History repeats itself: The acquisition method and nonrecurring charges

Abstract

The Financial Accounting Standards Board issued Statement No. 141 (R) that replaces Statement of Financial Accounting Standard No. 141, Business Combinations. The new standard mandates use of the acquisition method, which requires expense treatment for acquisition-related transaction costs. Expense treatment is a departure from purchase accounting procedures, but is consistent with past guidance of Accounting Principles Board Opinion No. 16 for the pooling-of-interests method. Restoration of historical and controversial accounting procedures resurrects past outcomes. This study utilizes econometric techniques to predict outcomes of the acquisition method. Evidence indicates that expensing acquisition-related costs may improve transparent reporting. The results, based on 638 business combinations from 1994 through 1998, support the expectation that expense treatment for acquisition-related costs increases the likelihood that these costs appear more frequently and are greater in magnitude.

Keywords:

• Business combinations
• Nonrecurring charges
• Acquisition accounting method
• Logistic
• Tobit
• Regressions

Acknowledgements

The author acknowledges the participants at the Northeast American Accounting Association 2006 annual conference for their invaluable comments as well as the comments from an anonymous reviewer.

Notes

1 See paragraph 13 on page 5 of SFAS No. 141 (R).

2 IFRS No. 3 superseded International Accounting Standard (IAS) No. 2. IAS No. 22 permitted the use of pooling and purchase methods (IASC, 1983).

3 See letters of comment to the FASB found at http://www.fasb.org/ocl/fasb-getletters.php?project=1204-001.

4 The terms mergers and acquisitions, and business combinations in this study represent the acquisition of the controlling interest in another corporation.

5 See paragraph 20 of the SFAS No. 141 (R).

6 See “Timing a ‘big bath’ to an Acquisition” by Martin Sikora as reported in Mergers and Acquisitions (1999), which includes remarks made by Robert F. Herz, then chairman of the SEC Regulation committee of the AICPA, now chairman of the FASB.

7 In the 1995 pooling merger between Kimberly Clark Corporation and Scott Paper Co., a $1.44 billion reserve for restructuring charges was established, and in later years was allocated to different projects not associated with the merger and eventually systematically reversed to earnings. Cendant Corporation, in connection with its 1996 pooling merger with Ideon Group Inc. intentionally overstated merger reserves that are later used for other purposes other than its original intent, including reversals to income as needed. Once Cendant exhausted the Ideon reserve, there was a greater need for the Cendant/HFS pooling merger in 1997 to establish additional inflated merger reserves (see SEC Enforcement Release Nos. 1542 and 1272 (SEC, 2000, 2002)).

8 In examining financial statement disclosures, target-referenced NRCs combined with firm-wide NRCs are included. NRCs do not represent a utilization of a purchase accounting reserve due to inconsistent and/or inadequate disclosures of purchase accounting entries and subsequent use of purchase accounting reserves. Target firms may recognize NRCs in the period between announcement and completion dates (known as the “stub period”). This tactic is called “spring-loading” earnings, and its use was alleged in Tyco's acquisition accounting to produce the appearance of growth and profitability following an acquisition (see “Does Tyco Play Accounting Games” by Herb Greenberg, Fortune, 2002). Disclosures of NRCs recognized by target firms during the stub period are generally not available and are not included in this sample.

9 In a separate analysis of size-contracting activities following an acquisition, a sample of 855 acquisitions of a controlling interest in another entity during 1994–1998, inclusive, reveals 764 contracting transactions were reported through the year 2000. Of that amount, 85% of the size-contracting transactions with respect to the acquired target firm were reported within 3 years of the acquisition date.

10 The correlation coefficients suggest the presence of multicollinearity among the independent variables. Additional diagnostic tests that include the examination of tolerance levels and variance inflation factors for independent variables in a weighted OLS regression reveal that high multicollinearity is not present. See Allison (2003).

11 Although in the initial sample, 58% of acquiring firms report the incidence of target-related NRC, not all acquiring firms report the monetary value of the NRC. The Tobit regression analysis excludes NRCs that are not clearly numerated.

Additional information

Notes on contributors

Nina T. Dorata

Nina T. Dorata is a member of the faculty at the Peter J. Tobin School of Business at St. John's University in Queens, NY. She received her Ph.D. from Rutgers University, in May 2003 under the direction of Bikki Jaggi. She is a CPA licensed in NY.