Introduction to Corporate Finance

Ross et al.: Fundamentals

of Corporate Finance, Sixth

Edition, Alternate Edition

VIII. Topics in Corporate

Finance

25. Mergers and
    Acquisitions

(^872) © The McGraw−Hill
Companies, 2002
meaning that a portion of it was deducted as an expense every year over some period of
time. In essence, the goodwill, like any asset, had to be depreciated until it was com-
pletely written off.
The amortization of goodwill was something that firms generally disliked because it
reduced reported earnings. However, notice that the amortization deduction was strictly
non-cash. Unlike true depreciation, it was not even a tax-deductible expense, so finan-
cial analysts just routinely ignored it.
Despite the cash flow irrelevance of goodwill amortization, FASB’s decision to re-
quire purchase accounting caused a great deal of protest, much of it due to the treatment
of goodwill and its impact on reported earnings. As a compromise, in 2001 FASB elim-
inated the requirement that goodwill be amortized and put in place a new rule. In
essence, the new rule says that each year firms must assess the value of the goodwill on
their balance sheets. If the value has gone down (or become “impaired” in accounting-
speak), the firm must deduct the decrease; otherwise, no amortization is required.
CONCEPT QUESTIONS
25.3a What is the difference between a purchase and a pooling of interests?
25.3bWhat is “goodwill”?
848 PART EIGHT Topics in Corporate Finance

TABLE 25.1

Accounting for

Acquisitions: Purchase

(in Millions)

Firm A Firm B

Working capital$4 Equity $20 Working capital $2 Equity $10

Fixed assets 16 Fixed assets 8

Total $20 Total $20 Total $10 Total $10

Firm AB

Working capital $6 Debt $18

Fixed assets 30 Equity 20

Goodwill 2

Total $38 Total $38

The market value of the fixed assets of Firm B is $14 million. Firm A pays $18 million for Firm B by issuing

debt.

TABLE 25.2

Accounting for

Acquisitions: Pooling of

Interests (in Millions)

Firm A Firm B

Working capital$4 Equity $20 Working capital $2 Equity $10

Fixed assets 16 Fixed assets 8

Total $20 Total $20 Total $10 Total $10

Firm AB

Working capital $6 Equity $30

Fixed assets 24

Total $30 Total $30