Accounting for business combinations is one of the most important and interesting topics
of accounting theory and practice. At the same time, it is complex and controversial. Business
combinations involve financial transactions of enormous magnitudes, business empires, success
stories and personal fortunes, executive genius, and management fiascos. By their nature, they
affect the fate of entire companies. Each is unique and must be evaluated in terms of its economic
substance, irrespective of its legal form.
Historically, much of the controversy concerning accounting requirements for business
combinations involved the pooling of interests method, which became generally accepted in
1950. Although there are conceptual difficulties with the pooling method, the underlying problem
that arose was the introduction of alternative methods of accounting for business combinations
(pooling versus purchase). Numerous financial interests are involved in a business combination,
and alternate accounting procedures may not be neutral with respect to different interests. That is,
the individual financial interests and the final plan of combination may be affected by the method
Until 2001, accounting requirements for business combinations recognized both the pooling and
purchase methods of accounting for business combinations. In August 1999, the FASB issued a report
supporting its proposed decision to eliminate pooling. Principal reasons cited included the following:
1.Pooling provides less relevant information to statement users.
2.Pooling ignores economic value exchanged in the transaction and makes subsequent
performance evaluation impossible.
3.Comparing firms using the alternative methods is difficult for investors.
Pooling creates these problems because it uses historical book values to record combinations,
rather than recognizing fair values of net assets at the transaction date. Generally accepted
accounting principles (GAAP) generally require recording asset acquisitions at fair values.
Further, the FASB believed that the economic notion of a pooling of interests rarely exists in
business combinations. More realistically, virtually all combinations are acquisitions, in which one
firm gains control over another.
GAAP eliminated the pooling of interests method of accounting for all transactions initiated
after June 30, 2001. Combinations initiated subsequent to that date must use the acquisition
method. Because the new standard prohibited the use of the pooling method only for
combinations initiated after the issuance of the revised standard, prior combinations accounted
for under the pooling of interests method were grandfathered; that is, both the acquisition and
pooling methods continue to exist as acceptable financial reporting practices for past business
Therefore, one cannot ignore the conditions for reporting requirements under the pooling
approach. On the other hand, because no new poolings are permitted, this discussion focuses on
the acquisition method.
INTERNATIONAL ACCOUNTING Elimination of pooling made GAAP more consistent with international accounting standards. Most major economies prohibit the use of the pooling method to account for business combinations. International Financial Reporting Standards (IFRS) require business
combinations to be accounted for using the purchase method, and specifically prohibit the pooling
of interests method.
Accounting for business combinations was a major joint project between the FASB and IASB.
As a result, accounting in this area is now generally consistent between GAAP and IFRS. Some
differences remain, and we will point them out in later chapters as appropriate.