The question of which one to buy or sell seems to arise whenever we work with a client involved for the first time with the purchase or sale of a company. The question is complicated, and made even more so by tax considerations, both in this country and others. We will cover the issue as broadly as possible, exposing some of the problems while remaining comfortably outside the realm of offering legal or tax advice. In this article, we will restrict ourselves to the term "buy," rather than continuing to say "buy or sell," pointing out wherever possible, those specific problems which affect only one side or the other of any transaction.
Several key issues come to mind immediately when addressing the problem of whether to purchase stock or assets. The first of these is the decision of whether to treat the transaction as a purchase or a pooling for purposes of accounting.
During the late 60s and early 70s, the term conglomerate assumed great luster with Wall Street sachems. To be called a conglomerate was generally enough to ensure several extra levels of earnings multiplier. We can only presume that conventional wisdom of the time perceived diversification as a surefire method of protecting against the ups and downs of various business segments. We can recall our first job outside the cocoon of public accounting. We were the chief financial officer of a company that offered computer services to the federal government, permanent placement, engineering and drafting temporary services, and small-run machine shop services. As a public corporation, traded in what was then known only as the over-the-counter market, we were quite proud, as we referred to ourselves as a "mini-conglomerate." Our firm, like most others of the period used the existing accounting principles advantageously whenever possible, a situation that was particularly applicable in acquisitions.
The existing rules governing whether or not a business combination could be treated as a purchase or a pooling of interests were somewhat loose. There even existed a concept which allowed for "part purchase, part pooling."
One of the clearest advantages of using the pooling approach was, and still is, that no matter what part of the year a deal was consummated, both earnings statement and balance sheets of the combined entities were shown as if the combination had been effected on day one of the operating year. This led to a very obvious and too often misused application of the pooling treatment. A large company, often a conglomerate, needing a boost in revenue or earnings could simply issue shares of stock and acquire one or more smaller companies during the last month of its fiscal year, pool them, and post yet another year of continued growth.
Things began to change during mid-1970 when the AICPA addressed the problems of business combinations with the release of APB Opinion 16. To date, very few opinions have received more interpretations and subsequent ancillary opinions than this one.
APB 16 laid down a set of criteria for determining what combinations could be treated as poolings. More to the point, it stated clearly that transactions had to meet all of the criteria in full, or lose the treatment.
Earlier discussions of poolings opined that the size of the entities involved should be approximately equal. APB 16 described a pooling as a combining of ownership interests and eliminated any reference to size, so long as other conditions were met. One key aspect of APB 16 was the requirement that any set of financial statements resulting from a pooling at any time during the accounting year had to clearly disclose this fact. This provision removed many of the benefits attached to year end acquisitions designed primarily to enhance revenue and net earnings.
APB 16, however, awarded some benefits to the purchase method and clearly removed these from the province of pooling. One such important item was the valuation of purchased assets. Since pooling was a simple combination, no revaluation of assets was permitted. There was even a rule that made the disposition of acquired assets very difficult during the first two years of a pooling. Under the purchase method, the parties were permitted a very important benefit.
The difference between the purchase price in any combination and the net value of assets acquired is referred to in accounting parlance as "goodwill." While most people involved in acquisitions recognize the existence of goodwill, its use by accountants and tax attorneys was much more clearly defined, and sometimes to the detriment of the buyer.
The IRS did not permit goodwill to be taken as a deductible item of expense on any tax return. Therefore, a buyer who acquired a large amount of goodwill, in buying a service company, for instance, would lose a significant tax deduction. Compounding the problem, accounting rules made the amortization of goodwill mandatory. Thus, even though accounts might permit amortization over periods as long as 40 years, reported income of companies with large amounts of purchased goodwill generally were lower than taxable income. Equally as important, corporations with 50% tax rates suffered the loss of significant cash flow by being unable to deduct goodwill amortization for tax purposes.
Large amounts of purchased goodwill on balance sheets were also frowned upon by bankers and analysts. When analyzing companies, both of these groups had the troublesome habit of eliminating all but assets such as cash, accounts receivable, and some kinds of inventory. Goodwill, and other "intangibles" were cast into the limbo of ratio analysis.
In true Solomonic fashion, however, the AICPA tooketh away, but it also gaveth! Those who accounted for business combinations using the purchase method were permitted to revalue acquired assets during the year of acquisition. This gave rise to another spate of abuses, as companies looked for and found what occasionally were somewhat outlandish "assets" to which they might attribute amortizable value for tax purposes.