Mergers and Acquisitions Accounting

Through 1999, firms engaged in M&A activity could choose between the purchase method and the pooling of interests method. When a buyer acquires a target, it usually pays more than the book value of the equity it acquires. Under the pooling of interests method, the financial statements of the two firms are combined at existing book value. Therefore the buyer does not have to reflect the difference between the purchase price and target book value. Under the purchase method, the target firm's assets and liabilities are adjusted to fair market value. If there is still a gap between the purchase price and the FMV of these items, goodwill is created for the balance. The goodwill is either amortized or tested annually for impairment. Either way, goodwill can reduce accounting income, which is not a problem under the pooling of interests method. Prior to the change in the accounting standard, managers seemed to prefer pooling of interests for this reason.

Interestingly, firms that used pooling of interests were not required to retroactively restate their financials after the rule changed, so they continue to benefit from it today.