Introduction
Accounting for business combinations has been characterized by numerous controversies with regard to financial reporting and financial market regulators have advanced varying interpretations and opinions. The pooling of interest method and the purchase method are some of the accounting methods that accountants have been utilizing extensively. The controversies between the two methods are due to the principle established by No. 16 of the Accounting Principles Board Opinion (Ayers, Lefanowicz & John, 2000). The principle postulates that the two methods can be used in the process of accounting for business combinations.
The purchase method requires an organization to “record the estimated fair value of all the liabilities and assets” (Dauber, Shim & Siegel, 2012, p.62). Therefore, accounting for assets and liabilities using the purchase method is not different from the normal treatment of assets and liabilities. If the price of a particular asset were higher than “the estimated fair value, the excess amount would be recognized as goodwill” (Dauber, Shim & Siegel, 2012, p.67). The goodwill was then amortized for duration of 40 years. However, the scenario has changed and the case is different. The direct cost of combination under the purchase method is capitalized as a component of the investment cost. Dauber, Shim, and Siegel (2012) assert that the “stock issuance costs are treated as a reduction of additional paid-in capital” (p.145). The acquiring firm should also ensure that relevant fair values are allocated to all liabilities and assets irrespective of whether they existed at the time of acquisition or not. Moreover, the total direct cost of acquisition must be accounted for as this cost relates to various issues for example legal fees and investment banking fees.
Main body
The pooling of interest method differs from the purchase method in a number of ways. First, “all the liabilities and assets of the firm being acquired were transferred to the acquiring firm’s financial accounts at its book value under the pooling-of-interest method” (Lehman, 2002, p.93). However, no goodwill was created. The pooling of interest method is used if common stocks are affected, which means that the resources of the two entities might not be distributed. Moreover, the acquisition transactions under the pooling of interest method are not settled through cash. The purchase accounting method leads to an increment in the acquiring firm’s annual income (Claude & Darroch, 2000). This aspect arises from the fact that the acquired firm’s income is included in the acquiring firm’s annual income statement as at the at the purchase date. On the contrary, the income of the acquired firm was integrated in the acquiring firm’s income statement as at the 1st day of the firm’s reporting period irrespective of the date of acquisition. Moreover, “the acquired firm’s retained earnings were added to the acquiring firm’s retained earnings under the pooling method; however, the retained earnings of the acquired firm are not integrated in that of the acquiring firm under the purchase method; in addition, the direct cost of acquisition under the pooling method is expensed during the period of purchase” (Lehman, 2002, p.88). The purchase method was used to account for acquisitions while the pooling method was used to account for mergers.
The acquisition method can be compared to the pooling of interest and the purchase method in a number of ways. First, the acquisition method is mainly centered on the fair value of the firm being acquired. Furthermore, all the costs associated with in-process research and development [IPRD] incurred are recorded at their fair value on the date of acquisition. Under the purchase method, the acquiring firm is required to determine the fair value of the IPRD that might not be used in the future. This amount should be expensed immediately. The fair value of the IPRD is also determined under the acquisition method. However, the amount is treated as non-current assets. If the acquisition proves successful, the acquiring firm is required to amortize the IPRD of the assets acquired over their lifetime. However, if the acquisition fails, the acquirer should write off the IPRD of the asset. Direct costs of the business combination are expensed and contingent assets and liabilities are acknowledged under the acquisition method. However, under the purchase and the pooling of interest method, contingents are not acknowledged. The objective of this method is to improve the shortcoming associated with how assets and liabilities are recognized and measured under the two methods. All assets and liabilities under the acquisition method are recognized using their fair value. Recording transactions using fair value makes the financial statements of business combinations transparent and relevant. Thus, fair reporting of intangible assets, for example goodwill is attained.
Of the two, the acquisition method is more superior with regard to financial reporting in business combinations as it aids in the identification of liabilities and assets in a particular merger. Moreover, the method is also very objective in reporting. Through this method, assets and liabilities are recognized at their fair value on the acquisition data. The effectiveness of the acquisition method also emanates from the fact that it enhances cross border comparison of financial statements.
A number of differences stand out with regard to consolidations under the US Generally Accepted Accounting Principles (GAAP) and the International Financial Reporting Standards (IFRS). One of the differences relate to consolidation model. The difference in the consolidation model emanates from differences with regard to how economic benefits are determined. The second area of difference relates to de facto control and consideration of variable interest. Under the US GAAP, “the consolidation model mainly focuses on controlling an organization’s financial interest; therefore, the entities under consolidation are evaluated in order to determine their variable interest entities [VIE]” (Marcus & James, 2009, p.106). If the entity is a VIE, the next step entails following the guidance as stipulated under ASC 810, and “if the entity is not categorized as a VIE, the control of the entity is determined through voting rights” (Dauber et al. 2012, p. 98).
The consolidation model under the IFRS emphasizes on the control power. The control is defined as “the parent company’s ability to administrate on the entity’s operating and financial policies in order to obtain the desired benefits” (Lehman, 2002, p.119). However, control by the parent company only exists if the parent company holds more than 50%, either directly or indirectly, of the total votes. Moreover, the parent company’s voting rights should be determined.
The difference in the two standards is also evidenced by accounting for special-purpose entities (SPEs). Accounting for consolidation under the US GAAP requires one to determine whether the entity is a VIE or an SPE. SPEs are in some instances categorized as VIE, as they are thinly capitalized and highly structured. Decision making rights under the IFRS does not always indicate the degree of control mainly so in situations whereby the decision making rights with regard to SPE is limited or structured. Therefore, it is imperative for other control indicators to be integrated.
A higher degree of disclosure with regard to the entity’s connection to VIEs is required under the US GAAP. The need for extensive disclosure is to provide the users of financial statements with a high degree of understanding on diverse aspects such as the risks associated with the VIE. There are no SPE-specific disclosure requirements under the current IFRS standards. The only disclosure requirement relates to the relationship between the subsidiary and the parent company. Moreover, “the IFRS 12 requires the entities involved in the consolidation to disclose information that will assist financial statement users to determine the effect, nature, and risks associated with the consolidation” (Marcus & James, 2009, p.69).
The potential voting rights between the parent and the subsidiary company may lead to the existence of difference with regard to the investors’ degree of influence. Marcus and James (2009) add, “Potential voting rights under the US GAAP are not taken into account in the process of determining whether the investor has considerable influence” (p.73). On the other hand, potential voting rights are a major consideration under the IFRS. Therefore, the IFRS standard is focused at determining whether the influence of the investee. However, the potential voting is used in determining equity earnings of the investor.
Preparing consolidated financial statement under the IFRS and the US GAAP differs in a number of ways. The US GAAP permits the “consolidated and the reporting entities to report their financial statements under different year-ends for duration of 3 months; moreover, significant effects that might occur between the reporting dates are integrated in the financial statements” (Weil et al., 2012, p.129). On the contrary, consolidated financial statement of the subsidiary and parent companies are prepared on the same date.
Joint venture is one type of consolidation that is commonly being adopted; however, the term is defined differently under the US GAAP and the IFRS. The US GAAP standards define the term joint venture to include entities that are jointly controlled. On the other hand, the IFRS define the term joint venture to include contractual agreement involving two or more parties. The agreement outlines the economic activity that the two parties intend to undertake. The activity to be undertaken is usually under joint control, which means that each of the parties has a right on the economic activities being undertaken. Moreover, unanimous consent is required before implementing the economic activity.
Before determining the accounting model to adopt, the US GAAP requires one to determine whether the joint venture is a VIE or not. The equity method is mostly used in the process of “accounting for joint ventures under the US GAAP, but both the equity and the proportionate method of accounting for joint ventures can be adopted under the IFRS” (Weil et al. 2012, p.118). The accounting items are recorded under their fair value. The method selected is determined by whether the joint venture is jointly controlled. Moreover, the fair value is not used.
Conclusion
In my own opinion, I would recommend the IFRS reporting standards as the standards contribute to a high degree of financial reporting when accounting for consolidations. The IFRS reporting standards require the parent and the consolidated firm to report using the fair value on the date of consolidation.
Reference List
Ayers, B., Lefanowicz, C., & John, R. (2000). The financial statement effects of eliminating the pooling-of-interest method of acquisition accounting. Accounting Horizons, 14(3), 1-19.
Claude, L., & Darroch, R. (2000). Financial reporting: Purchasing versus pooling. Ivey Business Quarterly, 63(2), 12-13.
Dauber, N., & Shim, J., & Siegel, J. (2012). The complete CPA reference. Hoboken, NJ: Wiley.
Lehman, C. (2002). Mirrors and Prisms: Interrogating Accounting (Advances in Public Interest Accounting). Bingley, UK: Emerald.
Marcus, P., & James, W. (2009). Fundamentals of advanced accounting. New York, NY: Cengage.
Weil, R., Schipper, K., & Francis, J. (2012). Financial accounting: An introduction to concepts, methods and uses (14th ed.). Mason, OH: South-Western Cengage Learning.