Last week I wrote about purchase and pooling acquisitions, and arrived at the conclusion that purchase accounting provides investors with better visibility on the balance sheet. I still feel that way, but I slipped up if I led investors to believe purchase accounting is a silver bullet. It's not. It can make comparing earlier financial statements very difficult.

By Richard McCaffery (TMF Gibson)
August 29, 2000

Last week I wrote about pooling and purchase accounting methods, the two different treatments used by companies when accounting for acquisitions.

I picked Cisco Systems (Nasdaq: CSCO) and JDS Uniphase (Nasdaq: JDSU) because we hold both in the Rule Maker Portfolio and they typically employ different accounting treatments for acquisitions, with Cisco favoring pooling and JDS favoring purchase.

(Of course, as some readers pointed out, it's not just a matter of favoring one method or the other. To treat an acquisition as a pooling of interests, a company must meet a strict set of requirements. While this limits some companies to one method for various acquisitions, companies have been known to go to great lengths to qualify for pooling of interests status, mainly because it creates no goodwill on the balance sheet, which in turn must be amortized. This reduces net income.)

I received a lot of interesting responses from readers, some criticism, and even some feedback from other Motley Fool writers and analysts on the topic (namely, Motley Fool Research Analyst John Del Vecchio and the Rule Maker's own Phil Weiss). Thanks to everyone who took the time to read this dense material and respond.

After thinking about things for another week, and pursuing some more research, I still believe purchase accounting often provides the investor with better information, particularly regarding goodwill and the cost of the acquisition.

Just to touch on one of the main points I made last week, here's a line taken from one of my favorite financial textbooks (a big, heavy, and expensive book) on one key weakness of pooling transactions: "Since the pooling method carries forward historical costs, no recognition is given to the true value of the assets acquired or any securities used to pay for the acquired company." -- The Analysis and Use of Financial Statements, by White, Sondi, and Fried

This means that a company can turn around and sell acquired assets at fair market value (even though they are recorded on the balance sheet at historical cost), which provides earnings with a sudden gain out of nowhere. In addition to this, I prefer seeing goodwill itemized on the balance sheet. It's a useful total of the premiums a company has been paying for its acquisitions.

However, I think I erred in making it sound like purchase accounting is a silver bullet, always preferable to pooling and always superior in terms of visibility. Truth be told, there are no silver bullets in investing. While there are rules of thumb, the best investors will tackle these issues on a case-by-case basis, observing a few key differences in the methods.

One of the biggest problems with purchase accounting is comparability with previous financial statements -- and, since that's what financial analysis is all about, that's a significant issue. It can make things difficult when trying to compare apples to apples.

Again, I'll use our own JDS as an example. Look at its income statement for the last two fiscal years. In July 2000, the company reported sales of $1.43 billion, up 143% from pro forma sales of $587.9 million a year ago.

Included in this year's -- and last year's -- sales figures are the acquisitions of Epitaxx, Sifam, Optical Coating Laboratory, Cronos, and Fujian Casix Laser. Results for recently acquired E-Tek were not included.

Typically, the problem with purchase accounting is that the prior year's results wouldn't get restated. This means that an investor looking at a growth chart would see a sudden spike in sales and might attribute it to organic growth. They would be mistaken, however, since the sales increase in a purchase accounting situation is often the result of an acquisition. It's kind of like mixing same-store sales growth and total-store sales growth.

JDS sidesteps the problem by restating last year's results to include sales from recent acquisitions -- but the company isn't required to do this. See, originally, JDS reported $283 million in sales for 1999. After the recent buying binge, however, they went back and restated the financials, leaving the company with $587.9 million in pro forma 1999 sales.

What's the upshot here? We're safe in thinking the 143% sales growth the company reported is an apples-to-apples, organic comparison, viewed as though JDS and its recent acquisitions always operated as one company.

Just keep in mind that investors who go back farther than this need to be careful what they're looking at. The company didn't jump from $185 million in 1998 sales to $587 million last year organically, but as the result of acquisitions.

This isn't a problem in pooling accounting, since prior financial periods are restated, and investors view the two companies as though they had always been one. This means the income statement won't show a sudden sales boost relative to an earlier period simply as the result of an acquisition.

The advantage of pooling in this case is obvious, and investors looking at acquisitive companies that employ the purchase method should know this. Check carefully to see what adjustments have been made.

Overall, I think the lesson is that there are advantages and disadvantages to each method, and the best preparation is to investigate any merger with a framework for understanding how each treatment affects the financial statements in drastically different ways.

Now for something completely different. It's almost time to invest another $500 in one of our Rule Maker companies. I'm very excited about Matt Richey's efforts yesterday to bring order to the way we make our buy decisions. I'll need to mull over his criteria a bit, and I'm eager to hear more from readers on this topic. Meanwhile, I'm inclined to go along with his suggestion and invest $500 in Yahoo! (Nasdaq: YHOO).

Have a great day.

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