Essentially the issue surrounds two methods of accounting, the purchase method and the pooling of interests (sometimes called "uniting of interests"). The purchase method records the acquired firm's assets and liabilities at market value, it sets up a goodwill account, and it requires amortization of this goodwill. Pooling of interests, on the other, records the acquired firm's assets and liabilities at the book values and does not record goodwill. No goodwill implies no goodwill amortization that would otherwise hit the income statement. The FASB's proposed standard eliminates usage of the pooling of interests method.

Pooling of interests at best helps the suppliers of the financial statements, i.e., the managers. The immediate benefit is that the income statement takes on no new expenses. Future benefits arise from the disposal of assets and liabilities that are recorded at less than fair market values. Such disposals give rise to fictitious gains for the business enterprise. These managers hope that investors are ignorant of the underlying book values and become fooled by future income statements.

There are two major reasons for the FASB taking its stance. First, investors cannot read the financial statements and ascertain the cost of the business combination when pooling is applied. When a corporation pays (say) $30 billion to acquire another entity and shows only (say) $1 billion of this cost on the balance sheet, the investors are correct to wonder what in the world happened to the other $29 billion. Pooling sweeps these costs under the rug; the purchase method discloses these costs clearly and accurately.

Second, the pooling method gives managers an opportunity to create and display fictitious revenues whenever they desire. If a target company has land at a book value of $10 million and it has a fair market value of $100 million, then the pooling method keeps the recorded land value at $10 million. This allows managers to create a $90 million gain whenever it wants. Such a gain, however, is merely accounting legerdemain; to be more blunt, it is a fraudulent statement of the firm's earnings. The FASB is simply trying to eliminate this abuse.

Let's look at the assertions by Representatives Cox and Dooley, assertions I am sure they heard from their corporate donors who oppose FASB on this issue. The major assertion is that elimination of pooling will reduce incentives for the urge to merge. Neither the representatives nor the high tech industry has offered any proof of this allegation, and I am not aware of any academic research that can support the claim. Besides, the assertion seems to be that managers need to manage their earnings and that they are willing to deceive investors. Does Congress really want to support such activities?

Strong evidence against this assertion comes in the form of how other countries treat business combination accounting. Most countries prohibit the pooling of interests method, and those which allow it do so under more restrictive circumstances. Corporations domiciled in Japan or Australia are not hindered from mergers and acquisitions just because they must employ the purchase method. Even in France, where pooling is permitted, managers seldom use pooling. If purchase accounting doesn't hurt them, why would it harm U.S. companies?

The second assertion by the Congressmen and the industry representatives is that this will hurt the high tech industry. This assertion may or may not be true. What is known, however, is that they have offered no proof. However, we may ask again, if the purchase method does not hurt high tech companies in other countries, what is so unique about U.S. firms that this accounting would injure them?

The biggest reason for Congress to butt out is that it will undermine accounting standards setting in this country. The FASB, consisting of 7 men who are experts in accounting and finance, conducts its operations in full sunshine, it hears from all constituents, and it deliberates openly and fairly. If Congress intervenes, it would damage whatever authority and credibility the FASB possesses.

My advice to Congress is to leave FASB alone unless it has evidence that it is unfair in its due process. Knowing that no such evidence exists, I suggest Congress stick to issues such as national defense, education, Medicare, and social security.

More by J. Edward Ketz