Use of Pooling of Interests to Avoid Write off of Purchase Price Allocable to Goodwill

April 1, 1997 Advisory

Where one company acquires another, either by purchase or in a tax-free reorganization, the acquiring company must generally treat the excess of the acquisition price over the value of the target's tangible assets as "goodwill" on its financial statements. Such goodwill is amortized on the company's books for as long as 40 years, with a resulting reduction in reported earnings in each of these years. Often, this write off of goodwill will distort a company's actual earnings after the acquisition.

Some acquirers in reorganizations or other types of tax-free acquisitions, however, may be able to avoid recognizing goodwill under the financial accounting "pooling of interests" rules. If the pooling rules apply, the transaction is not treated as an acquisition of one company by another, but rather as the uniting of two companies by the exchange of equity securities. The assets acquired in the transaction retain their historical cost basis (i.e., they are not "stepped up" to reflect acquisition cost), and no goodwill is recorded or amortized.

The pooling of interests rules apply where a company acquires a target firm's stock substantially in exchange for its own voting stock (or stock of a corporate parent), rather than for cash. The Accounting Principles Board's APB Opinion No. 16 provides twelve criteria that all must be met in order for an acquisition to be treated as a pooling of interests. Among the most significant are:

  • Each of the combining companies must be autonomous and not have been a subsidiary or division of another company within two years prior to the initiation of the plan of combination (except in a subsidiary merger where target shareholders receive stock of the acquiring corporation's parent). In addition, each company must be unrelated to the other combining companies (not more than 10% cross-ownership is allowed).

  • The acquiring corporation must exchange its voting common stock for at least 90% of the voting stock of the target company. The ratio of the interest of an individual common shareholder to those of other common shareholders in a combining company must remain the same as the result of the exchange of stock in the combination.

  • Generally, none of the combining companies may have changed the equity interest of its voting common stock within two years of initiating the plan of combination, by such means as unusual cash or stock dividends, stock redemptions, or additional stock issuances.

  • The combined corporation cannot have an agreement directly or indirectly to "bail out" shareholders for cash after the combination has been consummated, e.g., by a post-transaction stock redemption.

  • Generally, the combination must be consummated within one year from the date of its announcement to the shareholders.

Unlike the federal income tax rules governing tax-free reorganizations, the pooling rules contain no continuity of interest requirement precluding a target shareholder who receives stock of the acquiring corporation from selling this stock after the transaction. On the other hand, the pooling rules generally do prevent the acquiring company from quickly disposing of unwanted target assets. Another significant impediment to using the pooling rules in an acquisition is that these rules do not apply to a transaction involving contingent transfers of additional stock at a later date.

Practice Pointer

Due to the complexity of the requirements for a pooling, and the fact that all of the requirements must be met, clients should consult with counsel and their accountants as early in the process as possible. Even one seemingly innocent corporate action that takes place well prior to the transaction could preclude pooling treatment.