FASB Proposes Elimination of the Pooling Method for Business Combinations

By:
Kazutaka Mori (Partner, Japanese Practice, Detroit Office)

On September 7, the Financial Accounting Standards Board (FASB) issued a proposal for public comment on a draft statement of financial accounting standards for business combinations and intangible assets (including goodwill). The statement calls for amendments of Accounting Principles Board (APB) Opinion No. 16, Business Combinations, and APB Opinion No. 17, Intangible Assets.

The FASB's controversial proposal would eliminate the popular pooling method of accounting for business combinations. It is said that the number of the business combination transactions in the United States may decrease significantly, should the pooling method be eliminated. The proposal would also shorten the period of time over which goodwill could be amortized to 20 years, although current practice is generally toward shorter amortization periods.
An exposure draft sets forth the proposed standards of financial accounting and reporting, the effective date and method of transition, background information, and an explanation of the basis for the board's conclusions, but do not signify immediate implementation. The next step will be public hearings to be held through February.
A decision on whether to issue a final statement will be made in consideration of the written and oral comments. If the board decides the exposure draft requires extensive revision, a revised exposure draft will be issued. For example, a revision of a 1995 exposure draft on consolidated financial statements was issued in 1999.

Business Combinations
The current APB Opinion No. 16 approves both the purchase method and pooling method for accounting business combinations. Under the purchase method, identifiable net assets of the acquired company are valued at fair value and the excess of the purchase price over the fair value of identifiable net assets is recognized as goodwill.
Under the pooling method, the transaction is not treated as an acquisition, but a combination of interests, so that net acquired assets are measured at book value. A business combination occurs when (1) two or more companies become one (a merger), (2) two or more companies enter into a parent-subsidiary relationship (stock acquisition), or (3) one company acquires a part or all of another company's assets and debts (asset acquisition).
Companies are required to apply the purchase method unless all 12 pooling conditions are met. Generally, companies prefer the pooling interests method because when the purchase method is applied, current earnings and earnings per share can decrease as a result of an increase in depreciation due to valuation of assets at fair value and the amortization of goodwill.
The exposure draft proposes that all business combinations be accounted under the purchase method. The definition of business combination is basically the same for the exposure draft and APB Opinion No. 16, but the exposure draft clearly states that it includes an exchange of a business for a business. The exposure draft does not apply to transactions made by enterprises under common control and not-for-profit enterprises.
The purchase method requires that the acquiring and acquired company be identified and the exposure draft stipulates that the acquiring company be the company that has controlling interest. In the case of a merger, controlling interests are determined not only by voting rights but also by the composition of the board of directors and senior management of the combined enterprise.
As mentioned earlier, the purchase price over the fair value of the acquired company's identifiable net assets is recognized as goodwill (an asset). The exposure draft defines goodwill as consisting of unidentified intangible assets and identifiable intangible assets that are not reliably measurable. Examples of goodwill are new channels of distribution and synergies of combining sales forces. Intangible assets that are not included in goodwill are intangible assets that are reliably measurable and identifiable such as patents, copyrights, and favorable leases.
Although the purchase price is usually higher than the fair value of identifiable net assets, the fair value may exceed the purchase price if the acquired company is performing poorly. The exposure draft proposes an amendment to the accounting for the excess fair value of acquired net assets over cost.
APB Opinion No.16 requires that the excess be allocated first to noncurrent assets other than securities. If an excess still remains, recognition of the excess will be deferred and amortized in subsequent periods. The exposure draft would require the excess to be allocated first to intangible assets for which there is no observable market and, second, to depreciable noncurrent assets and other intangible assets with observable market. If all the assets to which the excess would be allocated are written down to zero and an excess still remains, that amount would be recognized as an extraordinary gain.

Intangible Assets
The exposure draft defines intangible assets as noncurrent assets (other than financial assets) lacking physical substance and categorizes them into goodwill and intangible assets other than goodwill.
Intangible assets recognized in a business combination, whether with or without goodwill, is measured at the fair value. On the other hand, the costs of internally developed intangible assets that are not specifically identifiable, have indeterminate lives, or are inherent in a continuing business are recognized as an expense when incurred.
Intangible assets other than goodwill are amortized over their useful economic lives (generally using the straight line method). If they have indefinite useful economic lives they are not amortized until their lives are determined to be finite. Amortization should not extend beyond 20 years unless the intangible asset generates clearly identifiable cash flows that are expected to continue for more than 20 years.
Goodwill is usually amortized over its useful economic life, but not over a period longer than 20 years.
FASB Statement No. 121, Accounting for the Impairment of Long-Lived Assets and for Long-Lived Assets to Be Disposed Of, is applied to all intangible assets. In addition, goodwill recognized by a business combination that meets more than one of the following criteria must be tested for recoverability no later than two years after the acquisition date:

• A high premium was paid
• An auction or bidding process was involved
• The amount of goodwill was significant relative to the cost of the acquired enterprise
• Payment was in the form of the acquiring enterprise's shares.

The views and opinions are those of the author and do not necessarily represent the views of KPMG LLP.