Case 5-2: Tyco International
Companies have been using merger-related accounting for merger and acquisition. The two proposed methods for companies are purchase method and pooling of interest method. According to generally accepted accounting principles (GAAP) framework, both of these methods are legally acceptable, but have different sets of accounting norms and principles. However, if the company has been using pooling of interest method then it inhibits a user’s ability to use accounting reports to make period-to-period comparisons because of various reasons.
As we know that, FASB (Financial Accounting Standard Board) recently disallowed the use of pooling of interest method for companies involve in accounting for business combination. This disagreement of FASB with pooling of interest method is due to large number of difficulties confronted by investors and stockholders in order to evaluate financial statements of many companies. There are actually 12 factors that companies must confirm before using the pooling of interest method of accounting. The primary rule is that if company acquires another company, the payment for acquired company must be done by exchange of stock rather than cash. Under the equity method of accounting, both these methods are used for consolidation for business combination. The significant differences between both these methods are as given below,
A. Pooling of interest method:
1) The consolidated balance sheet includes the net book value of assets of both the parent and its subsidiaries companies.
2) The consolidated balance sheet includes the net book value of liabilities of both the parent and its subsidiaries companies.
3) The consolidated balance sheet includes the retained earnings for both the parent and its subsidiaries companies.
4) Companies using pooling of interest method report the income as a whole or retroactive on the consolidated statements.
5) Depreciation is computed on historical book value instead of acquisition cost.
6) It eliminates recognition of any intangible assets or goodwill.
B. Purchase method:
1) The consolidated balance sheet includes the book value of parent company’s assets and the fair market value of assets of its subsidiary company as of the acquisition date.
2) The consolidated balance sheet includes the fair market value of liabilities of both the parent and its subsidiaries companies.
3) The consolidated balance sheet includes the retained earnings for only the parent company.
4) The reported income depicts the revenue after the purchase of subsidiary company.
5) Depreciation of assets is computed on book value of parent company and fair market value of its subsidiary.
Under purchase method, it is not difficult for investors and stockholders to make period-to-period comparison of financial statements. However, the pooling of interest method has entirely different phenomenon. The implications of pooling of interest method is that due to exchange of stock instead of cash, there is a continuity of ownership means the two ownership group simply combined to own larger portfolio of assets. There is no sale of company, so both the companies are not come under tax implications. Some companies such as Tyco regenerate its financial statement effectively to pretend the acquired company was a part of Tyco long before the deal closed. The retroactive reporting of earning helps the company such as Tyco to inflate its earning by accumulating income of subsidiaries. Computation of depreciation would be done on historical book value which in turn amplifies higher net income. There is no recognition of goodwill or any intangible assets, so companies would have amortization of goodwill. Under pooling method, parent company record asset of subsidiary company as its book value, so overstating of net income and understate the assets.
b. As we know that, the Tyco’s accounting tactics are based on the pooling of interest method of accounting. As we focus on the formula of price-to-earnings ratio is expressed as,
Price to earnings = Market price per share/ earnings per share = 103.25/ 0.60= 172.08
(In above formula, Stock price of 1999 is taken from historical prices of Tyco International Ltd., Yahoo! Finance mentioned in Reference).
As we know that, the P/E ratio depicts that how much investor is willing to pay per $1.00 of reported earnings. P/E ratio is higher for firms which have strong growth prospects, but it is lower for riskier firms. The above given calculation shows that in 1999, Tyco’s stock price is 172.08 times more than its earnings per share. Here in Tyco’s acquisition strategy, the company’s intention to show high P/E multiples has only two fundamental reasons,
1) Tyco was using pooling of accounting for its acquisition in which it was mandated that parent company can acquire subsidiary only by exchange of stock instead of cash. Consequently, Tyco can acquire any company by exchange fewer stock due to high stock price and high P/E multiples. The subsidiary company is also easily merge with Tyco in order to derive high returns on stock because of high P/E multiple.
2) Another reason of high P/E ratio for Tyco acquisition strategy is that, high P/E ratio attract investors and stockholders to invest in the company in order to gain large future returns. The reason behind investors and stockholders attraction towards high P/E multiple is to figure out how much they willing to pay today for the company’s expected earnings in the future.
c. As we know that, operating earnings is the earnings after deduction of cost of goods sold, operating expenses, and depreciation. The company which is using pooling of interest method of merger-related accounting for business combination can potentially inflate its operating earnings. Under pooling of interest method, the merger, restructuring, and other non-recurring charges account is debited for the book value of the acquired company, depreciation is calculated and reported on the historical book values of both parent and its subsidiary, and there is no recognition of premium that company paid to acquired company above its book value as goodwill. Due to these accounting norms, there is fewer depreciation and amortization of goodwill charges are deducted from the sales revenue. Moreover, pooling method understates the assets of subsidiary company, decline the amount of depreciation expense, and ignore premium amortization over the book value. Consequently, this pooling accounting potentially enables company to inflate future operating earnings.
The user of financial statement evaluate this inflation of operating earnings from company’s disclosures or notes of merger, restructuring, and other non-recurring charges, investment in subsidiary account, and the most important disclosure of pooling of interest transactions.
d. After the acquisition of company, the parent company would be trying to take the advantage of cost saving and some short-term gains derived from cutting cost. The parent company doesn’t know that these short-term gains couldn’t inflate its income or huge saving of cost, but it could loss long run income and many implicit gains. In the Tyco’s annual report of 1999, the company’s CEO Mr. Kozlowski stated that the company would focus on increasing revenues and margin expansion by persistent focus on cost reduction. According to Kozlowski, in order to expand company’s position in the marketplace, it is important to be a low-cost and high quality provider of solutions. In my opinion, it may be difficult to provide high quality products at low cost.
After acquisition of U.S. Surgical in 1999, Tyco has cut annual operating costs by $200 million by laid off the 1000 employees out of 6000 employees of U.S. Surgical, selling the pig farm that U.S. Surgical had been using for research and development and experimentation with organs for human transplant before acquisition. As a result of this cost cutting, Tyco permanently lost the proficient employees and research and development for innovation required for rapidly developing medical and health care supply business.
In the Tyco’s annual report of 1999, under the note of merger, restructuring, and other non-recurring charges, the company report stated that in order to cut cost, there was a huge lay off of employees about 932 positions in United States from manufacturing and distribution, sales and marketing, administrative, and research and development department. By laid off huge workforce, Tyco has lost long-term benefits from sales and marketing personals, innovation by research and development personals, and manufacturing experts personals.
e. During year 1999, Tyco used the accounting tactics in order to report high quality of earning by vigorously using pooling of interest method of accounting for acquisition. Tyco strategically used the discretion in GAAP by implementing strategy to set apart Cookie-jar reserves and timing of operating activities in accounting methodologies.
In the recent report, Tyco was forced to restate financial report of Fiscal 1999 and the first quarter of 2000 due to certain merger, restructuring, and other non-recurring charges. The company reported huge earnings in 1999 and decreasing earnings for the first quarter of 2000. According to U.S. Securities and Exchange commission, Tyco set aside cookie-jar reserves in year 1999 and began to reduce the liabilities in 2000 first quarter, thus reported increasing earnings.
It means that during the time of strong earnings, the company establishes additional expenses accruals and subsequently reduces the liabilities to generate earnings for future. These accruals of expenses or cookie-jar reserves are based on estimates and have varying degree of accuracy. The another discretion that Tyco used in its 1999 annual report is the timing of operating activities such that accounting system will record only those activities in the period that is most beneficial for management. By altering timing of events, the company reports higher fourth quarter sales and profit. However, by this way, company can inflated growth in the near term, but reduced profits in future period.
The market reaction to this alleged behavior is so severe because some discretion that Tyco did such as took $4 billion in merger-related charges in recent years, moved its headquarter from New Hampshire to Bermuda for tax saving, used pooling of interest method to inflate earnings and stellar stock price, set aside a cookie-jar reserves and timing of operating activities. Due to all this Tyco’s activities, one time inflated stock price went down forever and the stockholders and investors confronted huge loss in year 1999-2000.
f. Pro-forma earnings are not GAAP acceptable method. Many companies use pro-forma earnings to represent a healthy earning picture and informed investors that their business is in the most favorable condition. During earning announcement, companies have brought investors attention on pro-forma earnings. Actually, Pro-forma earnings are generated by adjusting GAAP income by excluding certain expenses items. The example of pro-forma earnings is an EBITDA (Earnings before interest, taxes, depreciation, and amortization). The EBITDA is earnings before the depreciation and amortization expenses that company has incurred during current year.
Pro-forma earnings is also said to be normalized earnings. Unlike the reported accounting profit according to GAAP, the pro-forma earnings of the company is an additional adjusted income statement that excludes following items,
1) Restructuring costs
2) Merger and acquisition costs
3) Depreciation of tangible assets
4) Amortization of intangible assets
5) A change in the value of a company’s investments
6) Taxes
7) Employee stock options for managers
8) Accounting charges to compensate for earlier mistakes.
In short, pro-forma earnings is not GAAP acceptable method and it a company strategy to portray high earnings by excluding various expenses and charges which are important for analysis. For example, Tyco has used pooling of interest method in which consolidation of financial statement almost resembles pro-forma earning which represent higher income by excluding merger related charges, amortization, less depreciation, and restructuring costs.
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