Pooling of interests method

What Is Pooling of Interests Method?

The pooling of interests method was an accounting approach used to combine the financial statements of two companies undergoing a merger or acquisition. Within the broader field of accounting for business combinations, this method treated the combination as if the two entities had always operated as one, simply summing their existing assets and liabilities at their historical book value on the combined balance sheet. The core characteristic of the pooling of interests method was its avoidance of recognizing goodwill or revaluing assets to their current fair value.

History and Origin

The concept behind the pooling of interests method can be traced back to early accounting practices for business combinations in the United States, with some lineage traced as far back as 1887 in relation to the Interstate Commerce Commission and accounting for earned surplus.²⁰ This approach evolved from the idea that certain combinations represented a continuation of existing businesses rather than a new purchase, particularly when changes were more in form than in substance, such as in mergers involving holding companies and their wholly-owned subsidiaries.¹⁹ This perspective led to the practice of recording the assets and liabilities of combining companies at their carrying amounts.¹⁸

For decades, the pooling of interests method existed alongside the purchase method. However, the Financial Accounting Standards Board (FASB), responsible for establishing Generally Accepted Accounting Principles (GAAP) in the United States, initiated efforts to eliminate it. On June 30, 2001, the FASB officially eliminated the pooling of interests method for business combinations with the issuance of Statement No. 141, "Business Combinations."¹⁷ The FASB noted that the pooling method made it difficult for analysts and other users of financial statements to compare the financial results of entities, as similar business combinations could be accounted for using methods that produced dramatically different outcomes.¹⁶ This move was largely driven by a desire to improve the quality of financial information provided to investors and to ensure that accounting practices more accurately reflected the underlying economics of transactions.¹⁵

Key Takeaways

• The pooling of interests method was an accounting technique used for business combinations, primarily mergers.
• It involved combining the book values of the merging companies' assets and liabilities without revaluation.
• A key feature was the absence of goodwill recognition and subsequent amortization expenses.
• The Financial Accounting Standards Board (FASB) eliminated the pooling of interests method in 2001, mandating the use of the purchase method for all business combinations.
• Its elimination aimed to enhance transparency and comparability in financial reporting by requiring fair value accounting.

Formula and Calculation

The pooling of interests method did not involve a complex formula or calculation for determining a purchase price or goodwill, as its core principle was to avoid revaluing assets and liabilities. Instead, it was a straightforward aggregation of existing accounts.

For instance, if Company A and Company B merged using the pooling of interests method, their balance sheets would simply be combined line-item by line-item:

This meant that any premium paid by one company for the other beyond the sum of their book values was not recognized as goodwill or any other separate asset. The historical retained earnings of both entities were also generally combined.

Interpreting the Pooling of Interests Method

Interpreting financial statements prepared using the pooling of interests method requires understanding that the combined entity's financial position did not reflect the actual market value paid in the combination. Since assets and liabilities were carried at their historical book value, the resulting financial metrics, such as return on assets or earnings per share, could appear more favorable than under other accounting methods. This was largely due to the absence of new amortization expenses that would typically arise from recognizing goodwill or fair value adjustments. Users of financial statements would need to be aware that the reported figures did not necessarily indicate the true economic cost or investment involved in the business combination. The method's simplicity in combining balance sheets meant that the financial narrative presented a seamless continuation of past operations.

Hypothetical Example

Imagine two software companies, "CodeFusion Inc." and "InnovateWorks LLC," decide to merge in 2000, before the pooling of interests method was eliminated.

Before Merger:

• CodeFusion Inc. (Acquirer):
  • Assets: $10 million (Book Value)
  • Liabilities: $3 million
  • Equity: $7 million
• InnovateWorks LLC (Acquiree):
  • Assets: $5 million (Book Value)
  • Liabilities: $2 million
  • Equity: $3 million

Using the Pooling of Interests Method:

Under this method, CodeFusion Inc. would simply combine the book values of InnovateWorks LLC's assets and liabilities with its own.

• Combined Assets: $10 million (CodeFusion) + $5 million (InnovateWorks) = $15 million
• Combined Liabilities: $3 million (CodeFusion) + $2 million (InnovateWorks) = $5 million
• Combined Equity: $7 million (CodeFusion) + $3 million (InnovateWorks) = $10 million

No goodwill would be recognized, even if CodeFusion Inc. effectively "paid" more than InnovateWorks LLC's book value (e.g., through a stock exchange that implied a higher market valuation). The combined balance sheet would just show the summed historical costs, without reflecting any premium for intangible assets like customer lists or brand recognition that might have been part of InnovateWorks' market value. The historical financial statements of both companies would typically be restated as if they had always been combined.

Practical Applications

While the pooling of interests method is no longer permitted for new business combinations, understanding its historical application is crucial for analyzing legacy financial reports. Prior to its abolition, it was widely used in various industries, particularly those with significant merger and acquisition activity like technology, because it could present a more favorable picture of reported earnings.¹⁴

Its practical applications, retrospectively, include:

• Historical Financial Analysis: To accurately interpret the financial performance and position of companies that underwent mergers or acquisitions before July 2001, analysts must understand how the pooling of interests method influenced their balance sheets and income statements. This includes recognizing the absence of goodwill from these transactions and its impact on reported asset values and profitability.
• Academic Study: It remains a significant topic in accounting education, illustrating the evolution of accounting standards and the ongoing debate over the most appropriate methods for reporting complex transactions.
• Legal and Regulatory Context: For legal or regulatory reviews of past corporate actions, understanding the accounting treatment employed at the time, including the pooling of interests method, is essential.

Limitations and Criticisms

The pooling of interests method faced significant limitations and criticisms, ultimately leading to its abolition by the Financial Accounting Standards Board (FASB) in 2001. A primary critique was that it did not reflect the economic reality of a business combination as an exchange transaction. By recording assets and liabilities at their historical book value rather than their current fair value, the method failed to recognize the actual consideration transferred in the merger or acquisition.¹³

This lack of revaluation meant that valuable intangible assets acquired in the transaction, such as brand recognition, customer relationships, or patents, were often not recorded on the combined balance sheet unless they were previously recognized by the acquired entity.¹² Consequently, the pooling of interests method could mask the true cost of an acquisition and potentially overstate a company's return on assets or earnings by avoiding the recognition of goodwill and its subsequent amortization expenses.¹¹ Critics argued that this approach hindered comparability between companies, as similar business combinations could be accounted for differently, making it challenging for investors and analysts to assess financial performance accurately.¹⁰ The FASB sought to improve the quality and comparability of financial information by requiring a single method, the purchase method, which mandates the recognition of assets and liabilities at their fair values.⁹

Pooling of Interests Method vs. Purchase Method

The key distinction between the pooling of interests method and the purchase method lies in how they accounted for the assets and liabilities of combining entities in a business combination.

The main confusion between the two methods stemmed from their differing impacts on financial statements, particularly on reported goodwill and subsequent earnings. The pooling of interests method presented a more consolidated, historical view, while the purchase method (and its successor, the acquisition method) aimed to provide a more current and economically relevant picture of the combined entity's financial position and performance.

FAQs

Why was the pooling of interests method eliminated?

The pooling of interests method was eliminated by the Financial Accounting Standards Board (FASB) in 2001 to improve the transparency, relevance, and comparability of financial reporting.³ It was criticized for not reflecting the true economic substance of business combinations and for allowing companies to avoid recognizing goodwill and its associated amortization expenses, which could artificially inflate reported earnings.²

What replaced the pooling of interests method?

The pooling of interests method was replaced by the purchase method of accounting for business combinations in 2001. This method was later refined and is now generally referred to as the acquisition method, under FASB Statement No. 141 (revised 2007).¹ The acquisition method requires that assets and liabilities of the acquired company be recorded at their fair values at the time of the acquisition.

Does the pooling of interests method still exist in any form?

No, the pooling of interests method is no longer permissible under Generally Accepted Accounting Principles (GAAP) for new business combinations. While the method itself is obsolete, understanding its principles is important for analyzing historical financial statements of companies that underwent mergers or acquisitions prior to its elimination in 2001.