The use of book value to estimate historical cost for assets in place and neglect of growth assets comes into conflict with market value most noticeably when a firm acquires another. Since acquisitions are made at market value, and the value of the acquired firm's assets are at book value, accountants are left with the unenviable task of reconciling the two at the time of the acquisition. How or whether they do so depends in large part on how the acquisition is accounted for. In a purchase accounting, the excess of market value over book value is called goodwill. Goodwill supposedly measures intangible assets that the firm has accumulated that could not be captured in the book value of the assets. In reality, goodwill captures the effects of three variables. The first is the difference between the book value of assets in place and their current market value, the second is the value of growth assets and the third is the premium over value that was paid by the acquirer for real or perceived synergy. Whatever the combination of variables that goodwill ends up measuring, it is also quite obvious that amortizing it over forty years, as required in the US for instance, is senseless. In fact, the negative effect of forced amortization on earnings seems to be sufficient to cause firms to try to qualify for a different acquisition accounting technique called pooling.
To qualify for pooling accounting, an acquisition has to be financed entirely with the stock of the bidding firm . In a pooling transaction, the book values of assets of the two firms are aggregated to arrive at the book value of assets of the combined firm. The new equity is valued in book value terms, and thus the market price paid on the acquisition is not considered. While pooling does allow firms to maintain the illusion that book values actually measure asset value, it obscures valuable information on the acquisition.
There are conditions where the choice between pooling and purchase can have real effects on the cash flows and value of the firm. The first is when all or some of the goodwill amortization is tax deductible. In any acquisition where market value exceeds book value, the use of purchase accounting should result in higher cash flows and value than the use of pooling accounting. The other is if there are constraints on dividend and debt policy, stated in terms of retained earnings, that might become tighter if there are amortization expenses that reduce earnings; if there are, the use of pooling accounting may provide the firm with more flexibility on both dividend and financing decisions.