An Empirical Evaluation of the Predictive Power of Purchase-Pooling Accounting Numbers
In recent years one of the more controversial alternatives in accounting appears to have been the purchase-pooling choice in accounting for business combinat io n s . This study attempts to evaluate these alternatives in the context of "usefulness to investors." Impetus for this research was provided by recent developments in capital market theory spearheaded by Markowitz, Sharpe, Fama, Lintner, Jensen, Beaver, and others. Their research into the behavior of security prices has led to the
... pment of the operational test of usefulness applied in this investigation. The individual security performance measure thus developed reflects adjustments for the individual risk faced by the firm as well as market wide e f f e c t s . Using the predictive ability criterion, this 2 empirical study assesses the relative association (r ) of multivariate sets of purchase-pooling accounting numbers with the risk-adjusted performance measure described in the preceding paragraph. Matched samples (purchasing and pooling) were selected from companies listed on the New York Stock Exchange using SIC classifications and asset size as viii matching criteria. To qualify for either sample, a firm must have engaged in one or more combinations during the period 1968-1971. In addition the firm must have used principally either the purchase or pooling method in all such combining activity engaged in during the study period. Thus the samples have a distinct pooling or purchase "character." The independent variables were limited to eleven accounting numbers classified primarily as either profitability, margin, return or turnover measures. Emphasis was also given to accounting numbers which would likely differ depending upon the accounting method chosen for the combination. The test results substantiate the hypothesis that purchase accounting numbers are more closely associated with a firm's stock market performance than are accounting numbers from firms using principally the pooling method in accounting for business combinations. This conclusion is based on the fact that approximately 70 per cent of the statistically significant cases favored the purchase sample. However, the fact that pooling was favored in 30 per cent of the comparable cases would tend to justify, at least to some extent, the existence of both alternatives. The results of this study should encourage other investigations of alternative methods using the predictive ability criterion in a decision oriented context. The ix writer believes this study will give direction to other similar investigations which can lead to further refinement and testing of the research methodology utilized. x CHAPTER I THE PURCHASE-POOLING CONTROVERSY In the decade of the 1 9 6 0 's one highlight of the American business scene was the increased amount of business combination activity. According to one economisti Many combinations have been encouraged as companies sought to increase earnings per share. In some instances this objective has been facilitated by the tax laws through debt-equity switching or the acquisition of companies with a tax loss carry forward, while in others it has been sought through the economies that could be effected. However, reported earnings also have been increased in some cases by the accounting methods used to record the tr a n s a c t i o n.1 This latter observation refers directly to the two alternative methods of accounting for business com b i nations, namely, the purchase and pooling methods. The Nature of the Problem From its research study on accounting for business combinations, the Accounting Principles Board (APB) of the American Institute of Certified Public Accountants (AICPA) asserted that "the accounting treatment of a combination may affect significantly the reported financial position and net income of the combined corporation for prior, Jules Backman, "An Economist Looks at Accounting for Business Combinations," Financial Analysts J o u r n a l , XXVI (July-August, 1970), 39. Viewpoint of the Accounting Profession Accounting for business combinations has been a difficult and often debated question within the profession This is evidenced by the publication of two research studies by the AICPA in the past ten years: 1.