Ross et al.: Fundamentals
of Corporate Finance, Sixth
Edition, Alternate EditionVIII. Topics in Corporate
Finance25. Mergers and Acquisitions
© The McGraw−Hill^871
Companies, 2002Through the years, a great deal was written on the two approaches, discussing their pros
and cons. This issue was made moot in 2001 because the Federal Accounting Standards
Board (FASB) eliminated the pooling of interests option. We discuss both approaches
next to illustrate some issues, but, because pooling is no longer allowed, our treatment of
it is brief. In all of this, keep in mind that we are examining purely accounting-related
issues. How a merger is treated for financial reporting purposes has no cash flow
consequences.
The Purchase Method
The purchase accounting methodof reporting acquisitions requires that the assets of the
target firm be reported at their fair market value on the books of the bidder. With this
method, an asset called goodwillis created for accounting purposes. Goodwill is the dif-
ference between the purchase price and the estimated fair market value of the net assets
(assets less liabilities) acquired.
To illustrate, suppose Firm A acquires Firm B, thereby creating a new firm, AB. The
balance sheets for the two firms on the date of the acquisition are shown in Table 25.1.
Suppose Firm A pays $18 millionin cash for Firm B. The money is raised by borrowing
the full amount. The net fixed assets of Firm B, which are carried on the books at
$8 million, are appraised at $14 million fair market value. Because the working capital is
$2 million, the balance sheet assets are worth $16 million. Firm A thus pays $2 million
in excess of the estimated market value of these net assets. This amount is the goodwill.^3
The last balance sheet in Table 25.1 shows what the new firm looks like under pur-
chase accounting. Notice that:
- The total assets of Firm AB increase to $38 million. The fixed assets increase to
$30 million. This is the sum of the fixed assets of Firm A and the revalued fixed
assets of Firm B ($16 million14 million $30 million). - The $2 millionexcess of the purchase price over the fair market value is reported as
goodwill on the balance sheet.^4
Pooling of Interests
Under a pooling of interests, the assets of the acquiring and acquired firms are pooled,
meaning that the balance sheets are just added together. Using our previous example, as-
sume that Firm A buys Firm B by giving B’s shareholders $18 million worth of common
stock. The result is shown in Table 25.2.
The new firm is owned jointly by all the stockholders of the previously separate
firms. The accounting is much simpler here; we just add the two old balance sheets to-
gether. The total assets are unchanged by the acquisition, and no goodwill account is
created.
More on Goodwill
As we just discussed, the purchase method generally leads to the creation of an intangi-
ble asset called goodwill. Pre-2001 guidelines required firms to amortize this goodwill,
CHAPTER 25 Mergers and Acquisitions 847(^3) Remember, there are assets such as employee talents, good customers, growth opportunities, and other
intangibles that don’t show up on the balance sheet. The $2 million excess pays for these.
(^4) You might wonder what would happen if the purchase price were less than the estimated fair market value.
Amusingly, to be consistent, it seems that the accountants would need to create a liability called ill will!
Instead, the fair market value is revised downwards to equal the purchase price.