practically all planning is on the tactical level.
service product line of the company acquired,
The immensely important strategical planning
efforts get postponed to a later date. That later
date sometimes comes after the merger has been
consummated and then it is often too late.
Tactical and Strategical Aspects of Mergers
The tactical aspects of a merger transaction in-
clude the price negotiations, service analysis,
evaluation of the company’s status in its industry
or area, the determination of asset values and lia-
bilities to be assumed, legal matters, terms of pay-
ment for the purchase, and relationships with
retiring executives of the company being ac-
quired. These tactical facets all involve questions
whose answers are signed, sealed and delivered
on the
merger date or within a few months there-
after. Too frequently all attention during merger
negotiations is directed to these tactical matters
at the expense of strategical matters.
The strategical aspects of a merger involve the
long-term relationships between the acquired com-
pany and the acquiring company. They include
plans for realigning executive personnel, plans for
consolidating service facilities, plans for cutting
back some of the activities of the acquired com-
pany and expanding other activities, plans for en-
tering new market areas, plans for enlarging the
Accounting for
Leonard S.
Partner, Laventhol Krekstein Horwath & Horwath
ACQUISITIONS today have become a figures
game. Generally, unless the figures work out, the
acquisition cannot be made. Naturally, the eco-
nomic and business factors must be present - but
so mustthe figures.
This is true, principally, if the acquiring com-
pany is publicly held. Where two closely-held
companies are involved, the considerations may
be completely different. However, to the public
company relying upon acquisitions for growth,
net income and earnings per share which will re-
sult from the acquisition may very well decide
whether the acquisition should or should not be
made.
or
plans for consolidating the research and testing
laboratories of both companies, plans for consoli-
dating the sales and reservation organizations of
both companies, plans for instituting centralized
or decentralized controls, and many other types
of projections, all designed to carry the merged
complex at least three years beyond the merger
date.
I have tried to set the stage for growth through
the
acquisitions by explaining critically important
preliminary steps and programs. Once these pre-
paratory elements have been fully considered
and effected, then a company is ready to under-
take an acquisition program with reasonable ex-
pectations for success.
David F. Linowes, CPA, delivered the opening
address before members of the seminar on
Mergers and Acquisitions, held November 17 on
the Cornell University campus. Mr. Linowes is
author of the book, Managing Growth Through
Acquisition, published by the American Man-
agement Association. He is a partner in the New
York office of Laventhol Krekstein Horwath &
Horwath, a member of the executive committee
of the American Institute of Certified Public Ac-
countants, and is also active in the United States
and New York Chambers of Commerce.
an
Acquisition
Douglas C.P.A.
Accordingly, I’ve been asked to discuss the
various accounting aspects of an acquisition.
Since most readers of this article are not account-
ants, I’ll be as non-technical as possible. But since
the subject matter is rather complex, I have pre-
pared a schedule (see the next pages ) , showing
the effect of acquisition accounting on the earn-
ings and per share earnings of the acquiring com-
pany. Continued
Leonard S. Douglas, CPA, member of the New
York Bar, is National SEC Partner of Laventhol
Krekstein Horwath & Horwath, certified public
accountants.
55
 A discussion of these accounting concepts
particularly appropriate this time, as they may
at
shortly be completely revised. A preview of the
proposed changes met with such overt opposition
by financial executives of acquisition-minded
companies, accountants and others, that the Ac-
counting Principles Board the arm of the Amer-
-
ican Institute of Certified Public Accountants
entrusted with responsibility of promulgating
generally accepted accounting principles when
-
contemplating these changes decided to recon-
sider the advisability of instituting them. As you
will see, if the proposed changes as discussed in
this article are ultimately adopted, they could se-
riously curtail the entire acquisition market.
But before discussing these proposed changes,
it is important to understand the concepts pres-
ently utilized. Basically, there are two methods
of accounting for an acquisition - the first as a
purchase and the second as a pooling of interests.
Purchase Acquisition
A purchase is a combination of businesses
where generally an acquired company is elimi-
nated. This results when the consideration paid
for the acquisition is in cash or notes, although
on occasion even the issuance of voting stock has
been reflected as a purchase. With the purchase
a new basis of
accountability arises, and the ac-
quiring company should revalue the assets ac-
quired and reflect them on their books at their
present values rather than at the seller’s book val-
ues. This should be done, although in
practice it
is not always done. To illustrate, let us assume
that the balance sheets of the respective parties
are as follows:
The Seller’s balance sheet reflects net assets
(shareholders’ equity) of $1,000, which is the book
value of its assets of $3,000 less liabilities of
$2,000. If the Buyer pays $4,500 for the outstand-
ing stock of the Seller he is paying $3,500 more
than the underlying equities as reflected on Sell-
is er’s books. This $3,500 must be allocated, first to
tangible assets such as property, plant and equip-
ment, and then to specific intangible assets such
as patents, franchises, etc. and the unallocated
balance to goodwill.
In columns 2, 3, 5 and 6 of the illustrative
schedule, the entire $3,500 has been allocated to
goodwill, an intangible asset, whereas in columns
4 and 7 the $3,500 has been allocated to tangible
assets - property and equipment. These alloca-
tions are arbitrary for illustrative purposes. In
practice, the allocations are made by competent
appraisers. The effect of these allocations upon the
Buyer’s income statement will become apparent
shortly.
In purchase accounting the Buyer reflects the
operating results of the Seller from the date of
acquisition, forward. The operating results are re-
flected prospectively only. They are never given
retroactive effect. Therefore, if the acquisition
takes place on the last day of the Buyer’s fiscal
year, Buyer would not include any of Seller’s op-
erating results in his statement of income, for that
year. If the acquisition took place at the end of
the sixth month, Buyer would include six months
of Seller’s results in his operating statement.
In effect, the period for which Seller’s operating
results are reflected by the Buyer and the require-
ment for the allocation of the excess purchase
price over net assets acquired are the factors that
distinguish the purchase method of accounting
from the pooling of interests method.
Acquisition by Pooling of Interests
The pooling acquisition is a combination of
businesses where substantially all of the owner-
ship interests in the constituent businesses survive
in the combined enterprise. Accordingly, the con-
sideration paid for the acquisition should be vot-
ing stock. No new basis of accountability of assets
arises. The assets and liabilities of the constituent
corporations are combined on the basis of their
respective book values and without considering
their actual values. Adjustments are made through
capital and surplus accounts to reflect the capital
stock issued for the acquisition.
Accordingly, as reflected in the illustrative bal-
ance sheets -
even though stock valued at $4,500
issued to acquire seller - the stock will be re-
corded in the combined balance sheet at $1,000,
the amount of Seller’s net equity. As such, no re-
allocation of asset values is required in a pooling
transaction and thus no goodwill. is created.
56
 SCHEDULE SHOWING THE EFFECTS OF ACQUISITION ACCOUNTING CONCEPTS ON
THE EARNINGS OF THE ACQUIRED COMPANY AND ITS EARNINGS PER SHARE

In a the Seller’s operating results are

pooling, substantial gain. There are many other similar sit-
combined with the Buyer’s retroactively. Accord- uations that have recently come under severe at-
ingly, if Buyer acquires Seller on the last day of tack, about which you may have read in the press.
his fiscal year, or for that matter, even after the
close of the fiscal year but before its financial re- Purchase vs. Pooling on Net Earnings
port for the year is issued, it may include Seller’s Now that of the significant distinctions
some
operating results for the entire year. If compara- between purchase and pooling accounting have
tive operating results are presented, the preceding
been pointed out, we should examine our sched-
year’s results must also be restated to include the ule to compare their effects upon the net earnings
full year’s operations of the Seller.
and the per share earnings of the acquiring com-
I believe the concept of pooling is sound and
should be retained, although a clearly defined pany.
In each case, our assumptions are as follows:
criterion should be established to prevent some
of the abuses in its application. These abuses, ~
Buyer - B, prior to its of Seller -
acquisition
which are incidentally to the spirit rather than S, has of
earnings $2,250 $2.25 per share on
or

the letter of the pooling concept, have enabled 1,000 shares outstanding. Its stock is selling at
some of the so-called growth 20 times earnings or $45 per share.
companies to achieve
instant growth. ~
B acquires S, which has net income of $450
An example would be the pooling of a rela- for 10 times earnings or $4,500, pay-
per year
tively passive company having assets worth sub-
ing in certain examples cash and in others
stantially in excess of their book values, accom- common stock or convertible preferred stock.

panied by the sale of a significant portion of such In each case the acquisition is deemed made
assets shortly before or after the acquisition at a half way through B’s fiscal year.

57
 Pooling. In the first example (Column 1) B is-
sues 100 shares of stock ($4,500 value) for S and
accounts for the acquisition as a pooling. Accord-
ingly, B’s earnings now combine the earnings of
the two companies, and per share earnings are in-
creased from $2.25 per share to $2.43 per share on
the 1,100 shares outstanding. Per share earnings
were increased since B used 20 times earnings
stock to acquire S at 10 times earnings. Figure-
wise, this is very favorable acquisition.
a the tax benefit available in the former.
Purchase with Cash. In Columns 2, 3 and 4, B
acquires S for $4,500 in cash which it borrows at
10% interest. Each of the three examples is ac-
counted for as a purchase. Accordingly, some dis-
position must be made of an amount of $3,500
representing the excess of the $4,500 purchase
price over the underlying $1,000 equity acquired.
In Column 2, the $3,500 excess has been allo-
cated to goodwill, but goodwill is not being
amortized. Under present accounting and SEC
rules, goodwill need not be amortized by periodic
charges to earnings. The rationale is that goodwill
has continuing value, and until such time as there
is an impairment in this value, there is no need to
provide for its amortization. The problem of ac-
counting for goodwill is undoubtedly the most ag-
gravating aspect of acquisition accounting. Lack
of uniformity in its handling abounds. However,
this seems destined for modification.
But going back to Column 2, the combined
earnings of B and S have been reduced to elimi-
nate S’s preacquisition earnings and to provide
for the net after tax cost of interest on the borrow-
ings used to finance the purchase price. As a re-
sult, per share earnings have been reduced to
$2.37 or 80 less than under the pooling. In subse-
quent periods when S’s operating results for an
entire year will enure to B, the cash purchase
should result in higher per share earnings than
the pooling as long as S’s earnings exceed the cost
of borrowing funds to finance the acquisition, and
provided that goodwill need not be amortized.
Column 3 assumes the same facts as in Column
2 but provides for the amortization of goodwill
over a
10-year period. Accordingly, net income is
further reduced by a provision for amortization
with no corresponding tax benefit - since no tax
deduction is available for the amortization of
goodwill. Accordingly, earnings per share has
been further reduced to $2.20 or 50 less than B
was earning
prior to the acquisition. Under such
conditions, B, rather than risk diluting its earn-
ings, may decide not to make the acquisition.
58
Under Column 4, the excess purchase price of
$3,500 has been allocated to property and equip-
ment rather than goodwill, and depreciated over
a
10-year useful. life. Although the depreciation
charge is equal in amount to the amortization of
goodwill charge in the previous example, depre-
ciation is tax deductible whereas the goodwill
write-off is not. Consequently, net income in Col-
umn 4 is $96 higher than Column 3, representing
Purch.ase with Stock. In Columns 5, 6 and 7 the
purchase is assumed to be made for 100 shares of
stock as in Column 1, but unlike that example -
which was accounted for as a pooling of interests
-
these are being accounted for as purchases.
Current accounting rules do not provide for man-
datory poolings. Accordingly, even where all of
the pooling criteria are present, the acquirer, at
its option, may still account for the acquisition as
a
purchase.
In both Columns 5 and 6, the excess purchase
price goodwill. In the for-
has been allocated to
mer, no amortization is being provided, whereas
in the latter amortization is being provided over
10 years. Per share earnings are computed at
$2.36 and $2.19, respectively or almost identi-
-
cal to Columns 2 and 3 which involved similar
goodwill allocations but a cash purchase rather
than a stock purchase. However, even though the
per share earnings are relatively comparable, ac-
tual net income figures ( line 12) vary signifi-
cantly, as the stock purchase requires no interest
computation but increases the number of shares
of stock outstanding.
In Column 7 the excess purchase price has been
allocated to property and equipment but no tax
benefit has been afforded to such depreciation
charge. Generally, where stock is issued in an ac-
quisition, the seller requires that the transaction
qualify as a tax-free reorganization so that neither
it nor recognize taxable gain
its shareholders will
on the transfer. However, the reorganization pro-
visions are a two-sided sword, and if it’s non-tax-
able to the seller, the buyer may not write-up the
basis of the assets acquired to obtain additional
tax benefits through higher depreciation charges.
In effect, for tax purposes, the buyer must provide
depreciation on property acquired based upon
the seller’s costs rather than their values on ac-
quisition. Where buyer for financial statement
purposes has allocated additional costs to proper-
ty acquired, as in this case, the higher deprecia-
tion charge will have no offsetting tax benefit.
 Convertible Pr ef erred Stock. Convertible pre-
ferred stock had been commonly used as an ac-
quisition too until the beginning of 1968 when
certain accounting changes all but rendered its
use obsolete. However, additional accounting re-
visions were made in 1969 which could conceiva-
bly restore them to favor provided there is a
-
marked reduction in the prime rate of interest.
This can best be illustrated in Columns 8 and 9,
where convertible preferred stock is utilized as
consideration for the acquisition, and the acquisi-
tions are reflected as poolings of interests. In both
instances the preferred is deemed convertible into
buyer’s common stock at the rate of $45, the mar-
ket price of such common stock.
In Column 8, the preferred carries a 5% cumula-
tive dividend and in Column 9 a 5.7% dividend.
Under current accounting rules (Accounting
Principles Board Opinion No. 15 which was pro-
mulgated in 1969 ) the 5% preferred stock will be
deemed a common stock equivalent whereas the
5.7% preferred will be considered a senior secu-
rity. As such, each must be handled differently in
computing earnings per share.
The classification of the preferred is determined
by the relationship of its yield to its fair value at
the date of issue. If on issuance, the yield is at
least 66%% of the then prime bank interest rate,
it is a senior security, and if the yield is less than
66%% it is a common stock equivalent. With the
current prime rate at 812%, any convertible secu-
rity yielding 5.67%, or 66%% of 812% will be a senior
security. The determination is made on the date
of issuance, and once a determination is made,
it remains in effect thereafter, even though the
prime rate or the underlying value of the stock
may change. This represents a change from the
residual security concept which had been in effect
prior to the enactment of APB No. 15. Under
that concept, a security could change back and
forth from a residual to a senior security, depend-
ing upon the market action of the underlying
common stock.
In Column 8, the 5% preferred is a common
stock equivalent. Accordingly, earnings per share
are computed as if the convertible preferred stock
had been fully converted. Therefore, instead of
1,000 shares of common stock being outstanding,
1,100 shares of common stock and common stock
equivalents are considered to be outstanding.
In Column 9, the 5.7% preferred is deemed a
senior security and earnings per share are com-
puted by deducting from net income of $2,700,
59
preferred dividend requirements of $257 and di-
viding the balance by the actual common shares
outstanding.
As I said before, prior to APB No. 15 and its
predecessor APB No. 9, convertible preferred
stock was very common acquisition device.
a
However, the preferred had to be reflected
once
on a fully diluted basis, it no longer lent itself
to a per share earnings pick-up by the acquiring
company. Consequently it is seldom used.
Review of Possible Changes
The examples given above are rather detailed
in order to present as graphically as possible the
effect of various applications of accounting for
acquisitions. All of these techniques are accepta-
ble under current accounting rules. This can mean
that given the same set of facts, different ac-
quirers can report different earnings depending
upon the accounting method utilized.
As previously mentioned, however, the lack of
uniformity in applying these concepts have been
under continuous attack by Wall Street analysts,
the SEC and others. The most vociferous attacks
have been launched against poolings of interests
because of the many abuses in its usage and also
because of the gradual erosion of the criterion
which originally established poolings. The ac-
counting profession undertook several lengthy and
costly studies on the subject, and finally in Sep-
tember 1969 the American Institute of CPAs let
it be known that the Accounting Principles Board
contemplated issuing an opinion which would
deem most acquisitions as purchases, thereby al-
most completely eliminating the poolings of inter-
ests method of accounting.
The statement indicated that since a bi.isiness
combination is an economic transaction in which
one corporation acquires another the cost of an
acquired company should be determined by the
same principles of accounting as for the acquisi-
tion of an asset. This cost should be allocated to
the assets and liabilities based on the fair values
of the identifiable individual assets less liabilities
assumed and the remainder of the cost should be
recorded as goodwill. This goodwill must be
amortized by systematic charges to income over
the period estimated to be benefited but not to
exceed 40 years.
An exposure draft encompassing these propo-
sals was to be issued by the Accounting Principles
Board, but the Board is having serious second
thoughts on the whole matter . 8