a corporate marriage should not be recorded as a purchase, for if there is no investing enterprise, the business combination cannot be viewed realistically in the context of an investment decision. The pooling-of-interests treatment should be allowed for a busi- ness combination between separate and equal entities when a review of all circumstances surrounding the exchange transaction verifies that the dominant reporting enterprise is unidentifiable. When business combina- tions are considered in mass, this particular type of combination situa- tion will be rare and have limited application in accounting practice; thus, allowing pooling treatment for such a corporate merger should not impair the general usefulness and reliability of financial information. If the conditions of a genuine corporate marriage exist (similar to Wyatt's conditions for a fair-value pooling), it may be appropriate to ignore the market value of stock issued to effect the business com- bination exchange transaction and assume that the assets of the surviv- ing enterprise are equal to the sum of the assets of the two formerly separate enterprises. With respect to accounting recognition in the financial statements, such a business combination would be viewed as involving no change of economic substance. If nothing of economic sub— stance has occurred in the exchange transaction, the conclusion follows that accounting for assets on the same basis as they were carried by the predecessor entities is an appropriate basis of accountability for the resultant entity. APPENDICES APPENDIX A LIST OF COMPANIES CLASSIFIED UNDER SIC GROUP NUMBERS 281, 283, AND 284 Acquisitions by Leading Industrial Chemical Firms, 1951-61 1961 sales rank among 500 laggept 13 24 49 54 56 66 74 80 129 155 179 215 217 231 233 282 302 310 341 394 402 405 408 421 496 SIC No. 281 Company B. I. Du Pont de Nemours & Co. Union Carbide Corp. . . . . . . . . . . . . . . Monsanto Chemical Co. . . . . . . . . . . . . . Dow Chemical Co. Allied Chemical Corp. . . . . . . Olin Mathieson Chemical Corp. . . . . American Cyanamid Co. . . . . . . . . . . . . . W. R. Grace & Co. . Food Machinery & Chemical Corp. Koppers Co. , Inc. . . . Celanese Corp. of America . . . . Stauffer Chemical Co. . . . . . . . . . Rohm & Haas Co. . . . . American Viscose Corp. Air Reduction Co., Inc. Hooker Chemical Co. . Diamond Alkali Co. . . . . Chemetron Corp. . . . . . . . . . . . . . . . Eagle-Ficher Co. . . . . . . . . . . . . . . Reichhold Chemicals, Inc. wyandotte Chemicals Corp Witco Chemical Co., Inc. American Enka Corp. Pennsalt Chemical Corp. Harshaw Chemical Co. Total 192 Number wO‘wmr-‘O‘NJ-‘mxobl 204 193 APPENDIX A (cont.) Acquisitions by Leading Drug Firms, 1951-61 SIC No. 283 1961 sales rank among 500 largeat Company Number 103 American Home Products . 4 177 Chas. Pfizer & Co., Inc. 8 199 Rexall Drug & Chemical Co. 18 216 Sterling Drug, Inc. 8 219 Merck & Co. , Inc. . . . 2 234 Parke, Davis & Co. . . . . . l 247 Warner -Lambert Pharmaceutical Co. 6 256 Eli Lilly & Co. . . . . . . . . . . . 2 275 Upjohn Co. . . . . . . . . . . . . . . -- 288 Bristol-Myers Co. . . 5 290 Smith, Kline & French Laboratories . 2 311 RichardsonrMerrell, Inc. 8 325 Abbott Laboratorie s . ~- 367 Mead Johnson & Co. . 1 462 Schering Corp. . . . . 2 463 'Miles Laboratories, Inc. ._1 Total 71 Acquisitions by Leading Cosmetic Firms, 1951-61 SIC No. 284 1961 sales rank among 500 laggeat Company Numbe; 26 Procter & Gamble Co. . . 6 75 Colgate-Palmolive Co. 6 122 Lever Bros. Co. . . . . . . . . 3 266 Avon Products, Inc. . -- 308 Revlon, Inc. . . . . . . . . . . . . . 9 474 Purex Corp., Ltd. _2 Total . 33 Source: Select Committee on Small Business, House of Represent- atives, 87th Congress. Staff Report: 'Meggepa and Snpegconcentgation, Agguiaitiona of 500 Largest Industrial and 50 Laggest‘Marchandising Finns, Nov. 8, 1962, pp. 46-52. LIST OF COMPANIES POSSIBLY TO BE SELECTED FOR THE STUDY 194 APPENDIX B 1964 1965 S & P 1963 Rank S & P Major SIC Fortune Stock Industry Group Company 500 Ranking Classification No. B. I. Du Pont de Nemours & Co. 12 A+ Chemicals 281 Procter & Gamble Co. 24 A+~ Cosmetics 284 Union Carbide Corp. 26 A Chemicals 281 'Monsanto Co. 33 A Chemicals 281 Dow Chemical Co. 50 A Chemicals 281 Allied Chemical Corp. 52 A- Chemicals 281 FMC Corp. 69 A Chemicals 281 w. R. Grace &' Co. 73 A- Chemicals 281 Colgate-Palmolive Co. 74 A- Cosmetics 284 American Cyanamid Co. 75 A Chemicals 281 Celanese Corp. of.America 82 A- Chemicals 281 American Home Products 109 A+- Drugs 283 Hercules Powder Co. 118 A Chemicals 289 Chas. Pfizer & Co. 130 A+ Drugs 283 Johnson & Johnson 159 A Drugs‘Misc. 384 Air Reduction Corp. 175 A- Chemicals 281 Warner-Lambert Pharm. Co. 177 A Drugs 283 ‘Rohm & Haas Co. 189 A+ Chemicals 281 Gillette Co. 204 A- Cosmetics 342 fMerck & Co., Inc. 214 A+ Drugs 283 Rexall Drug & Chemical Co. 215 A- Drugs 283 Stauffer Chemical Co. 219 A- Chemicals 281 Sterling Drug, Inc. 226 A+ Drugs 283 Bristol-Myers Co. 229 A+' Drugs 283 Abbott Laboratories 280 A Drugs 283 Hooker Chemical Co. 283 A- Chemicals 281 Parke, Davis & Co. 290 A Drugs 283 RichardsondMerrell, Inc. 316 A Drugs 283 Diamond Alkali Co. 319 A- Chemicals 281 Pennsalt Chemicals Corp. 368 A Chemicals 281 Note: shares traded on the NYSE over the ten-year period 1956-65. All of the companies on this list have had their common 195 APPENDIX C LIST OF EIGHT COMPANIES SELECTED FOR CASE ANALYSIS Allied Chemical Corporation, 61 Broadway, New York 6, New York Bristol-Myers Company, 630 Fifth Ave., New York 20, New York Colgate-Palmolive Company, 300 Park Ave., New York 22, New York Diamond Alkali Company, 925 Euclid Ave., Cleveland 4, Ohio Pfizer (Chas.) & Co., Inc., 235 East 42nd St., New York 17, New York Procter & Gamble Company, 301 East 6th St., Cincinnati 2, Ohio Richardson‘Merrell, Inc., 122 East 42nd St., New York 17, New York Warner‘Lambert Pharmaceutical Co., 201 Tabor Rd., Morris Plains, New Jersey 196 APPENDIX D LIST OF ACQUISITIONS AND MERGERS FOR EIGHT SELECTED COMPANIESI 1951-65 Allied Chanical CorpOEation Mbizewood Insulation Co. (1953) 2 Plaskon Division of Libbey-Owens-Ford Glass Co. (1954, p.a. ) Artex Roofing Co. (1954) Williams Roofing Co. (1954) ‘Mutual Chemical Co. of America (1954) valley Asphalt Co., Inc. (1954) Newark Plaster Co. (1956) Harmon Color WOrks from B. F. Goodrich Co. (1959, p.a.) Specialty Resins Co., Inc. (1960) ‘Union Texas Natural Gas Corp. (1962, pooling of interests) Mesa Plastics Co. (1964) Southern PrOpane-Co. (1964) Harrison Gas Service, Inc. (1964) Epiatol-Myega Company .Angier Chemical Co., Ltd. (1952) Tubos de Estano, S.A. (1952, p.a.) Luzier's, Inc. (1955) Kimball Manufacturing Corp. (1955) Grove Laboratories, Inc. (1958) Khasana G.m.b.H. Dr. Albersheim (1958) Clairol, Inc. (1959) Drackett Co. (1965, pooling of interests) Colgate-Palmoliva Company Wildroot Company, Inc. (1958) Sterno Corp. (1959) S. M. Edison Chemical Co., Inc. (1960) Lakeside Laboratories, Inc. (1960, pooling of interests) Consumer Products Division of Unexcelled Chemical Corp. (1961, p.a.) Reefer-Caller, Inc. (1961) Barbier & Dauphin, S.A. (1963) Lombardi Companies, S.p.A. (1964, p.a.) 1The list is gathered from Moody's Investor Service, Standard & Poor's Corporation records, and various annual reports. Some foreign and partial acquisitions may have been omitted because source informa- tion was lacking. All known "purchase with immediate write-off" and "pooling of interests" treatments have been indicated. 2p.a. represents a partial acquisition. 197 APPENDIX D (cont.) Diamond Alkali Company Kolker Chemical Works, Inc. (1951, purchase with write-off) Belle Alkali Co. (1953) Black Leaf Division of Virginia-Carolina Chemical Corp. (1955, p.a.) Black Leaf Division of Virginia-Carolina Chemical Corp. (1957, remaining interest) Bessemer Limestone and Cement Co. (1961, pooling of interests) Chemical Process Co. (1961) Fiber Chemical Corp. (1961) Central New Jersey Chemical Corp. (1961) Harte & Co., Inc. (1962, p.a.) Heritage House Products, Inc. (1964) Harte & Co., Inc. (1965, remaining interest, pooling of interests) Cha . ze & Com nc. J. B. Roerig &.Company (1953, purchase with write-off) Morton-Withers Chemical Co. (1957) Dupont y Cia (1957) Fiber Division of Virginia-Carolina Chemical Co. (1958, p.a.) Dumex Companies (1958, p.a.) ‘Kemball, Bishop & Co., Ltd. (1958) New England Lime Co. (1961, pooling of interests) Paul-Lewis Laboratories, Inc. (1961, pooling of interests) Globe Laboratories, Inc. (1961, pooling of interests) Thomas Leeming & Co. (1961, pooling of interests) Pacquins, Inc. (1961, pooling of interests) Barbasol Co. (1962) C. K. Williams & Co., Inc. (1962, pooling of interests) Knickerbocker Biologicals, Inc. (1962, pooling of interests) Desitin Chemical Co., Inc. (1963, pooling of interests) Metals for Electronics, Inc. (1963) Coty, Inc. (1963) Coty International Corp. (1963) Gibsonburg Lime Products Co. (1964, pooling of interests) Dolite Co. (1964) British Alkaloids, Ltd. (1964) Societe Chimique Agricole du Centre, S.A. (1964) Baker Laboratories, Inc., from'U.S. Vitamin & Pharmaceutical Corp. (1965, p.a.) Bridge Colour Co. (1965) Hull and Liverpool Red Oxide Co. (1965) Seger Co. (1965) Institut Serotherapique de Gembloux (1965) Propas Co. (1965) G. P. Proprietary, Ltd. (1965) 198 APPENDIX D (cont.) Procter & Gamble Company W. T. Young Foods, Inc. (1955) Nebraska Consolidated Mills Co. of Omaha (1956, p.a.) Hines-Park Foods, Inc. (1956) Duncan Hines Institute, Inc. (1956) Charmin Paper Mills, Inc. (1957) Clorox Chemical Co. (1957) Superior Foods, Inc. (1960, p.a.) J. A, Folger & Co. (1963, pooling of interests) Rei'Werke A. G. (1965) ch dso -Me ell Inc. fo erl ick Ch cal Com an Extruded Plastics, Inc. (1953, purchase with write-off) Dr. Hess & Clark, Inc. (1955) National Drug Co. (1956) Walker Laboratories, Inc. (1958) Lavoris Co. (1958) Milton Antiseptic, Ltd. (1958) Clearasil, Inc. (1959) Laboratorios Moura Brasil-Orlando Rangel, S.A. (1959) M118, S.A. (1962) Lumalite Corp. (1963) Diger-Selz (1963) Gascoigna-Crowther, Ltd. (1964) Laboratorios Picot, S.A. (1964) Farmochimica Autolo-Calosi (1964) Sterol Derivatives, Inc. (1964) Istituto Sieroterpico Italiano, S.p.A. (1964) Productos Quinicos Berkman, S.A. (1965) Nomdsol Products (1965) Bradley Industries, Inc. (1965) Earner-Lambert Ehapnaceutical Company (fornarlv Warner-Hudnut, Inc.) Meltine Co. (1951, purchase with write-off) Lambert Co. (1955, pooling of interests) Emerson Drug Co. of Baltimore City (1956, pooling of interests) ‘Nepera Chemical Co., Inc. (1956, pooling of interests) Oculine Co. (1959) Lactona, Inc. (1961) DuBarry Perfumery Co., Ltd. (1962) .American Chicle Co. (1962, pooling of interests) West Indies Bay Co. (1964) Smith Brothers, Inc. (1964) Research Specialties Co. (1964) Laboratories S.A(M, (1964) Hall Bros. (Whitefield), Ltd. (1964) 199 mmuum>coo ma xooum monummmud on» umnu mmESmmm maoaumaHAEoo mmmaamsn mmwnu you coaumuwuo ouHMi .maoauwoaflaam monumaH mmwz.mcm muuoamu Hanson msoqum> "moudom .mumu coamum>doo um xooum noEEoo ouca N.m ¢.m km.m .oaH s.oo a muumm .oo «amxH¢.maoam«a mama o.m m.o¢H to.mm .oo mHoaso smofiuma< .ou .Eum:m_uuon8m4uumnumz Noma n.m N.o¢~ H.qN mew Hmuoumzimmxma doafip .auoo fimowamao mmaHH< Nomfi m.H H.HH %¢.oH .oo undamu a maoummaaa umemmmmm .oo “mea< maoamfia Homa o.H o.m ~.n .oo Hmoaamno wumamz .oo .eumam uumnEmAwuodumz ommfi H.N O.N H.HH .00 mean newsman .oo sauwnm uumnamqwuoaumz omma mmEHu n.H m.oH m.mm .oo uquEmA .ocH .uscpamuumaumz mmmH maam> xoom ou AmcoHHHHE Gav aofiumuwuu ksmaaoo nmuasvo< hamdaoo wafiuaovo< umflw umoo mmmnousm mo oaumm o:~m>.xoom um>o swam umou mmmnouam m>aumaom mo mmmoxw mo mamz mo oemz mFmMMMHZH mo mUZHAoom zm>wm zo ZCHB¢SMomZH QHHUmHmm m NHszmm< 200 APPENDIX F FINANCIAL RATIOS AND GROWTH RATE FACTORS1 Li idit tios: Cash + Receiyablea + Inventory Current Liabilities 1. Current Ratio 8 ,, éalea (n) 2. Receivable Turnover e ab e + ece ables _ 1 2 3. Inventory Turnover 2 C t o Goods Sold (nL I ento + In e to ' 1 2 Ef ie c tios: 4 E in P0 = etIcoe foeI eTax in) ' arn g wer ot As ets (n) +TotiaL_§_§,_A 9133 (n ' 1) 2 Salsa Ln) 5' Asset Turnover Total Assets + Tot 1 sets n ‘ 1 2 Net Incpne before Inapmea Tayes 6. Income Margin ‘-' Sales lThe current year and the previous year are indicated by (n) and (n-l), respectively. Information about the computer program for financial statement analysis used may be obtained from Western Data Processing Center, Grad- uate School of Business Administration, The University of California, Los Angeles, California. Also see David K. Eiteman, "A Computer Program for Financial Statement Analysis," Financial Analyata =Jougnal, XX (November-December 1964), 61 T68. Twa changes should be noted as varia- tions from the published program: Operating Income is Net Income Before Income Taxes; and Operating Assets are Total Assets. 201 APPENDIX F (cont.) Profitability Ratios: Net Income + Fixed Charggs 7' Return on Capital g Total Capital (n) + Total Capital (n - 1) 2 8. Return on Common = Net to Common_ Stock Equity Com. Stk. E . n + Co . St . E . n - l 2 9. Cash Flow to Common _2 Net tQ_Connon + Depgeciation Stock Equity Com. Stk. Eg. (n) + Con. Stk. Ed. in,- 1) 2 PM: Adinsted Averagg Price 10' Price Earnings Ratio Adjusted Earnings per Share =1 Adjusted Diyidend pep Shape 11' Dividend Yield Adjusted Average Price = ndjnsted Ayegage Price 12' Price to Book Value Adjusted Book Value per Share a._.__ALe_aa 13. Price to Cash Flow Adi“ ted r e Price Adjusted Cash Flow per Share W= 14. 15. Long-Term.Debt as a Per Cent g Long‘Tarm Debt of Total Capital ‘Total Capital Common Stock as a Per Cent _ Connpn ggnity of Total Capital - ‘Total Capital APPENDIX F (cont.) iMiacellaneoua Ratios: Net Incone + Income Tanes + Fined Charges 16. Interest Coverage = Fixed Charges ___n____1s_2ixi_____ 17. Dividend Payout e Como Stoc dends- Net to Common l8. 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Acowumm Hmmhuamuv coaumufluuoa< nuHB mmmsousm .q m>wumapmua< A.ucoov u mezmmm4 BIBLIOGRAPHY BIBLIOGRAPHY Books Backer, MOrton (ed.). Modern Accounting Theory. Englewood Cliffs, ‘N. J.: Prentice-Hall, Inc., 1966. Edwards, Edgar O. and Bell, Philip W. Ihe Iheory and Measurement of Business Income. Berkeley and Los Angelesz‘University of Cali- fornia Press, 1964. Finney, H. A., and Miller, Herbert E. ci e o c oun I e - mediate. 6th ed. Englewood Cliffs, N. J.: Prentice-Hall, Inc., 1965. Hayes, Douglas A. Lnyegtmgntsz Analysis and management. New York: The'Macmillan Company, 1961. Hendriksen, Eldon S. Accounting Iheogy. Homewood, 111.: Richard D. Irwin, Inc., 1965. 'Ladd, Dwight R. Co e 0 ar 0 e 0 nd e P l c. Homewood, 111.: Richard D. Irwin, Inc., 1963. ‘McCarthy, George D. Agggigitigna and Mergers. New York: Ronald Press Company, 1963. ‘Meigs, walter B., Johnson, Charles E., and Keller, Thomas F. ngggggf gig;g_égggggging, ‘New YOrk: McGraw-Hill Book Company, Inc., 1963. 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