cheng et.al (2005) - the value relevance of earnigs and book value under and purchase accounting

8/2/2019 Cheng Et.al (2005) - The Value Relevance of Earnigs and Book Value Under and Purchase Accounting

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THE VALUE RELEVANCE OF

EARNINGS AND BOOK VALUE

UNDER POOLING AND PURCHASE

ACCOUNTINGC. S. Agnes Cheng, Kenneth R. Ferris, Su-Jane Hsieh

and Yuli Su

ABSTRACT

This study examines the value relevance of reported earnings and book

value under pooling-of-interests and purchase accounting. Using a sampleof 110 merger or acquisition transactions from the period 1988 to 1996,

the value relevance of the two accounting approaches is investigated by

examining the correlation of post-merger earnings and book value with

share price. Regression analysis using Ohlsons (1995) valuation model is

conducted for the merger year (m) and the subsequent year (m 1)

using three samples (pooling only, purchase only and a combined

sample). The results are as follows:

When pooling accounting is used, only earnings are value relevant, and

the results are consistent with earnings under pooling being more value

relevant than book value. When purchase accounting is used, both earnings and book value are

value relevant and no significant difference was found between the value

relevance of earnings and book value.

Advances in Accounting

Advances in Accounting, Volume 21, 2559

Copyright r 2005 by Elsevier Ltd.All rights of reproduction in any form reserved

ISSN: 0882-6110/doi:10.1016/S0882-6110(05)21002-7

25


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A Vuong test indicates that the adjusted R

2

of the valuation modelunder purchase accounting significantly exceeds that under pooling for

the merger year only for the combined sample. Thus, this result provides

weak evidence that the earnings and book value under purchase

accounting better explain firm value than those under pooling. The relative value relevance of earnings and book value under the two

methods is pooling earnings4purchase earnings and purchase book

value4pooling book value. Using proxy variables for earnings and book value reflecting the

consolidation framework of Statement of Financial AccountingStandards (SFAS) Nos. 141 and 142, the results indicate that the

proxy variables yield earnings and book value data that better explain

firm value than those produced using either pooling accounting or

purchase accounting for half of the testing periods and sample groups.

Thus, our results provide some evidence to support the FASBs decision

to eliminate pooling accounting.

INTRODUCTION

According to Ohlson (1995) and Ohlson and Zhang (1998), firm share price

can be explained by both earnings and book value. Prior studies (Barth,

Beaver, & Landsman, 1993; Barth, Beaver, & Landsman, 1998; Collins,

Morton, & Xie, 1999; Chamberlain & Hsieh, 2001) have shown empirically

that both earnings and book value explain share price. However, only a few

studies have investigated the relative weights of earnings and book value in

firm valuation (Burgstahler & Dichev, 1997; Collins, Maydew, & Weiss,1997; Barth et al., 1998; and Cheng, Hsieh, & Yip, 2003). Collins et al.

(1997), for example, found that the relative value relevance of earnings and

book value shifted from earnings to book value using a sample of firms for

the period of 19531993. Their evidence indicates that the shift was due to

an increase in one-time items and negative earnings. Using a sample of firms

from 1974 to 1993, Barth et al. (1998) also report that the value relevance of

earnings and book value shifted from earnings to book value as the financial

health of a firm declines.

This study extends these previous studies by investigating whether theaccounting choice for business combination (i.e., pooling-of-interests

accounting or purchase accounting) affects the relative value relevance of

earnings and book value, and perhaps, total firm value. We first investigate

C. S. AGNES CHENG ET AL.26


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the relative value relevance of pooling earnings (E

Pooling

) versus poolingbook value (BPooling) and the relative value relevance of purchase earnings

(EPurchase) versus purchase book value (BPurchase).1 Our results indicate that

when pooling accounting is used, only earnings are value relevant, and the

results are consistent with earnings being more value relevant than book

value. However, when purchase accounting is used, both earnings and book

value are in general value relevant, and these two accounting variables are

equally value relevant. This result is consistent with Ohlson and Zhang

(1998), who suggest that the relative weights for earnings and book value

may vary for different accounting methods depending upon how well thoseearnings reflect a firms permanent earnings.

The incremental value relevance of earnings over book value (or vice

versa) under pooling and purchase accounting is also studied. Our results

suggest that, when pooling is used, earnings have incremental value

relevance over book value, but not vice versa. When purchase accounting

is used, earnings have incremental value relevance over book value.

However, our empirical evidence does not suggest that book value has

incremental value relevance over earnings, except for the combined sample.

Second, we compare the combined explanatory power of earningsand book value under pooling versus purchase accounting to investigate

whether the accounting choice for business combination affects the

combined value relevance of earnings and book value. We find that the

purchase method has a significantly higher adjusted R2 for the acquisition

year only. Thus, our finding weakly suggests that firm value is more

closely associated with earnings and book value under purchase accounting

than under pooling.

Lev (1989) observes that when investors perceive deficiencies in reported

earnings (e.g. a one-time earnings increase from early adoption of SFAS 87),investors may use an adjusted earnings measure for valuation purposes. To

evaluate which earnings and book value (i.e. pooling or purchase

accounting) is more value relevant, we compare the relative value relevance

ofEPooling versus EPurchase and BPooling versus BPurchase. We find that EPooling

is more value relevant than EPurchase but BPurchase is more value relevant than

BPooling. This result suggests that EPooling and BPurchase are more correlated

with firm value than EPurchase and BPooling, regardless of which method is

adopted to account for a business combination.

The Financial Accounting Standards Boards (FASB) decision toeliminate pooling has had little (if any) empirical support to date (Wahlen,

Boatsman, Herz, Jennings, Jonas, Palepu, Petroni, Ryan, & Schipper, 1999).

In an attempt to provide some empirical evidence regarding the new

The Value Relevance of Earnings and Book Value 27


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consolidation standard, we evaluate the FASBs consolidation reportingapproach that purchase accounting, without required amortization of

goodwill, be used to account for all business combinations (i.e., SFAS Nos.

141 and 142). In the absence of required periodic amortization of goodwill,

the new reporting framework should yield earnings that are closer to EPooling

than to EPurchase.2 Therefore, a valuation model with EPooling and BPurchase

used as proxies for the earnings and book value under SFAS No. 141/142 is

utilized to evaluate the new framework. The adjusted R2 from this proxy

model is investigated to see whether it is significantly greater than that of

either pooling accounting or purchase accounting. We find that the earningsand book value of the proxy framework better explains share price than that

from either pooling or purchase accounting for half of our testing samples

and years. From a value-relevance prospective, this finding provides some

evidence to support the FASBs position that purchase accounting, without

required amortization of goodwill be used to account for business

combinations.

BACKGROUND AND PRIOR STUDIES

The accounting for business combinations has long been one of the most

controversial financial reporting issues. At the center of the controversy is

Accounting Principles Board (APB) Opinion No. 16, issued in 1970. This

opinion permits acquiring companies to use either purchase accounting or

pooling-of-interests accounting to account for merger and acquisition

transactions.3 The principal differences between the two methods involve

the accounting for any premium paid in the transaction and the valuation

assigned to the acquired net assets. Under pooling accounting, anyacquisition premium is ignored and the acquired firms net assets are

consolidated at their existing book value. Under purchase accounting, the

acquisition premium is recognized as goodwill and the acquired net assets

are recorded at their fair market value.4 Thus, the book value of the

consolidated net assets under pooling will typically be less than those

reported under purchase accounting (i.e., BPoolingoBPurchase) immediately

following an acquisition transaction. And, differences in the post-merger

consolidated earnings will result from the amortization of any purchased

goodwill and the depreciation associated with any revaluation of acquirednet assets. The additional amortization and depreciation charges usually

cause post-merger consolidated earnings under purchase accounting to be

lower than those reported under pooling (i.e., EPurchaseoEPooling).



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Since earnings is a key metric used to evaluate firm and managerialperformance, managers of acquiring firms usually prefer the pooling method

because it frequently enables the consolidated entity to report higher post-

merger earnings. This reporting result occurs despite an absence of any

real cash flow difference between the two methods.5 Further, although

purchase accounting does yield higher consolidated book values than does

pooling, acquiring firm managers rarely value this financial outcome, in part

because the purchase method often results in a lower return-on-equity

(ROE) and market-to-book ratio (Ayers, Lefanowicz, & Robinson, 2000),

which are financial metrics frequently used to assess firm and managerialperformance.6

The FASB has been debating the merits of the two consolidation

frameworks for years. The Board has expressed concern over the flexibility

in accounting treatment permitted by APB Opinion No. 16 and with

the noncomparability of post-merger consolidated financial statements

when different consolidation treatments are used. A related concern

is that pooling may distort the economic reality of some transactions

because it fails to recognize the goodwill clearly present in some merger

transactions.Despite strong industry opposition, especially from the banking and

technology industries, the FASB unanimously voted in 1999 to eliminate the

use of pooling (SFAS No. 141, Business Combinations). It has been

predicted that the elimination of pooling as a consolidation framework

could slow the pace of mergers and acquisitions in some industries, and

consequently, hamper the growth of some acquisition-oriented companies.

Vincent (1997), for example, reports that some acquisition transactions were

canceled when approval of the use of pooling accounting could not be

obtained from regulatory authorities.To counter these market-related concerns, the FASB proposed that any

goodwill recognized under the purchase method not be subject to write-

down unless an impairment of that asset occurred. One consequence of this

is that acquirers using the purchase method would be able to report higher

consolidated book values as compared to pooling accounting while also

reporting higher post-merger consolidated earnings than was previously

possible under purchase accounting. Thus, purchase-based earnings under

SFAS No. 142, Goodwill and Other Intangible Assets, would more

closely approximate those reported under pooling, ignoring the additionaldepreciation associated with any revalued net assets.

Empirical studies to date have failed to obtain conclusive evidence

indicating that the post-merger accounting numbers produced using the



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purchase method are more value-relevant than those under pooling.

7

In an attempt to provide such evidence, we compare the combined value

relevance of earnings and book value under pooling and purchase

accounting with that of a proxy representing the SFAS No. 141/142

framework.

Prior Studies

Ayers et al. (2002) document that acquiring firms sometimes paid a premiumto obtain the use of the pooling method, thus suggesting the expected receipt

of certain financial benefits from use of the method (e.g. an increase in share

price around the acquisition date). However, Hopkins, Houston, and Peters

(2000) suggest that no direct financial benefits are associated with the use of

pooling. Similarly, Hong, Kaplan, and Mandelker (1978) and Davis (1990)

both report that higher share prices were associated with firms adopting the

purchase method, but not with the pooling method, during the period

preceding merger announcement date.

Other related studies evaluate the information content of goodwilland goodwill amortization. Jennings, Robinson, Thompson, and Duvall

(1996), for example, provide evidence that recorded goodwill is positively

associated with market value. Vincent (1997) observed that while the

imputed AAP for pooling transactions is not value-relevant, the reported

AAP for purchase transactions is undervalued and positively, significantly

correlated with share price for the 3 years following an acquisition.

Similarly, Henning, Lewis and Autumn (2000) found a significant, positive

association between market values both with going-concern goodwill and

synergy goodwill (i.e., core goodwill). Thus, the preponderance of evidencesuggests that goodwill be reported on the balance sheet as an asset and is

value relevant.

On the other hand, a majority of studies examining the value relevance of

goodwill amortization conclude that goodwill amortization is not value

relevant. For example, Linderberg and Ross (1999) conclude that goodwill

amortization is irrelevant in firm valuation. Similarly, Henning et al.

(2000) found that market value is not associated with the amortization of

core goodwill.8 And, Jennings, LeClere and Thompson (2001) found no

incremental usefulness of goodwill amortization for explaining shareprice, concluding that goodwill amortization adds noise to earnings

measurement in explaining share price. Finally, Moehrle, Reynolds-

Moehrle, and Wallace (2001) found that earnings before extraordinary



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items are equally informative in explaining market adjusted returnsas earnings before extraordinary items and goodwill amortization.

Contrary to these studies, Vincent (1997) found that AAP amortization

for purchase transactions is not only negatively associated with

market value but is also understated for the two years following

an acquisition. Thus, with the exception of Vincent (1997), most prior

studies suggest that investors perceive goodwill amortization to be irrelevant

in firm valuation.

In summary, prior research provides empirical evidence to support the

claim that purchased goodwill is value relevant but goodwill amortization isnot. However, the question of whether the choice of business combination

method affects the value of the combined entity and which earnings/book

value (purchase or pooling accounting) is more value relevant remain

unanswered.

Contributions of the Current Study to the Extant Literature

This study differs from prior studies regarding the value relevance ofgoodwill and goodwill amortization in that it investigates the value

relevance of the accounting acquisition premium (i.e., goodwill plus any

step-up in asset value). The study extends the literature concerning the

study of the relative weights of earnings and book value on firm valuation

by examining the relative value relevance of earnings and book value

under alternative consolidation accounting methods. This study investigates

the incremental value relevance of earnings over book value (or vice

versa) under the pooling and the purchase accounting. We also

study whether the accounting choice of business combination methodaffects the combined value relevance of earnings and book value, and

compare EPooling versus EPurchase and BPooling versus BPurcahse to assess which

variables (i.e. EPooling or EPurchase; BPooling or BPurcahse) are more correlated

with firm value regardless of the method adopted to account for a business

combination. Finally, this study provides evidence to evaluate the FASBs

decision to eliminate pooling accounting and to abandon goodwill

amortization.

The next section describes the research questions studied and the

methodology used. The method of sample selection and financialcharacteristics of the sample firms are then described, followed by the

empirical analyses and results. A final section presents the study

conclusions.



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RESEARCH QUESTIONS AND METHODOLOGY

Estimated Earnings and Book Value under Alternative Consolidation

Treatments

When purchase accounting is used in an acquisition transaction, the

accounting acquisition premium (AAP) is reported on the consolidated

balance sheet in the form of any revalued net assets or as goodwill. While the

accounting for the AAP increases the book value of the consolidated entity

under purchase accounting, the amortization/depreciation of the AAP

decreases future consolidated earnings. On the other hand, use of the poolingmethod in a merger transaction requires the acquirer to report only the book

value of the acquired firm in the consolidated financial statements and ignores

the AAP. As a consequence, post-merger earnings under pooling are not

dampened by the amortization/depreciation of any implied AAP and the

acquired net assets are not revalued. Thus, for a merger/acquisition

transaction with positive AAP, adopting the purchase method should result

in a higher reported book value but lower earnings than if pooling were used.

The estimated difference in annual earnings between the two consolidation

methods can be proxied by the annual amortization of the AAP; and, thedifference in reported book value can be proxied by the unamortized AAP. To

estimate AAP, we subtract the most recently available book value of the target

firm prior to acquisition from the publicly reported purchase price to derive

the accounting acquisition premium (AAP).9 We then add the estimated AAP

to the reported book value of the consolidated entity in the pooling sample

(BPooling) to proxy for consolidated book value as ifthe purchase method had

been used (BPurchase). On the other hand, we subtract the AAP from the

reported book value of the consolidated entity in the purchase sample

(BPurchase) to proxy for consolidated book value as ifthe pooling method hadbeen used (BPooling). Although AAP amortization can be computed in several

ways (i.e., Vincent, 1997), consistent with the FASBs proposed 1999

disclosure standard for goodwill, we amortize the AAP over 20 years to

estimate the differential between EPooling and EPurchase for each transaction.

Thus, the relationship of EPooling (reported earnings under pooling),

EPurchase (reported earnings under purchase), BPooling (reported book value

under pooling) and BPurchase (reported book value under purchase) can be

summarized as follows:

EPurchase EPooling AAP=20

BPurchase BPooling unamortized AAP



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whereEPurchase reported (for purchase firms) or estimated (for pooling firms)

net income using the purchase method

EPooling reported (for pooling firms) or estimated (for purchase firms)

net income using the pooling method

BPurchase reported or estimated book value using the purchase method

BPooling reported or estimated book value using the pooling method

AAP purchase pricebook value of the acquiree

AAP/20 amortization of AAP10

For the pooling sample, EPooling and BPooling are reported numbers while

EPurchase and BPurchaseare estimated (derived); and, for the purchase sample,

EPurchase and BPurchase are reported numbers and EPooling and BPooling are

estimated similarly.

Research Questions 1 and 2 and Test Models The Relative and

Incremental Value Relevance of Book Value and Earnings

The following two questions are investigated to evaluate the relative value

relevance of earnings and book value under pooling and purchase

accounting:11

Question 1. Is the value relevance (weight) of EPooling equal to the value

relevance of BPooling when pooling accounting is used?

Question 2. Is the value relevance (weight) of EPurchase equal to the value

relevance of BPurchase when purchase accounting is used?

The following two questions are investigated to evaluate the incrementalvalue relevance of earnings over book value, or vice versa:12

Question 3. Is the combined value relevance of EPooling and BPooling

greater than that of EPooling or BPooling ?

Question 4. Is the combined value relevance of EPurchase and BPurchase

greater that of EPurchase or BPurchase ?

As indicated in Biddle, Seow and Siegel (1995), two variables can be equally

value relevant (with the same information content) but both are incrementalor neither is incremental. On the other hand, it is possible that one variable

has greater information content than the other and only the variable with

the greater information content is incremental or both are incremental.



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Thus, a relative value relevance test provides different information from thatprovided by an incremental value relevance test.

Since AAP constitutes a significant proportion of an acquirers book

value as of the beginning of the acquisition year (115% and 92% for the

pooling and purchase samples, respectively; see Table 2), and since goodwill

has been documented as an asset in prior studies, the omission of the AAP

from the consolidated balance sheet under pooling could constitute a

material understatement of total assets. As a consequence, we expect

investors to place little (or no) weight on this potentially misvalued variable

(i.e., B

Pooling

). On the other hand, since the AAP is reported on theconsolidated balance sheet under purchase accounting, we expect investors

to value the informational content of BPurchase. Further, since the

information content of earnings relative to share price is well established,

we expect investors to value both EPurchase and EPooling, although the

relevance of EPurchase is of some question given that researchers have

consistently found goodwill amortization not to be value relevant (Henning

et al., 2000; Jennings et al., 2001). However, since the magnitude of the

AAP amortization is small relative to the size of the AAP and a previous

study found that earnings with or without goodwill amortization are equallyinformative in explaining adjusted returns (Moehrle et al., 2001), we

expect EPurchase to be value relevant13. The model used to evaluate the

value relevance of earnings and book value was developed by Ohlson

(1995):14

Pjt a bnEjt cnBjt jt

where:

Pjt Market value of firm j at a 3-month lag of fiscal year-end t.Ejt Earnings (excluding extraordinary items) of firm jat fiscal year-end t.

Bjt Book value of firm j at fiscal year-end t.

ejt The residual term.

The following models are used to compare the weights of earnings and book

value under pooling and purchase accounting:

For pooling:

Model A:1 : Pjt d0 d1nEPooling

jt d3nSIZEjt1 mjt

Model A:2 : Pjt d0 d2nBPooling

jt d3nSIZEjt1 mjt


jt d2nBPooling

jt d3nSIZEjt1 mjt



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For purchase:

Model B:1 : Pjt y0 y1nEPurchase

jt y3nSIZEjt1 njt

Model B:2 : Pjt y0 y2nBPurchase

jt y3nSIZEjt1 njt


jt y2nBPurchase

jt y3nSIZEjt1 njt

where:Pjt Market value of firm j at 3-month lag of fiscal year-end t,

deflated by shares outstanding.15

EPooling Reported (i.e., for pooling sample) or estimated earnings (i.e.,

for purchase sample) using the pooling method, deflated by

shares outstanding.

BPooling Reported or estimated book value using the pooling method,

deflated by shares outstanding.

EPurchase Reported (i.e., for purchase sample) or estimated (i.e., for

pooling sample) earnings using the purchase method, deflatedby shares outstanding.

BPurchase Reported or estimated book value using the purchase method,

deflated by shares outstanding.

SIZEjt1 The market capitalization of the acquiring firm at the end of

year t 1:t Year m or m 1; m is the acquisition year.

Thus, the market price (P), earnings (E) and book values (B) are all in pershare form to control for heteroscedasticity. Also, we add an additional

size variable, the market capitalization of the acquirer, to further control

for any market capitalization- related scale effect which may still exist in a

per-share model.16

For purposes of this study, the value relevance of accounting data is

evaluated by the correlation of post-merger earnings and book value with

share price during the merger year (m) and one year following merger

(m 1). Based on the assumption that a firms current share price reflects all

available economic information about the firm, the higher the correlation ofearnings and book value with share price (i.e., the higher the explanatory

power of earnings and book value), the more value-relevant the accounting

data can be assumed to be.



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Since the derived measures are likely to contain measurement errors,

17

wenot only analyze the data using a combined sample for year m and m 1;but we also analyze the data on the basis of segmented samples (i.e., pooling

and purchase samples). Thus, three samples a combined pooling and

purchase sample, a pooling sample, and a purchase sample are used for

each model.

The adjusted R2 values of Models A.1 and A.2 are compared using the

Vuong (1989) test to assess the relative value relevance of earnings and book

value for the pooling method (i.e., EPooling versus BPooling).18 A similar test is

performed for Models B.1 and B.2 for the purchase method (i.e., E

Purchase

versus BPurchase). In addition, adjusted R2 values of Models A.1 and A.3 and

the adjusted R2 values of Models A.2 and A.3 are compared using Vuong

(1989) tests, which is suitable for both nested and nonnested regression

models. These analyses investigate whether Model A.3 (with both EPooling

and BPooling in the model) has incremental explanatory power over

model A.1 (with only EPooling) or Model A.2 (with only BPooling).

Similar tests are also performed for the adjusted R2 values of Models

B.1 and B.3 and the adjusted R2 of Models B.2 and B.3 to investigate

whether Model B.3 (including both E

Purchase

versus B

Purchase

) hasincremental explanatory power over Model B.1 (with only EPurchase) or

Model B.2 (with only BPurchase).

Research Question 5 and Test Model Comparing the Total Value

Relevance of Book Value and Earnings

To investigate the question of which consolidation accounting method canbetter explain post-transaction share price, the value relevance of combined

earnings and book value under each method is investigated. Consequently,

our fifth research question is

Question 5. Is the value relevance of combined earnings and book value

the same under pooling and purchase accounting?

Models A.3 (pooling) and B.3 (purchase) are used to investigate this

question. The adjusted R

2

for both models are compared using threesamples (combined, pooling, and purchase). Vuong (1989) likelihood ratio

tests are conducted to evaluate the combined earnings and book value

explanatory power of the two methods.



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Research Questions 6 and 7 and Test Models A Comparison of EPooling

with EPurchase and BPooling with BPurchase

Lev (1989) observes that when investors perceive deficiencies in the predictive

ability of reported earnings, investors may use adjusted earnings (rather than

reported earnings) for valuation purposes. Hence, an examination of the

relative value relevance of EPooling versus EPurchase and BPooling versus

BPurchase can reveal whether the reported or the derived earnings and book

value are used by investors when assessing firm value under the two business

combination methods. If E

Pooling

is more value relevant than E

Purchase

, thiswould suggest that investors use reported (derived) earnings when assessing

firm value for firms adopting pooling (purchase) and vice versa. Similarly, if

BPooling is more value relevant than BPurchase, this would suggest that

investors use the reported (derived) book value when assessing firm value for

firms adopting pooling (purchase) and vice versa.

Thus, our sixth and seventh research questions are:

Question 6. Is the value relevance of EPooling equal to EPurchase ?

Question 7. Is the value relevance of BPooling

equal to BPurchase

?

To study these research questions, the following models are employed

using the combined sample:


jt d3nSIZEjt1 mjt


jt y3nSIZEjt1 njt


jt d3nSIZEjt1 mjt

Model B:2 : Pjt y0 y2nBPurchasejt y3nSIZEjt1 njt

Vuong (1989) tests are then used to compare the adjusted R2 of Model

A.1 with that of B.1, and to compare the adjusted R2 of Model A.2 with that

of B.2.

Research Question 8 and Test Model Studying the Value Relevance of

Earnings and Book Value under the SFAS No. 141/142 Proxy Framework

In 2001, the FASB voted to eliminate the use of pooling accounting for

consolidation accounting purposes (i.e., SFAS No. 141). Further, the Board



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concluded that any goodwill capitalized to the balance sheet in anacquisition transaction would not be subject to periodic amortization, but

instead would be evaluated annually for any impairment in value (i.e., SFAS

No. 142). Under the new framework, the pooling method is eliminated and

goodwill is not subject to amortization. In an attempt to study whether the

SFAS No. 141/142 framework provides more value relevant data than either

pooling or purchase accounting, BPurchase and EPooling were used to proxy

for the book value and earnings under the new framework.19 Our research

question for the new framework is:

Question 8. Is the value relevance of the proxy FASB framework greater

than, equal to, or less than that of pooling accounting or purchase

accounting?

The following model is used to evaluate the value relevance of the new

proxy framework:

Model C : Pjt g0 g1nEPooling

jt g2nBPurchase

jt g3nSIZEjt1 Zjt

The explanatory power of Model C is compared with that of Model A.3

(pooling) and that of Model B.3 (purchase) using a Vuong likelihood ratiotest (1989). Significant Z values from the Vuong tests would imply that the

combined earnings and book value of Model C are more value relevant than

those of either Model A.3 or B.3.

Sample Selection and Financial Characteristics of Sample Firms

Sample Selection

The sample firms used in this study were selected from the 100 largest

transactions based on reported purchase price published annually by Mergersand Acquisitions magazine for the period 19881996. Because of their size,

these acquisitions are likely to receive extensive news coverage, be followed by

financial analysts, and gain the attention of investors regarding the potential

earnings and financial ratio impact from an acquirers consolidation

accounting method. Thus, the share price of the firms associated with these

transactions is more likely to reflect the economic impact of the consolidation

accounting method than that of smaller size transactions.

In addition, the following criteria were imposed for purposes of sample

selection:

1. The acquirer must obtain at least 50% of the acquirees outstanding

shares in a single transaction.



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2. The merger/acquisition footnote information is available on the Lexis/Nexis database, and the consolidation accounting method and effective

date of the transaction can be clearly identified.

3. In the case of multiple transactions in the merger year (year m) and

subsequent year (m 1), one of the following two situations must exist in

order to include the transaction in the sample: (a) all mergers/acquisitions

in those years are accounted for using the same consolidation accounting

method (i.e., all using purchase or all pooling); (b) the total purchase

price of any alternatively accounted transactions may not exceed 15% of

the purchase price of the merger/acquisition transaction under study (i.e.,a materiality criterion).

4. Both the acquirer and acquiree firms have data available on the

Compustat tapes. Specifically, to be included in the sample, the acquirer

must have the lagged market capitalization value available at year m (that

is, the first quarter market value at year m 1),20 as well as the earnings,

dividends, and book value available at the end of year m. On the other

hand, the acquiree must have its book value available at year m.

Criterion 1 was imposed to insure homogeneity in transaction pricing

(i.e., all transactions involved a controlling interest and hence would be

priced to reflect the presence of a control premium). Criteria 2 and 4 were

imposed to insure consistency in the availability of transaction data. Finally,

criterion 3 was imposed to constrain the effects of alternative merger/

acquisition transactions on post-merger share price.

Based on these criteria, 111 transactions were selected, of which 45 used

pooling-of-interests accounting and the remaining 66 used purchase

accounting. Of the 66 purchase firms, one appears to be an outlier. When

adjusting the book values of the purchase sample (BPurchase) firms to the as

if pooling book value (BPooling), this firms as if pooling book value

equals $-4951.75 million (unscaled). When including this firm, the coefficient

of as if pooling book value is negative for both years. When the firm is

removed from the sample (i.e., N 65), the coefficients change to positive.

Thus, this firm was deleted and the final sample consists of 45 pooling and

65 purchase firms.21 Table 1 details the sample selection process (Panel A)

and an industry breakdown of the sample (Panel B).

Financial Characteristics of Sample

Selected preacquisition financial variables, including total assets (TA),

market value (MV) and book value (B), were obtained for both the acquirer



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and acquiree firms. Except for the book value of the acquiree, all variables

are measured as of the end of year m 1; where m is the transaction year.The book value of the acquiree is measured as of the most closely available

quarter preceding the transaction date. In addition, the market value ratio

(i.e., AAP/market value of acquirer),22 purchase price, the AAP, amortized

AAP, AAP/book value of the acquirer, and the amortized AAP/net income

ratio were also obtained.

Panel A of Table 2 reports these variables. At time m 1; the size of theacquirers using the purchase method is, in general, greater than those usingpooling, as indicated by the significantly higher mean values of market value

and book value. On the other hand, the size of the acquirees for both the

Table 1.Description of Sample.

Panel A. Sample Selection Process

1. Number of merger and acquisition transactions identified from Mergers and

Acquisitions from 19881996.

900

2. Number of merger and acquisition transactions not meeting the criteria that

at least 50% of the target companys ownership is acquired.

335

3. Number of merger and acquisition transactions for which data are

unavailable on the Lexis/Nexis database.

252

4. Number of merger and acquisition transactions not meeting the materiality

criterion for multiple mergers or acquisitions.

61

5. Numbers of merger and acquisition transactions for which financial data are

unavailable on Compustat and CRSP.

141

6. Outlier removal 1

Final sample 110

Panel B. Final Sample by Industry

SIC Code Industry Pooling sample Purchase sample

Number (%) Number (%)

1014 Mineral industry 2 4.44 1 1.54

1517 Construction industries 0 0.00 0 0.00

2039 Manufacturing 11 24.44 28 43.08

4149 Transportation, communication & utilities 5 11.11 13 20.00

5051 Wholesale trade 0 0.00 4 6.15

5259 Retail trade 2 4.44 4 6.15

6067 Finance, insurance & real estate 19 42.22 8 12.31

7089 Service industries 5 11.11 6 9.23

9197 Public admin., conglomerates 1 2.22 1 1.54

Total 45 100.00 65 100.00



17/35

purchase and pooling samples are similar, with none of the t-values for firmsize significant. Also, acquirers using the purchase method have a

significantly higher net income than those using pooling.

No significant differences between the two samples are observed for the

purchase price, AAP, AAP scaled by the book value, amortized AAP,

or amortized AAP scaled by the net income.23 Thus, we conclude that,

for our sample, neither the purchase price nor any of the AAP or AAP-

related variables is a determinant of an acquirers consolidation accounting

policy choice.

Prior studies (Davis, 1990; Dunne, 1990; Nathan & Dunne, 1991) haveused various financial variables to explain the choice of consolidation

accounting method. The results of these studies suggest that the use of

pooling accounting results in higher post-merger earnings but lower post-

merger assets. Thus, pooling will tend to be preferred by acquirers with a

low return on investment (ROI or ROA) low earnings growth in prior years,

or a low interest coverage ratio. On the other hand, income-sensitive firms

(e.g. firms with a concern for political costs) may tend to prefer purchase

accounting for its income-reducing effect. In addition, acquirers concerned

about violating debt covenant provisions involving total assets or bookvalue, may also prefer purchase accounting for its asset-increasing effect.

Thus, to gain a further understanding of the characteristics of the sample

firms, data for the following financial variables for the acquirers in our

sample were obtained: ROA, ROI, earnings per share (EPS) and earnings

growth (EPSG), interest coverage ratio (ICR), and the net tangible assets/

debt ratio. The mean and standard deviation were calculated for each

variable for the prior year (m 1) and the transaction year (m).

Panel B ofTable 2 reports the mean of these variables; the t-value for the

difference between the mean values for the pooling and purchase samples isalso provided. For year m 1; none of the mean values are significantlydifferent. For year m, only the t-value for the net tangible assets/debt ratio is

significant, but the result is opposite to expectation. Consequently, this

analysis failed to unambiguously identify any financial variable as a

determinant of consolidation accounting method choice for the sample used

in this study.

EMPIRICAL ANALYSES AND RESULTS

Table 3 reports the descriptive statistics for the variables used in the

regression models for year m (Panel A) and year m 1 (Panel B). t-tests



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Table 2. Sample Firm Characteristics.

Pooling sample Purchas

No. of obs. Mean SD No. of obs. M

Panel A: Firm characteristics, AAP and AAP-related variables

TA(A)m1 45 15274.00 18348.00 65 175

MV(A)m1 45 5523.20 8974.50 65 96

BV(A)m1 45 2169.40 2909.30 65 38

NI(A)m1 45 264.41 325.65 65 5

TA(T)m 45 5594.60 11662.00 65 40

MV(T)m 45 1556.70 2012.20 65 18

BV(T)m 45 540.65 891.86 65 4

PurPrice 45 1914.30 2448.20 65 20AAP 45 1387.30 2107.10 65 16

AAP/BV(A)m1 44 1.15 1.47 63

Amortized AAPm 45 25.89 41.18 65

Amortized AAPm+1 45 69.37 105.35 65

Amortized AAP/NI(A)m+1 44 1.32 7.17 65


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Panel B: Selected financial ratios for acquirer firms

ROIm1 45 0.13 0.15 64

ROIm 45 0.05 0.48 65

ROAm1 45 0.04 0.09 64

ROAm 45 0.01 0.16 65

EPSm1 45 2.34 1.73 65 EPSm 45 1.78 2.04 65

EPSGm1 45 0.89 4.84 64

EPSGm 45 0.20 1.38 65

ICRm1 43 8.18 15.71 64

ICRm 42 5.49 9.96 64

TADm1 41 6.01 10.71 63

TADm 42 6.04 12.43 64

Due to data availability, the sample size varies from 4145 for the Pooling sample and from 6365 for the

in millions. TA(A)m1, MV(A)m1, BV(A)m1, and NI(A)m1 represents the total asset, the market value

of acquirer firm at year m1, respectively. Year m is the acquisition year. TA(T)m, MV(T)m, and BV(T)mvalue, and the book value of the target firm at the closest available quarter to the acquisition date at year m

price. AAP Accounting acquisition premium PurPrice%BV(T)m. AAP/BV(A)m1, is referred to as

AAP AAP/20 where partial year amortization is applied for the acquisition year m. Amortized A

acquisition premium/Net income of the acquirer firm. ROI Return on Investment. ROA Return on

Share excluding extraordinary items. EPSG EPS growth rate (EPSmEPSm1)/|EPSm1|. ICR Int

before income tax and interest charges)/interest charges. TAD Net tangible assets/debt.: denotes statistical significance at the 5% level; !: denotes statistical significance at the 10% level.


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Table 3. Summary Statistics for Variables used in the Regressio

Original measures (Unscaled Measures)

Pooling sample Pu

Mean SD Min Max Mean SD

Panel A: Year m

N 45 65

Pjm 39.32 19.39 0.59 100.87 38.62 1

[9348.15] [14297.24] [32.84] [75795.81] [11539.96] [1595E

Poolingjm

1.66 2.06 5.09 7.07 2.35

[399.44] [688.56] [439.54] [3807.00] [583.80] [80

BPooling

jm14.76 9.43 1.33 43.54 7.61 1

[2776.84] [3516.55] [96.42] [18921.00] [2909.88] [516

EPurchasejm 1.52 2.08 5.15 6.94 2.09

[373.55] [676.55] [444.67] [3792.22] [546.79] [79

BPurchasejm 22.01 9.20 6.07 46.93 18.23

[4138.28] [4546.10] [429.44] [19260.88] [4542.39] [526

SIZEjm1 [6298.60] [9737.24] [67.55] [53859.92] [9763.73] [1394

DEjm 0.15 0.13 0.00 0.49 0.26

[25.89] [41.18] [0.00] [212.05] [37.01] [5

DBjm 7.25 6.19 30.67 0.25 10.62 1

[1361.44] [2081.93] [10902.66] [65.36] [1632.51] [194


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Panel B: Year m 1

N 45 65

Pjm+1 41.52 24.90 0.47 118.69 44.66 2

[11423.40] [17010.77] [27.38] [69310.38] [14129.08] [1763

EPooling

jm1 2.02 1.79

2.81 5.05 2.06 [325.14] [823.38] [3794.00] [1748.00] [718.88] [124

BPooling

jm114.25 8.20 0.27 32.36 9.22 1

[2849.96] [3008.00] [20.09] [13850.00] [3248.94] [561

EPurchasejm1 1.69 1.76 2.82 4.84 1.55

[255.77] [782.96] [3811.73] [1406.42] [635.39] [122

BPurchasejm1 20.24 7.52 6.28 36.36 18.71

[4142.04] [4164.19] [466.91] [15768.62] [4798.24] [576

SIZEjm [9348.15] [14297.24] [32.84] [75795.81] [11471.17] [1596

DEjm1 0.33

0.26 0.01 1.18 0.51

[69.37] [105.35] [3.41] [552.03] [83.50] [9

DBjm1 6.00 4.82 22.08 0.24 9.49 1

[1292.08] [1976.59] [10350.62] [61.95] [1549.30] [184

Unscaled measures original measures*shares outstanding. Nrepresents the number of firm observation

millions. Pis the 3-month lagged price. EPooling and BPooling are the earnings per share and book value per

firms in the pooling sample, these are the reported measures whereas derived measures are calculated

EPurchase and BPurchase are the earnings per share and book value per share based on purchase method. SIZ

at the end of previous year. DE EPooling EPurchase : DB BPooling BPurchase:: denotes statistical significance at the 1% level.


22/35

were conducted for the mean difference of the reported accounting numbersand the as if accounting numbers (i.e., EPurchase and BPurchase for the

pooling sample, and EPooling and BPooling for the purchase sample).

All t-values for the mean difference between the reported net income

numbers and the as if net income numbers are significant at the one

percent level for both years m and m 1: Similar results are also obtainedfor the book value variable. These results suggest that the consolidation

accounting method did have a significant effect on post-merger earnings and

book value.

Empirical Results of the Relative and Incremental Value Relevance of

Earnings and Book Value Research Questions 14

Table 4 reports the regression results of Models A.1, A.2 and A.3 using the

combined sample (Panel A), the pooling sample (Panel B) and the purchase

sample (Panel C). Each regression is conducted using year m (the merger

year) and m 1 data. The regression results of Model A.1 indicate that

when using the pooling method, earnings are value relevant (i.e., significantat the one percent level) across all samples and for both periods. The

adjusted R2 values are in the range of 2769%. However, the regression

results of Model A.2 indicate that when using the pooling method, book

value is value relevant only for the pooling sample and the adjusted R2

values are in the range of 1136% (i.e., much lower adjusted R2 values than

those of Model A.1 with EPooling).The control variable, market capitaliza-

tion, is value relevant across the different samples and different time periods

for both Models A.1 and A.2.

The regression results of Model A.3 indicate that when both earningsand book value are included, only earnings are value relevant while book

value is not, across all samples and for both years. Further, the adjusted R2

values are in the range of 2669%, which are not materially different

from those of Model A.1 (with only EPooling ). A Vuong (1989) test was

conducted to compare the adjusted R2 of Model A.1 and A.2 (a relative

value relevance test). The result indicates a significant difference between

the adjusted R2 of Model A.1 (with only EPooling) and that of Model A.2

(with only BPooling) for all samples and years tested except for year m and

m 1 of the pooling and purchase sample, respectively. This suggeststhat market participants assign more weight to earnings than to book

value for valuation purposes when using the pooling method.24 Thus,

we conclude that the value relevance of EPooling is greater than that of



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Table 4. Value Relevance of Earnings and Book values Regression Analysis B

Year N Model A.1 Model A.2 Model A.3

Adj. R2 d1 d3 104 Adj. R2 d2 d3 10

4 Adj. R2 d1 d2 d3

Panel A: Combined sample

m 110 0.44 4.76 4.36 0.16 0.26 5.11 0.44 4.64 0.12 4.26

(7.72)

(4.21)

(2.00)* (4.04)

(7.42)

(1.13) (4.10

m 1 110 0.35 3.42 5.92 0.19 0.18 6.58 0.35 3.40 0.04 5.90

(5.31) (5.01) (0.97) (4.98) (5.18) (0.22) (4.95

Panel B: Pooling sample

m 45 0.46 5.50 5.41 0.25 0.72 8.16 0.45 5.89 0.12 5.19

(5.13) (2.39)* (2.69)* (3.13) (4.02) (0.40) (2.20

m 1 45 0.69 8.82 11.20 0.36 0.86 10.00 0.69 9.89 0.39 11.20

(7.42) (7.55) (2.33)* (4.75) (6.79) (1.25) (7.60

Panel C: Purchase sample

m 65 0.46 4.56 4.32 0.13 0.10 4.54 0.45 4.55 0.07 4.17(6.12) (3.88) (0.61) (3.15) (6.07) (0.57) (3.62

m 1 65 0.27 2.70 3.81 0.11 0.06 4.95 0.26 2.69 0.04 3.75

(3.73)

(2.51)* (0.28) (2.96)

(3.69)

(0.18) (2.41


jt d3nSIZEjt1 mjt


jt d3nSIZEjt1 mjt


jt d2nBPooling

jt d3nSIZEjt1 mj

N represents the number of firm observations for each year. t-statistics is in parenthesis. Pjm is the 3-mon

EPooling

jm and BPooling

jm are the earnings per share and book value per share based on pooling method for firm

sample, these are the reported measures whereas derived measures are calculated for firms in the purchathe earnings per share and book value per share based on purchase method for firm jin year m. SIZEjm1firm jat year m 1: Z-value reported in the A.1 v A.2 column tests the hypothesis that adjusted R2 of A.2. Z-value reported in the A.1 v A.3 column tests the hypothesis that adjusted R2 of model A.1 is e

reported in the A.2 v A.3 column tests the hypothesis that adjusted R2 of model A.2 is equal to that of

tailed test.: denotes statistical significance at the 1% level; *at the 5% level; !at the 10% level.


24/35

B

Pooling

, possibly because goodwill is not accounted for under poolingaccounting.

An incremental value relevance test comparing the adjusted R2 of Model

A.1 (with EPooling) and that of Model A.3 (with both EPooling and BPooling)

was conducted using the Vuong test (1989). No significant difference

was found for all samples and testing years. However, significant differences

were found for the adjusted R2 of Model A.2 versus A.3 for most samples

and years tested. These results suggest that pooling book value does

not possess incremental explanatory power over pooling earnings, whereas

pooling earnings possess incremental explanatory power over poolingbook value.

Most prior studies investigating the value relevance of goodwill indicate

that goodwill is value relevant (Jennings et al., 1996). The consolidated book

value under pooling excludes the AAP, which, in general, is a substantial

component of an acquirers balance sheet.25 Thus, it is plausible to observe

that book value under pooling is not value relevant since a significant

portion of the value of acquired assets (i.e., AAP) is omitted from the

consolidated book value. On the other hand, a majority of prior studies

found that goodwill amortization is irrelevant in firm valuation (Linderberg& Ross, 1999; Henning et al., 2000) and that earnings including or excluding

the goodwill amortization are equally informative (Moehrle et al., 2001).

Thus, our finding of value relevant earnings under the pooling method is

consistent with these prior studies.

Table 5 reports the regression results of Models B.1, B.2 and B.3

(purchase method) using the combined sample (Panel A), the pooling

sample (Panel B), and the purchase sample (Panel C), respectively. The

regression results of Models B.1, B.2 and B.3 indicate that earnings and

book value are both value relevant (i.e., significant at the 0.01 or 0.05 level)regardless of whether the model includes only earnings (as in Model B.1),

book value (as in Model B.2) or both earnings and book value (as in Model

B.3).26,27 Further, the control variable (size) is value relevant for all samples

and all periods. The adjusted R2 values are in the range of 2365%, 2555%,

and 3264% for Models B.1, B.2 and B.3, respectively. This result is quite

different from that of the pooling method in which only earnings were found

to be value relevant.

To evaluate whether market participants assign different weights

to earnings and book value when using the purchase method, Vuong(1989) tests are conducted to compare the adjusted R2 values of Model

B.1 versus B.2. Although the adjusted R2 of model B.2 is greater than

that of model B.1 for most samples and years, the Vuong (1989) test results



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Table 5. Value Relevance of Earnings and Book Values Regression Analysis B

Year N Model B.1 Model B.2 Model B.3

Adj. R2 y1 y3 104 Adj. R2 y2 y3 10

4 Adj. R2 y1 y2 y3 104 B


m 110 0.44 4.96 4.11 0.44 1.07 5.93 0.52 3.13 0.68 4.93

(7.67) (3.95) (7.74) (5.76) (4.28) (4.38) (5.03)

m 1 110 0.32 3.08 5.83 0.34 1.02 6.96 0.40 2.23 0.80 6.27

(4.59) (4.78) (5.08) (5.88) (3.34) (3.94) (5.45)

Panel B: Pooling sample

m 45 0.46 5.46 5.33 0.55 1.35 8.62 0.56 2.04 1.02 7.49

(5.14) (2.35)* (6.33) (4.26) (1.44) (3.27) (3.48)

m 1 45 0.65 8.59 11.30 0.50 1.55 10.00 0.64 8.06 0.17 11.20

(6.75)

(7.20)

(4.42)

(5.40)

(4.20)

(0.38) (7.04)


m 65 0.44 4.80 4.03 0.37 0.90 4.94 0.49 3.55 0.50 4.33(5.88) (3.55) (4.89) (4.13) (3.85) (2.54)* (3.95)

m 1 65 0.23 2.43 3.69 0.25 0.83 5.21 0.32 1.97 0.69 4.09

(3.21) (2.35) (3.45) (3.47) (2.68) (2.94) (2.74)


jt y3nSIZEjt1 njt

Model B:2 : Pjt y0 y2nBPurchase

jt y3nSIZEjt1 njt


jt y2nBPurchase

jt y3nSIZEjt1 nj

N represents the number of firm observations for each year. t-statistics is in parenthesis. Pjm is the 3-mon

EPooling

jm and BPooling

jm are the earnings per share and book value per share based on pooling method for firm

sample, these are the reported measures whereas derived measures are calculated for firms in the purchase s

earnings per share and book value per share based on purchase method for firm jin year m. SIZEjm1 is thejat year m 1: Z-value reported in the B.1 v B.2 column tests the hypothesis that adjusted R2 of model value reported in the B.1 v B.3 column tests the hypothesis that adjusted R2 of model B.1 is equal to tha

the B.2 v B.3 column tests the hypothesis that adjusted R2 of model B.2 is equal to that of model B.3.

column tests the hypothesis that adjusted R2 of model B.3 is equal to that of model A.3 (reported in Tab

test.Significance at the 1% level; *at the 5% level; !at the 10% level.


26/35

indicate that the difference is not significant, except for year m 1 ofthe pooling sample. Thus, it appears that investors do not assign

different weights to earnings and book value when valuing the consolidated

entity under the purchase method. Thus, we conclude that when

using the purchase method, both earnings and book value are value

relevant and the value relevance of EPurchase equals the value relevance

of BPurchase.

Incremental value relevance tests were also conducted by comparing the

adjusted R2 of Model B.1 (with EPurchase) with that of Model B.3 (with both

E

Purchase

and B

Purchase

) and the adjusted R

2

of Model B.2 (with B

Purchase

)with that of Model B.3. Vuong (1989) tests indicate a significant difference

between the adjusted R2 of Model B.1 and that of Model B.3 for the

combined sample only, but a significant difference for the adjusted R2 of

Model B.2 versus B.3 for all samples and years tested except for year m of

the pooling sample. These results suggest that under purchase accounting,

earnings have incremental explanatory power over book value. However,

book value does not have incremental value relevance over earnings, except

for the combined sample.

Empirical Results of Total Value Relevance of Earnings and Book Value

Research Question 5

Although the adjusted R2 values under the purchase method are, in general,

higher than those under the pooling method across all samples and for all

years (except for year m 1 of the pooling sample), the test results (reported

in the last column of Table 5) indicate that the earnings and book value

under purchase accounting better explain the market value of the sample

firms than those using pooling accounting for year m of the combinedsample only.28 Thus, our empirical results provide weak evidence to support

the notion that earnings and book value under purchase accounting are

more value relevant than those under pooling accounting.

In summary, based on the regression results of Models A.1, A.2, A.3

(pooling method) and B.1, B.2 and B.3 (purchase method), we conclude the

following:

1. When pooling accounting is used, only earnings are value relevant and

the results are consistent with earnings under pooling being more valuerelevant than book value. In addition, earnings have incremental value

relevance over book value but not vice versa. This is likely due to the

omission of goodwill from pooling book value.



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2. When purchase accounting is used, both earnings and book value arevalue relevant, and there is no significant difference between the value

relevance of book value and earnings. In addition, earnings have

incremental explanatory power over book value; however, our evidence

does not suggest that book value has incremental explanatory power over

earnings, except for the combined sample.

3. Earnings and book value under purchase accounting better explain firm

value than those under pooling only for the acquisition year of the

combined sample. Consequently, our findings only weakly support the

notion that earnings and book value under purchase accounting are morevalue relevant than those under pooling.

Empirical Results of a Comparison of EPooling with EPurchase and BPooling

with BPurchase Research Questions 6 and 7

Using the combined sample, the Vuong test for the difference in the adjusted

R2 of Model A.1 (EPooling only) and B.1 (EPurchase only) (see Tables 4 and 5

for the adjusted R2

s) results in a Z value of 2.14 (significant at the 5% level)for year m 1:29 The Vuong test for the difference in the adjusted R2 ofModel A.2 (BPooling only) and B.2 (BPurchase only) (see Tables 4 and 5 for the

adjusted R2s) yields a Z value of3.07 and 3.08 (significant at the 1%

level) for year m and m 1; respectively. Thus, the empirical evidencesuggests that the value relevance of EPooling is greater than that of EPurchase

and the value relevance of BPurchase is greater than that of BPooling.

In summary, our results indicate that earnings under pooling accounting

are more value relevant than earnings under purchase accounting while both

are value relevant in firm valuation. Further, our empirical evidence alsoindicates that purchase book value (BPurchase) is more value relevant than

pooling book value (BPooling). Thus, we conclude that EPooling and BPurchase

are more highly correlated with firm value than EPurchase and BPooling

regardless of which method is adopted to account for a business

combination.

Empirical Results of the Value Relevance of Earnings and Book Value

Under the SFAS No. 141/142 Proxy Framework Research Question 8

Table 6 reports the regression results of Model C. The independent variables

of Model C (a proxy for the SFAS No. 141/142 framework) are EPooling and



28/35

BPurchase, which are the two most value relevant accounting numbers as

indicated by the previous test results. Thus, as expected, the coefficients of

EPooling and BPurchase are all significant at the 1 or 5% level for all samples

except for the earnings of year m and the book value of year m 1 of the

pooling sample.30 Similar to the previous regressions, the coefficient of the

control variable (SIZE) is significant for all samples and all periods. Theadjusted R2 values are in the range of 3468%. These adjusted R2 values are

all higher than the adjusted R2 values for Model A.3 (pooling) or Model B.3

(purchase) except for year m 1 of the pooling sample. The Vuong

Table 6.Value Relevance of Earnings and Book valuesRegression

Analysis Based on SFAS No. 141/142 Proxy Framework.

Year N Model C Vuong test

Adj. R2 g0 g1 g2 g3 104 C v A.3 C v B.3


m 110 0.52 15.12 3.00 0.67 5.08

(5.03) (4.24) (4.26) (5.21) 1.90* 0.18

m 1 110 0.42 17.37 2.55 0.73 6.30

(4.09)

(3.88)

(3.60)

(5.59)

1.45

!

1.78*Panel B: Pooling sample

m 45 0.56 8.60 2.00 1.03 7.55

(1.39) (1.38) (3.24) (3.51) 1.48! -0.65

m 1 45 0.68 13.78 8.96 0.04 11.20

(2.01)! (4.87) (0.10) (7.43) 0.71 2.49*


m 65 0.49 17.88 3.45 0.45 4.52

(5.03) (3.94) (2.25)* (4.18) 1.05 0.34

m 1 65 0.34 23.46 2.17 0.64 4.17

(4.60) (3.04) (2.71) (2.88) 1.27 1.35!

Model C : Pjt g0 g1nEPooling

jt g2nBPurchase

jt g3nSIZEjt1 Zit

Nrepresents the number of firm observations for each year. Pjm is the 3-month lagged price for

firm jat year m. EPooling

jm and BPooling

jm are the earnings per share and book value per share based

on pooling method for firm j in year m. For firms in the pooling sample, these are the reported

measures whereas derived measures are calculated for firms in the purchase sample. EPurchasejmand BPurchasejm are the earnings per share and book value per share based on purchase method for

firm j in year m. SIZEjm1 is the total market capitalization for firm j at year m 1: Z-valuereported in the C v A.3 column tests the hypothesis that adjusted R2 of Model C is less than

or equal to that of Model A.3 (reported in Table 4). Z-value reported in the C v B.3 column

tests the hypothesis that adjusted R2 of Model C is less than or equal to that of Model B.3

(reported in Table 5). Both Vuong tests are one-tailed test.Significance at the 1% level; *at the 5% level; !at the 10% level.



29/35

likelihood ratio tests indicate, however, that the explanatory power ofModel C is significantly higher than that under pooling accounting only for

both years of the combined sample and year m of the pooling sample. The

explanatory power of Model C is significantly higher than that under

purchase accounting only for year m 1 of the combined sample, the

pooling sample and year m 1 of the purchase sample.31

Our empirical evidence provides moderate support to the notion that the

value relevance of information under the SFAS No. 141/142 proxy

framework is greater than that under either pooling or purchase accounting,

and provides some support for the decision of the FASB to eliminatepooling accounting and goodwill amortization.

CONCLUSIONS

This study extends the extant literature on the relative value relevance of

earnings and book value by investigating the impact of accounting choice

for business combinations. We also investigate the combined value relevance

of earnings and book value under pooling versus purchase accounting. Inaddition, a comparison of EPooling versus EPurchase and BPooling versus

BPurchase is conducted to reveal which accounting variable (i.e., EPooling or

EPurchase) is more value relevant. Finally, the appropriateness of eliminating

pooling accounting and goodwill amortization (SFAS Nos. 141 and 142) is

evaluated by comparing the value relevance of financial information under a

proxy for SFAS Nos. 141 and 142 with that of pooling and purchase

accounting.

Using 110 sample firms from the period of 19881996, our empirical

evidence suggests the following:

1. When pooling accounting is used, only earnings are value relevant; and

the results are consistent with earnings under pooling being more value

relevant than book value. The incremental value relevance test indicates

that earnings possess incremental value relevance over book value but not

vice versa. This is likely due to the omission of goodwill in the pooling

book value.

2. When purchase accounting is used, both earnings and book value are

value relevant, and no significant difference is observed between the valuerelevance of book value and earnings. The incremental value relevance

test indicates that earnings have incremental explanatory power over

book value. However, the empirical evidence does not suggest that book



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value has incremental explanatory over earnings, except for the combinedsample.

3. Using the combined sample, the combined earnings and book value

under purchase accounting better explain firm value than those under

pooling method only for the adoption year. Therefore, our empirical

results only weakly support that notion that purchase accounting is more

value relevant than pooling accounting.

4. The relative value relevance of earnings and book value under the two

methods is

EPooling4EPurchase and BPurchase4BPooling

This finding suggests that EPooling and BPurchase are more correlated with

firm value than EPurchase and BPooling regardless of which method was

adopted to account for business combination.

5. A proxy for the SFAS Nos. 141 and 142 consolidation reporting

framework was found to produce earnings and book value data that

better explain firm value than those produced either by the pooling

method or by the purchase method for half of the samples and tested

years. Therefore, from a value relevance perspective, our empiricalfindings provide some evidence to support the new consolidation

framework in which the pooling method is eliminated and goodwill is

not subject to annual amortization.

NOTES

1. EPooling and BPooling are reported numbers for the pooling sample while they arederived (as if pooling method is adopted) numbers for the purchase sample. On the

other hand, EPurchase and BPurchase are reported numbers for the purchase samplewhile they are derived (as if purchase method is adopted) numbers for the poolingsample. The procedures for deriving EPooling (EPurchase) and BPooling (BPurchase) for thepurchase (pooling) sample are detailed in the following section.

2. Under SFAS Nos. 141 and 142, purchase-accounted transactions may still resultin lower earnings than under pooling due to the higher depreciation charges associatedwith any net asset revaluation characteristic of purchase-accounted acquisitions. Sincethe size of the asset step-up is available for only a limited number of observations inour sample, we assume that the majority of the premium over book value paid in anacquisition (referred to as the accounting acquisition premium, or AAP) is attributableto goodwill rather than to any asset step-up. Thus, earnings under the new FASBframework should be closer to earnings under the pooling method (i.e., EPooling) thanto those under the purchase method (i.e., EPurchase). As a result, we use EPooling toproxy for earnings under the new FASB framework. Our assumption that the majority



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of the AAP is attributable to goodwill is supported by the findings of Henning, Lewis,and Autumn (2000). They found that, on average, about 81% of the AAP isattributable to goodwill, with only 19% attributable to asset step-up.

3. To qualify for pooling treatment under APB No. 16, an acquisition had to meet12 conditions. Of the 12 conditions, the most difficult for acquirers to meet were (1)the transaction be a stock-for-stock exchange and (2) at least 90% of the target firmsvoting shares be acquired.

4. In this study, the sum of the premium paid in an acquisition and any step-up innet asset value (i.e., where the fair market value of the target firm exceeds its bookvalue) is referred to as the accounting acquisition premium (AAP). Thus, AAPequals the purchase price minus the book value (proportionate to the acquisition

percentage) of the acquired firm. For the merger year m, AAP BPurchase

2

BPooling

;where BPurchase is the reported (estimated) book value and BPooling is the estimated(reported) book value when purchase (pooling) accounting is used.

5. The tax benefits of a stock-swap acquisition are the same regardless of theconsolidation method used unless the acquirer buys the (net or gross) assets directlyfrom the target firm and places those assets in a newly created subsidiary, wherein thenew subsidiary may claim additional tax depreciation on the stepped-up asset valuesimplied by the transaction.

6. Managers may prefer the purchase method when the total debt-to-total assetsratio or the debt-to-equity ratio is high; purchase accounting causes these ratios todecline following many acquisition transactions.

7. The only study we know of that addresses this issue is Vincent (1997). Due toinconsistent results, Vincents study was unable to provide definitive conclusions.

8. They found an association between market value and the amortization ofresidual goodwill (calculated as purchase price minus any asset step-up and coregoodwill).

9. If an acquisition is less than 100%, the acquisition ownership percentage ismultiplied by the book value of the acquired firm and then subtracted from thepurchase price to estimate the AAP.

10. In our models, we adopt 20 years as the amortization period for the AAP asthis was consistent with the goodwill amortization proposal of the FASBimmediately prior to the adoption of SFAS No. 142. We also used a 10-year

amortization period in earlier versions of the paper and the results are similar. Sincethe amortization period is a constant applied to all firms in calculating the adjustedearnings, the choice of the period should not affect the significance level of thecoefficient of earnings or the conclusions of our study.

11. Specifically, we investigate which variable, earnings or book value, is morevalue relevant (i.e., possesses more information content) under the pooling andpurchase methods. This test is similar to the test of relative information contentperformed in Biddle, Seow, and Siegel (1995).

12. We are studying whether one variable has information content beyond thatprovided by another (i.e., does earnings have incremental value relevance over bookvalue? If it does, the adjusted R2 of the model including both earnings and book

value should be significantly greater than that of model with only book value). Thisis similar to the incremental information content test performed in Biddle et al.(1995).



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13. The required footnote disclosures under purchase accounting generallyenable investors to develop comparative pro forma information as if poolingaccounting had been used, whereas the reverse is generally not possible underpooling.

14. Ohlson (1995) derived his model using the notion that the current marketvalue of a firm is equal to the present value of future expected dividends. Thisvaluation model has been applied in many empirical studies (e.g., Aboody, 1996;Vincent, 1997; Collins, Maydew, & Weiss, 1997; Chamberlain and Hsieh, 1999;Collins et al., 1999). When the model is implemented, all variables are scaled by theshares outstanding to avoid heteroscedasticity.

15. To simplify the symbols, we use P for market value deflated by shares

outstanding in Models A.1A.3 and B.1B.3 and also in Model C. A similar practiceapplies to earnings (E) and book value (B).16. Barth and Clinch (2001) indicate that share-deflated price specifications (i.e.,

market price deflated by shares outstanding) are most effective to mitigate equity-related heteroscedasticity (a form of scale effect). Thus, we deflate variables in thetest model by shares outstanding to control for heteroscedasticity. In addition, wealso add market capitalization (SIZE, at the end of year m 1) as an independentvariable to control for market capitalization-related scale effects.

17. When estimating our proxy for consolidated book value, measurement errorsmay arise from timing differences relating to the most recently available bookvalue; that is, the actual book value of a target firm at the specific transaction date

may never be reported and is not observable by the researchers. To mitigate thisproblem, we use the most recently reported book value. We cannot unambiguouslyconclude whether the derived book value is biased upward or downward for eachmethod; however, we can predict the direction of bias for the earnings proxy. Notethat the AAP includes both goodwill and any net asset revaluation, with the lattertypically requiring a faster write-off than goodwill. Hence, the inferred depreciationis likely to be slower than the actual depreciation, suggesting that the estimatedEPurchase for the Pooling sample is likely to be biased upward and the estimatedEPooling for the Purchase sample is likely to be biased downward. In addition to thesepotential measurement errors, there may be other measurement errors caused by theassumptions adopted by the researchers in calculating these estimates.

18. Since SIZE is the common variable in Models A.1 and A.2, any difference inthe adjusted R2 of these two models would be attributable to the EPooling (in ModelA.1) and BPooling (in Model A.2).

19. Because of incremental depreciation resulting from any asset revaluation,earnings under the new framework should be less than that under EPooling. However,we assume that the majority of the AAP is attributable to goodwill and thus useEPooling as a proxy for SFAS No. 141 earnings. This assumption is consistent with thedata of Henning et al. (2000).

20. The valuation model (Ohlson, 1995) used in this study regresses market valueon earnings and book value. Annual earnings are, in general, available a few monthsafter fiscal year-end. In order to allow sufficient time for the securities market to fully

reflect the annual earnings in share price, we use a 3-month lagged marketcapitalization value (i.e., a 3-month lagged share price times the number of sharesoutstanding).



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31. The independent variable which distinguishes Model C from Model B (thepurchase method) is earnings (i.e., EPooling for Model C and EPurchase for Model B)and the difference is attributed to the amortization of AAP. Since many of oursample firms have only a partial year amortization for year m since the acquisitionoccurred in the mid-year, the difference between EPooling and EPurchase is morematerial for year m 1 than for year m (see Table 3 for detailed numbers). This mayexplain why the Vuong test indicates that the Z is significant for year m 1 onlywhen comparing the adjusted R2 of Model C with that of Model B.

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cheng et.al (2005) - the value relevance of earnigs and book value under and purchase accounting

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