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Post of the Day
September 16, 1999

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Subject:

Gimmick Accounting

Author: stuckeysj

Pooling is clearly a gimmick developed to hide the true cost of acquisitions. As TMFPuck's article states, its main purpose is to generate commissions for investment banking companies handling mergers and acquisitions.

I really see no valid argument for allowing pooling accounting except as a way to pull the wool over some investors' eyes. It distorts financial results as it creates historical financial results for a combined company that did not in fact exist. Comparisons to periods previous to the ones covered in the most recent financial statements are impossible and meaningless as only the two most recent years' balance sheets and three most recent years' income statements, cash flow statements and statement of shareholders' equity are restated.

"I really see no valid argument for allowing pooling accounting except as a way to pull the wool over some investors' eyes."

Also, I have found that pooling historical financial results can obscure problems which one of the merging companies may be experiencing. A recent company I looked at involved a larger, financially successful company merging with a smaller financially struggling company. The restated financials of the surviving entity showed a steady improvement in profitability of the combined companies. However, this obscured the fact that the smaller company was deteriorating rapidly while the larger company was showing modest improvement that initially overcame this deterioration, providing the illusion of improving results. Eventually the rapid deterioration of the smaller company overcame the modest improvement of the larger company and investors were treated to a "surprise" in which the new combined company was facing possible insolvency. Unless an investor was savvy enough to comb through the previous years' financials of BOTH companies and disaggregate the reported, combined performance of the entities, he or she would have been fooled into believing the merger was a positive event. Most individual investors do not have the time nor the expertise for these exercises. With purchase accounting, the negative impact of the smaller company's financial deterioration would have shown up immediately in falling margins and returns on capital

In addition, in order to make a true "apples to apples" ROIC comparison, one must take the additional step of calculating unstated goodwill by reviewing the purchase transaction details and seeing how much above book value the acquiring entity paid. This is a sometimes difficult exercise many investors, especially busy individual investors, may not have the time nor expertise to accomplish. Without these adjustments, a company's ROIC would be overstated in future periods, possibly resulting in investors overpaying for the business. I believe most sophisticated investors ignore the impact of amortization of goodwill on a company's income statement and remove it from EPS or ROIC calculations. Thus, purchase accounting clearly provides more and more accurate information to investors upon which they may base their investment decisions.

"...pooling is simply another method to obfuscate a company's actual future earning power relative to its true invested capital."

Honestly, as an investor, I find the current trends in accounting practices disturbing. Many companies, under pressure to meet analysts expectations to support their stock prices, are adopting aggressive revenue recognition/expense deferral practices. I will not belabor the point by providing many recent examples involving large, well-known companies as they have been well publicized in financial periodicals. However, I recently spoke to a former auditor who had worked for years at one of the Big 5 accounting firms. He indicated that in his final years he was increasingly under pressure to bill more hours, meaning he had less time to do in-depth audits. In addition, these firms are under increasing pressure to generate other income from consulting etc., which may create conflicts of interest. I am not an alarmist and do not mean to overstate the risk to investors, however, the increasing frequency of these earnings restatements calls into question the integrity of even audited financial results. Investors still have a heavy responsibility to do their own due diligence.

Back to the original point, pooling is simply another method to obfuscate a company's actual future earning power relative to its true invested capital. Its elimination will produce benefits for all investors. I hope the debate is not politicized as was the stock option debate of several years ago. As this would do nothing but enrich the investment banking community at the expense of individual investors.

Foolishly,
Steve