1. Differential Market Reaction to Pooling and Purchase Methods
Author(s): Michael L. Davis
Reviewed work(s):
Source: The Accounting Review, Vol. 65, No. 3 (Jul., 1990), pp. 696-709
Published by: American Accounting Association
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2. THE ACCOUNTING REVIEW
Vol. 65, No. 3
July 1990
pp- 696-709
Differential Market Reaction to
Pooling and Purchase Methods
Michael L. Davis
Lehigh University
SYNOPSIS: In this study I reexaminethe impact of merger accounting
method by using a sample of tax-free mergersdrawnfrom a differenttime
period and using more refined cumulative average residual (CAR)
methodology.As in the Hong et al. study, the purchasemethod sample ex-
hibits significant positive CARs over the entire period, which appear to
originatein the intervalprecedingthe announcement.The pooling method
sample does not generate any significantresidualsor CARs.
To identify variablesfor which merger accounting method may be
proxying, covarianceanalysis is used to determinethat variablesomitted
from the capitalasset pricingmodel (CAPM)do not influencethe abnormal
returns.Furthermore, probitanalysisis used to investigatepotentialindirect
cash-flow effects such as managerial A
income manipulation. positive rela-
tionship between leverage and income-reducingpolicies is observed. This
suggests that firms with high financialrisk(leverage)may preferpurchase
accountingto reduce reportedearningsand regulators' attention.Tax char-
acteristics of the acquired firms (net operating loss and investment tax
credit carryforwards) also examinedas they can result in indirectcash-
are
flow effects, such as reduced postmerger corporate income taxes. The
limited data available indicate that tax factors have little impact on the
CARs.
Finally,a variablerepresentingthe relativebargaining strengths of the
merging firms is tested for association with accounting method used. A
statisticallysignificantrelationship observed, and two implications
is follow
from this result:(1) acquiringfirmsin a strong bargaining position are more
likelyto use the purchasemethod, and (2) as the bargaining strengthof the
This article is an extension of my Ph.D. dissertation at the University of Massachusetts. I am indebted
to my dissertation committee, Pieter Elgers (chairman), James Owers, and George Treyz. I also would like
to thank James A. Largay, III, and the two anonymous referees for their many substantive suggestions on
earlier drafts of this paper. Use of Dean Crawford's (1986) data set is gratefully acknowledged. Funding was
provided by the Peat Marwick Main Foundation.
Submitted July 1987.
Revisions received October 1988, July and December 1989.
Accepted January 1990.
696
3. Davis-Pooling and Purchase Methods 697
acquiring firm decreases, the consideration given to the target firm in-
creases while the magnitudeof the CARs decreases.
The contributionsof the study are as follows. First,the abnormalre-
turns to tax-free purchase method mergers, first observed by Hong et al.,
are found to persist and appearto originateduringthe preannouncement
period. Second, other CAPM-omitted variablesdo not appearto influence
these results. Finally,two tests of the association between potential in-
direct cash-flow effects and the CARsare significantand providea partial
explanationfor the observed abnormalreturns.
Key Words: Pooling Method, Purchase Method, Mergers, CAR Method-
ology.
Data Availability: Data utilizedin this study are availablefrom the author.
E evidencesuggeststhatacquiring
MPIRICAL firms'equityvaluesdo not increase
in a significant manner during the period surrounding the merger (Mandelker
1974; Ellert 1976; Langetieg 1978) or in the period surrounding the merger an-
nouncement date (Dodd 1980, Asquith and Kim 1982; Malatesta 1983). Yet, Hong et al.
(1978) observed significant positive abnormal returns in the period surrounding the
merger date for a sample of mergers that used the "purchase" method of accounting,
but not for mergers that adopted the "pooling" method. Although financial statements
typically differ under the two methods, these differences lacked direct cash-flow im-
pact in the mergers studied by Hong et al., so that merger accounting method probably
was not the cause of the observed market differences. The objective of this study is to
examine the extent to which merger accounting method was a proxy for other variables
in the Hong et al. study.
I. Background
Merger Returns to Acquiring Firms
Early merger studies (e.g., Mandelker 1974; Ellert 1976; Langetieg 1978;Elgers and
Clark 1980) use monthly data to estimate CARs around the "mergereffective date," the
date of final approval by the target firm's stockholders. The observed positive CARs,
however, occur about a year or more prior to the effective date. The likely explanation
is that, in an efficient market, much of the market response to a merger occurs around
the earlier public announcement of the proposed merger.
Later studies use the announcement date and estimate weekly or daily residuals to
more accurately determine when the marketreaction occurs. For example, Dodd (1980)
observes positive CARs of 5.4 percent in the 41 days prior to and including the an-
nouncement date. Eckbo (1983) notes significant CARs of 4.9 percent for a sample of
horizontal mergers that were contested by antitrust law enforcement agencies in the
period 20 days prior to, and the ten days following, the first public announcement. Fi-
nally, Asquith (1983) shows a significant CAR of 14.5 percent for the period 480 days
prior to and including the announcement date.
4. 698 The Accounting Review, July1990
In summary, any market response to a proposed merger likely will be observable
around the first public announcement date, due to information leakage and evaluation
of the potential economic impact.
MergerAccounting Methods
If a merger satisfies 12 specified conditions in Accounting Principles Board
Opinion No. 16 (APBO 16) (1970),pooling-of-interests accounting must be used and the
net assets of the acquired firm remain stated at book value. Failing any of the 12
conditions requires use of the purchase method under which assets acquired and
liabilities assumed are restated to their fair marketvalues, and goodwill is recorded and
amortized if the consideration given exceeds fair value of the net assets.
Ceteris paribus, postcombination net income under the purchase method will be
lower (higher)than under pooling when the value of the consideration paid exceeds (is
less than) the book value of the net assets acquired. If, however, the merger qualifies as
a tax-free reorganization under Sections 354 and 368 of the Internal Revenue Code, the
tax bases of assets acquired and liabilities assumed remain unchanged. Consequently,
the two accounting methods can result in different reportedearnings that have no direct
impact on tax-related cash flows. Merger accounting method, therefore, would not
likely be the cause of any observed valuation differences between samples of tax-free
mergers but instead would proxy for one or more underlying variables.
The Hong et a]. Study
Hong et al. examined monthly price movements of a sample of 122 pooling method
and 37 purchase method mergers occurring from 1954-1964 (prior to APBO 16). All
qualified as tax-free reorganizations so that differential tax-related cash-flow effects
were avoided. As Hong et al.'s sample included only mergers in which the marketvalue
of the securities issued exceeded the book value of the net assets acquired, firms using
the purchase method reported higher depreciation and amortization charges and,
therefore, lower net income than if pooling-of-interests accounting had been used.
No statistically significant abnormal price behavior was observed for the pooling
method sample in the 120-monthperiod surroundingthe effective date of the merger. In
contrast, the purchase method sample exhibited strong positive price movement in the
12 months preceding the effective date, with the CAR reaching 8.8 percent (p s 0.05).
Several factors, however, make it difficult to draw inferences from Hong et al.'s results:
the residuals were centered around the effective date instead of the announcement
date; monthly residuals were used; average residual and CARvalues were not reported;
and finally, their sample of purchase method mergers was small and occurred primar-
ily in the first four years of their 11-year test period.
Hypotheses
In light of these results, this study seeks to investigate potential explanations for the
differential market reaction observed by Hong et al. Using a different sample and time
period, a three-step approach is utilized. First, CARs for a sample of tax-free mergers
are examined without regard to merger accounting method used, focusing primarilyon
5. Davis-Pooling and Purchase Methods 699
the period leading up to the announcement date. In null form, the first hypothesis
tested is:
Hi: Residuals for the acquiring firms will not be significantly different from zero.
Second, the sample is disaggregated into pooling and purchase method mergers,
leading to hypothesis H2 and a replication of Hong et al.:
H2: No differential market reaction will be observed between the subsamples of
pooling and purchase method firms.
Third, if hypothesis H2 is rejected, as suggested by Hong et al.'s results, the under-
lying variables) for which the accounting method may be serving as a proxy will be
examined.
II. Sample Selection and Methodology
Sample Selection
Potential sample firms during 1971 to 1982, a post-APBO 16 time period, were
identified in Mergers and Acquisitions. Merger accounting method and tax status were
obtained from the merger proxy statements. Sample selection techniques were similar
but generally more restrictive than those used by Hong et al. A size screen of five per-
cent (the ratio of shares issued in the acquisition to acquiring firm shares outstanding
prior to the merger) was used to exclude mergers expected to have no measurable im-
pact. Also, companies with one or more other mergers whose combined value exceeded
25 percent of the merger under study during the estimation and test periods were ex-
cluded from the sample.I Final samples of usable firms were 108 pooling method and 69
purchase method mergers. The average size of an acquired firm relative to the market
value of the acquiring firm was 16.3 percent for the pooling sample (21.9 percent in
Hong et al.), and 18.5 percent for the purchase sample (not reported in Hong et al.).
Methodology
The returns for a particular firm i in time t are represented by the market model:
re=c-a+Oirmt.++e11, (1)
where rmtis the market return in period t; ci and 0f are the conventional market model
coefficients for firm i using the CRSPvalue-weighted index; and et is a stochastic resid-
ual term that is assumed to satisfy OLS assumptions.
An important assumption underlying this model is that systematic risk (0i3)does not
change significantly over the period under study (Sunder 1973). Because mergers may
alter the underlying risk of the combining firms (e.g., Dodd and Ruback 1977; Galai and
Masulis 1976; Mandelker 1974), this study, similar to Hong et al., estimated one set of
parameters for the preannouncement period and another set for the postannouncement
I Hong et al. also used a 25 percent valuation exclusion, but only for 24 months of their 60-month observa-
tion period. This resulted in two methodological weaknesses. First, CARs were estimated during periods when
other significant mergers also may have been occurring. Second, their market model parameter estimation
period overlapped the CAR observation period, so that their parameter estimates also could have been influ-
enced by other significant mergers.
6. 700 The Accounting Review, July 1990
Table 1
Estimation and Test Periods, in Weeks
Announcement MergerEffective
ANN-52 ANN-26 Date (ANN) Date (EFF) EFF+26 EFF+52
InterimPeriod
(varies by merger)
Premerger Postmerger
Parameter < Test Period D Parameter
Estimation Estimation
Period Period
period.2Moreover, the expectation of nonzero residuals aroundthe event dates necessi-
tates obtaining the parameter estimates during a period excluding those event dates.
Table 1 summarizes the time periods used here. Weekly residuals3 are estimated
for a test period extending from 26 weeks before the merger announcement date
(ANN -26) to 26 weeks after the merger effective date (EFF+ 26). Marketmodel param-
eters are estimated during the 26 weeks prior to and after the test period. Because the
interval between the announcement and effective dates varied across mergers (the
mean was 102 trading days as in Dodd 1980), the test period varied from one merger to
another.
Average residuals (AR)and cumulative average residuals (CAR)for each sample are
given by:
M
AR,=(1/M) Eei,, (2)
i=1
T
CART= ,AR,9 (3)
tza
where M = the number of firms in the group;a = the first week of the cumulation period;
and T=the last week of the cumulation period.
The test statistic is the mean standardized CAR, described at length in Dodd and
Warner(1983). To compute this test statistic, the residual e,, is standardized by its esti-
mated standard deviation sit4 to form:
Se5,=ei,/si,, (4)
2 Postannouncement period mean beta increased (decreased) slightly for pooling (purchase) method firms.
Neither change was significant, but given variability in individual firm betas and the importance of beta in
estimating residuals, the two sets of parameters were used.
3 Marais (1984) finds that weekly residuals may deviate from normality with respect to skewness and
kurtosis. The CARs in this study were examined and some did deviate from normality due to a few outliers.
When these were removed, normality was approximated, with little change in the overall results.
7. Davis-PoolingandPurchase
Methods 701
where Sei,= standardized residual for firm i in week t and ei, = residual for firm i in
week t.
The standardized cumulative residual, SCR,,, over any interval t = Ti,... , T2,is:
Ta,
SCR, = (SeJ 2
T2-T15+1). (5)
t= TI,
The test statistic for a sample of M firms is:
M
Z9 SCRit/ r-f. (6)
i=1
Because each Se,, is assumed to be distributed unit normal in the absence of abnormal
performance, Z is assumed unit normal.5A two-sample t-test utilizing the SCR for each
sample is used to test for a difference in CARsbetween the purchase and pooling firms.
III. Tests of Hypotheses
Table 2 provides a summary of the CARs during various intervals. As reported in
panel A, a statistically insignificant CAR of 7.33 percent is observed for the full sample
over the entire test period. In the period prior to the announcement date, however, sig-
nificant CARs of 5.28 percent and 2.71 percent are noted in the -26 through ANN and
-11 through ANN week periods, respectively. No significant residuals are noted in the
week of the announcement. These results are similar to Dodd (1980)and Eckbo (1983),
and they provide evidence for rejecting hypothesis H1.
Evidence on hypothesis H2 is reported in panel B of table 2. Also, figure 1 presents
a plot of the CARs for both groups over the test period.6As in Hong et al., differential
abnormal returns are observed. CARs for firms using the pooling method are frequently
positive but never statistically significant. In contrast, the purchase method CARs are
both positive and statistically significant throughout the entire test period, although, as
4 The value of s,, is given by:
sit -
D +(R~ t ,)
V(
where:
s?= residual variance for firm i from the market model regression;
Di= number of observations during the estimation period for firm i;
R,., = rate of return on the market index during week t of the observation period;
R. = mean rate of return on the market index during the estimation period; and
REw, rate of return on the market index during week v of the estimation period.
=
s It is possible that the mean cumulative residual and the mean standardized cumulative residual could be
of different sign if there are a few extreme negative outliers. These instances occurred infrequently in this
study, but they did result in opposite signs in several statistically insignificant intervals in table 2.
6 As the interim period between the
announcement and merger effective dates varies from firm to firm, it is
collapsed into a single measurement period.
8. 702 The Accounting Review, July1990
Table2
OverVariousIntervals
Summaryof CARs(Percentage)
Panel A. All Firms:
Interval Test
(Weeks)' CAR Statistic
ANN-26 through EFF+26 7.33 1.37
-26 through ANN 5.28 2.18b
-11 through ANN 2.71 1.98b
-4 through ANN 1.75 1.61
ANN week -0.06 -1.01
Interim 1.99 0.49
EFF week -0.25 -0.95
EFF+1 through EFF+26 0.30 -0.20
Panel B. Disaggregated Samples:
Purchase Firms Pooling Firms
Interval Test Test Test Statistic
(Weeks)' CAR Statistic CAR Statistic on Difference
ANN-26 through EFF+26 13.56 2.70a 3.34 -0.41 2.37b
-26 through ANN 9.07 2.80a 2.85 0.56 1.84c
-11 through ANN 4.58 2.46b 1.51 0.57 1.56
-4 through ANN 3.03 2.19b 0.94 0.31 1.52
ANN week -0.06 -0.37 -0.05 -1.00 0.33
Interim 2.42 1.27 1.72 -0.40 1.24
EFF week -0.15 -0.35 -0.31 -0.94 0.32
EFF + 1 through EFF + 26 2.22 0.62 -0.92 -0.76 0.96
' ANN= Announcement week per The Wall Street Journal; EFF=Effective week. Numbers are weeks
relative to the announcement or effective week.
" Significant at .01.
bSignificant at .05.
' Significant at .10.
expected, most of the reaction appears to occur in the 26 weeks prior to the announce-
ment.7
IV. Investigation into Potential Explanations
Nonmerger-Related CAPM-Omitted Variables
Numerous studies have examined the impact of the following omitted variables in
the simple one-period capital asset pricing model (CAPM):P/E ratio (Basu 1977, 1983),
firm size (Banz 1981; Reinganum 1981), earnings surprise (Beaver et al. 1979;
Hagerman et al. 1984), leverage (Bernard1986), and marketmodel parameterestimates
(Blume 1971, 1975, 1979; Elgers et al. 1979). In this study, I examine whether the
" Examination of the weekly ARs indicated that, while none was significant for the pooling method firms,
eight of the purchase method ARs were significant (p c 0.05). Five of the eight occurred in the 26-week period
prior to the announcement date, with three of these coming in weeks -11, -9, and -4. The AR in week -11
was the largest (2.4 percent, test statistic = 3.88), and this group of three ARs appears to be responsible for the
CARs remaining significant throughout the remaining test period. This finding is similar to Hong et al.
9. Davis-Pooling and Purchase Methods 703
Figure 1
CARs Over Test Period for Pooling Method
and Purchase Method Samples
14.0
12.0
10.0
8.0 - Purchase
6.0
4.0 -
2.0 - Pooling
0.0 PI
-2.0 I l li I 1 1
ANN-26-20 -10 ANN EFF +10 +20 EFF+26
Interim
Week
pooling/purchase results documented here may be due to the accounting method proxy-
ing for one or more of these variables. Analysis of covariance (ANCOVA)is used to
assess whether these variables exercise any detectable influence on the CARs. The vari-
ables are defined as follows:
PIE ratio: Price to earnings ratio at the end of the year prior to the announcement
year.
Size: The natural log of the marketvalue of the firm's outstanding stock at the
beginning of the announcement year is used.
a, /3: The preannouncement period estimates of alpha and beta are used.
Earnings Change in annual EPS in the announcement year divided by share price
surprise: at the beginning of the announcement year.8
Leverage: Ratio of the book value of total liabilities to total assets at the end of the
year prior to the announcement year.
8 This formulation assumes that market earnings expectations follow a random walk without drift. While
some studies include a drift term (e.g., Bernard 1986), both Ricks (1982) and Biddle and Lindahl (1982) find their
results to be relatively insensitive to the choice between a random walk with and without drift. Also, share
10. 704 The Accounting Review, July 1990
Table 3
Analysis of Covariance-Dependent Variable: CAR; Treatment Variable:
Merger Accounting Method; Covariates: Alpha, Beta,
Acquirer Size, Earnings Surprise, and Leverage
Week - 11 throughAnnouncementWeek(N= 168)'
Degrees of Sum of Mean
Source Freedom Squares Square F-statistic p-value
Equalityof adjusted
cell means 1 0.0354 0.0354 1.57 0.21
Zero slope for
covariates 6 0.1248 0.0208 0.92 0.48
Error 160 3.6051 0.0225
Equalityof slopes 6 0.1929 0.0321 1.45 0.20
Error 154 3.4122 0.0222
'Nine firms excluded due to outlier values for P/E ratio.
The 11-week period prior to the announcement week, during which most of the sig-
nificant CARs originate, is used in the ANCOVAanalysis. These results are reportedin
table 3. Merger accounting method is not significant, nor are any of the potentially con-
founding covariates. The test for equality of slopes does not support rejection of the hy-
pothesis that the regression coefficient for each covariate differs among groups. Thus,
the ANCOVA results indicate that the differential pooling/purchase method returns
noted first by Hong et al., and replicated here, are not explained by these nonmerger
related omitted variables.
Postmerger Indirect Cash-Flow Impacts
This section describes three procedures employed to ascertain whether the differ-
ential returns-and the apparent importance of merger accounting method-are linked
to potential indirect cash-flow effects.
ManagerialIncome Manipulation. Several researchers have investigated the propo-
sition that managers manage their firms' reported earnings. For example, Watts and
Zimmerman(1978)argue that the incidence of political costs (regulation,negative pub-
licity, etc.) is related to firm size and that larger firms tend to lobby for accounting stan-
dards that reduce income. Also, Zmijewskiand Hagerman(1981)find a significant posi-
tive relationship between income-increasing policies and the existence of management
price is used as the deflator to avoid the small or negative denominator problem that can occur with EPS.
Christie (1987) also concludes that the "correct" deflator in returns studies is the market value at the beginning
of the period. The analysis was performed using quarterly earnings, defining the surprise as actual earnings
minus the Value Line forecast, using the most recent earnings before the merger announcement. Data were
available for 86 pooling method and 36 purchase method firms. Results were similar to those presented in
table 3.
11. Davis-Pooling and Purchase Methods 705
Table 4
Probit Analysis*
Dependent Variable: 0 for Purchase (Income Deflating),
1 for Pooling (Income Inflating)
Expected
Sign (-M- - - ?
Capital Total Concentration x % Correctly
Constant Beta Intensity Assets Ratio Leverage Test Predicted
0.9683 0.0430 0.1841 -0.0001 -0.3165 -2.2005 12.12h 70.1
(0.967) (0.190) (0.990) (-1.449) (-0.298) (-2.851)"
* Asymptotic t-statistics in parentheses.
Significant at 0.01.
Significant at 0.05.
compensation plans based on reported earnings.9 Because the pooling and purchase
methods generally have a differential effect on reported earnings, management might
value these differential effects highly and attempt to structurethe merger so that one or
the other accounting method could be used.10
Probit analysis, a dichotomous dependent variable model, is used to estimate this
impact, where zero is for income-decreasing effect and one is for income-increasing
effect."1The variables used in this study are the same as in Hagerman and Zmijewski
(1979) and Zmijewski and Hagerman (1981), which are size (total assets and total sales;
results are presented only for total assets as each measure yielded similar outcomes),
beta, capital intensity (fixed assets/total assets), competition(marketshare), and leverage
(total debt to total equity).
Coefficients estimated for the probit model appear in table 4; negative coefficients
indicate association with an income-reducing policy. Leverage is the only significant
variable.12 Univariate tests indicate the same finding: leverage for the purchase method
sample (0.23) is significantly higher than for the pooling method sample (0.18, p <0.05).
Although this outcome is not consistent with studies that find a negative relation-
ship between leverage and income-reducing policies, Crawford(1986)provides a possi-
ble explanation. He notes that purchase method firms are more likely than pooling
method firms to have debt covenants based on net assets or net tangible assets rather
than on income. No analysis of this issue is performed in this study.
Tax Effects. Even though tax-free mergers generally have no direct tax effects on
the merged companies, net operating loss (NOL)or investment tax credit (ITC)carry-
forwards possessed by the acquired firm could reduce postmerger corporate income
9 Other studies include Daley and Vigeland (1983), Holthausen and Leftwich (1983), and Crawford (1986).
10Satisfying all 12 conditions specified in APBO 16 is
required for the pooling method to be used;
companies cannot simply "choose" which accounting method will be used. Meeting these conditions may not
be a costless procedure for either bidder or target.
II Hagerman and Zmijewski (1979) and Zmijewski and Hagerman (1981) provide a complete discussion of
the inappropriateness of OLS and a review and application of probit analysis to these types of situations.
12 Multicollinearity may reduce the significance of collinear variables. The largest correlation (0.385) is
between leverage and capital intensity.
12. 706 The Accounting Review, July1990
Table 5
Characteristics of the Excess of Market Value of
Consideration Paid (MV) Relative to the Book
Value of the Acquired Firm (BV)
Poolings Purchases
MV-BV (mean value, in millions) $60.7' $22.1'
(MV-BV)/BV (mean value) 206.3%' 81.2%'
(MV-BV)/NI2 (mean value) 201.9%' 76.9%'
' Means significantly different at .01.
2
NI = Net Income of acquiring firm in the year prior to the mergerannouncementdate. The allocation of
the excess to specific assets is generally unknown, so that amortizationperiods are also unknown. Compar-
ing the excess to one year's income obviously overstates the annual impact, but does allow for relative com-
parison between the two samples.
taxes.13 To examine the extent to which such indirect cash-flow effects affect CARs dif-
ferently for the two types of mergers, I examined data for 27 pooling method target
firms and 25 purchase method target firms14from the COMPUSTATResearch File. Five
of the purchase targets and none of the pooling targets had NOL carryforwards.This
distribution provides weak support for the hypothesis that the CAR results for the pur-
chase method acquiring firms may be due, in part, to the market impounding this po-
tential benefit into share price. In three of these five mergers, however, the acquiring
firm also had an NOL prior to the announcement and after the effective dates, possibly
deferring the benefit of the acquired NOL. Only one target in each category had an ITC
carryforward. Thus, the limited data available indicate that the indirect cash-flow
effects of taxes may not be a material factor in determining CAR differences.
Bargaining Strength. The marketplace for mergers is imperfectly competitive be-
cause every firm is somewhat unique, so that there are no perfect substitutes. The final
transaction price can also be influenced by the bargaining strengths and skills of
merger participants. In addition, the excess of the transaction price, or marketvalue of
consideration given, over the book value of the acquired firm's net assets, represents a
wealth transfer to the acquired firm's shareholders and may be indicative of each firm's
relative bargaining strength. The larger this excess, the lower (higher) the bargaining
strength of the acquiring (target)firm, so that the acquiring firm may be predisposed
toward using the pooling method in order to avoid recording the premium and its sub-
sequent amortization.
Table 5 reports the "excess" for the sample companies from three different
perspectives: absolute amount; percent of book value of the acquired firm; and percent
of the acquiring firm's net income in the year preceding the announcement date. From
all three perspectives, the mean excess is found to be significantly higher for the pool-
ing method mergers, which is consistent with the phenomenon described above."5
13 Scholes and Wolfson (1989) note that tax laws can provide compelling motivations to structure a merger
as tax-free if the acquired firm has NOLs.
14 Data were not obtainable for the remaining target firms.
is Using bid premia, Robinson and Shane (1990) note a similar result with their sample of 95 mergers.
13. Davis-Pooling and Purchase Methods 707
Table 6
Regression of Bargaining Strength Proxy (BSP)
Against Firm CAR Values'
Week -11 through
AnnouncementWeek R2
Both Samples Combined: CAR= 0.06074- 0.02247 BSP 0.037
(N = 169)2 (-2.547)"
Pooling Method Firms Only: CAR=0.02864-0.00836 BSP 0.008
(N= 104)2 (-.899)
Purchase Method Firms Only: CAR=0.09617-0.05823 BSP 0.089
(N = 65)2 (-2.481)]
't-statistics are in parentheses.
2
Small book values (BV)relativeto large marketvalues (MV)can result in disproportionatelylarge values
for BSP. Four pooling method and four purchase method firms were excluded, as their BSP values ranged
from 9.6 to 109.6 (mean value 39.7) whereas the majorityof the BSP values ranged from 0.002 to 5.0 (mean
value 1.5).
" Significant at 0.05.
To test for an association with the CARs, the proxy for bargaining strength (BSP)is
assumed to be approximated by the second measure in table 5:
BSP=(MV-BV)/BV. (7)
It is hypothesized that as BSP increases-implying that the acquiring firm's bargaining
position decreases-the CARs would decrease.
To test this hypothesized relationship, BSP is regressed against the acquiring firms'
CARs during the same 11-week preannouncement period used in the ANCOVA analy-
sis. The results, reported in table 6, are as hypothesized. BSP's coefficient is negative
and significant for the combined samples and for the purchase method mergers sepa-
rately. The BSP coefficient for the pooling method mergers is also negative but is not
significant. Thus, it appears that there is a reasonably predictable association between
the CARs and the proxy for relative bargaining strength.'6
Two conclusions follow from this analysis. First, the larger the excess of market
value paid over the underlying book value of the net assets acquired, the more likely the
merger will be structuredas a pooling-of-interests.Second, the magnitude of the excess
appears to proxy for the relative bargaining strength of the two parties. The larger the
wealth transfer, the lower the abnormal returns to the acquiring firm's shareholders.
Indeed, for the pooling method acquiring firms analyzed here, which paid an average
excess nearly three times that paid by the purchase method firms, their shareholders,
on average, did not reap any significant abnormal returns.
V. Summary and Conclusions
This study replicates and extends the study by Hong et al. (1978). First, using a dif-
ferent time period and sample, abnormal returns for a sample of tax-free mergers are
16
Similar results were obtained using the 26-week preannouncement period (-26 through ANN) and the
entire test period (ANN -26 through EFF + 26).
14. 708 The Accounting Review, July1990
estimated and significant CARs are observed in the preannouncement period. How-
ever, the results differed by merger accounting method. The purchase method sub-
sample exhibits significant positive CARs over the entire period, whereas the pooling
method subsample's CARs are not significant.
A positive relationship between leverage and income-reducing policies is observed,
suggesting that highly leveraged firms may prefer purchase method accounting to
reduce reported profits. Also, the association of the CARs with a proxy for relative bar-
gaining strength is significant. This outcome suggests that the magnitude of the CARs is
negatively correlated with the amount paid in excess of book values and that pooling-of-
interests accounting is more likely to be used when the excess is large.
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