Merger-Related Accounting Inhibits Case Study

1. Describe how merger-related accounting inhibits a user’s ability to use accounting reports to make period-to-period comparisons. Is this true for both the purchase method and pooling method? Explain.

Merger-related accounting inhibits a user’s ability to use accounting reports to make period-to-period comparisons. Since once mergers occur, the combined company is different than either of the two former separate companies. It is often difficult to assess the performance of the combined firm relatively to two former separate firms. This is true for both purchase and pooling methods, and the effect is worse for pooling method.

Let us first compare the differences between purchase and pooling method when preparing consolidated financial statements.

Table 1: Purchase vs. Pooling Methods for Consolidated Financial Statements

Then let’s see how the above different accounting treatments can affect various values and ratios that need analysts’ attention.

Table 2: Effects on Values and Ratios for Purchase vs. Pooling Methods

When the pooling method is used, in terms of balance sheet effect, fair value of the assets of the acquired company is not considered and thus the assets of the combined company are usually understated. Since the assets are understated, combined equity is understated. This means that return on assets and return on equity ratios are overstated. In terms of income statement effect, as the depreciation for pooling method is based on the historical costs rather than fair value, the depreciation expenses will be understated. More importantly, the retroactive reporting of earnings helps the company such as Tyco to inflate its earning by accumulating income of subsidiaries.

When the purchase method is used, even it avoids the problems that pooling methods have, the intercorporate transactions and cash flows are not revealed.

1. Explain why a high price-to-earnings ratio is crucial to Tyco’s acquisition strategy?

We think that a high price-to-earnings ratio is crucial to Tyco’s acquisition strategy because it has two advantages. Firstly, it can help Typo acquire other subsidiaries using pooling accounting with smaller amount of shares. Secondly, pooling accounting acquisition ensures a stable growth of earnings on the income statement, thus making the high P/E ratio today reasonable to investors, hence Tyco may keep using the high P/E ratio for subsequent acquisitions.

As we can see from the case, Tyco was known as a “rollup” company which used its high stock price to acquire lower Price-to-earnings multiples. Tyco’s acquisitions were mainly done by pooling accounting, which means parent company could only acquire the subsidiary by exchanging stocks rather than cash. Since a high P/E ratio of Tyco represents a higher stock price, thus with a higher stock price, Typo could acquire other subsidiaries using fewer shares.

On the other hand, by applying pooling accounting, Tyco overstated its earnings to some degree in order to maintain a stable growth rate. The high and stable earnings growth would attract investors to invest in Typo’s stocks today. Since investors could expect a higher return in the future, they would consider the high P/E ratio today reasonable and thus the high P/E ratio of Typo could retain.

1. How do merger-related charges potentially enable a company to inflate future operating earnings? How can a user of financial statements assess whether this is occurring?

When a company uses purchase method to describe its acquisitions, the money spent to purchase the target companies will be simultaneously recorded in the consolidated financial reports as the fair value of assets and liabilities and goodwill. The tangible assets after consolidation will be depreciated for future period after carefully considering their useful life. The goodwill that generated from acquisition activities will be taken impairment test to determine its genuine value. Thus, it is hard for Tyco International to manage future operating earnings under purchase method.

However, pooling method will induce merger-related charges and this large charges will be expensed in the first year of acquisitions. The company can inflate future operating earnings by spending large acquisition charges in one shot. In other words, it needs not spend such a large sum of money in later years if there are no acquisitions afterward, and thus manipulate a huge increase in net income in the future compared to the first year of acquisition. As a user of financial statements, he should first determine whether the merger-related charges should be spent in a period of time. If analysts justify that the charges should be written off from now to a future point, the net income of the financial year that the acquisition occurs and the following writing-off period should be adjusted to the normal level. After revision, the net income will not be overvalued in the following years and the company will not be able to inflate its future operating earnings.