Accounting & Tax

Why J&J Jumped to Purchase Accounting

Proposed $1.3 billion deal with Inverness highlights new merger accounting.
Craig SchneiderMay 11, 2001

Suddenly, the purchase accounting method is not all that terrifying to pharmaceutical and health-care giants.

At least that’s the message Johnson & Johnson sent on Wednesday when it announced that it is in “advanced discussions” to acquire Inverness Medical Technology’s diabetes care products business for $1.3 billion.

J&J said in a statement that it would account for the transaction under the purchase method. This is surprising for several reasons.

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For one thing, acquisitive drug companies have historically preferred the pooling-of-interests method of accounting, because it allows pharmaceutical firms to avoid hefty amortization of goodwill and earnings dilution.

What’s more, J&J’s $10.5 billion pending acquisition of Alza Corp. uses the pooling method.

Thirdly, given that the Financial Accounting Standards Board (FASB) is scheduled to end pooling for mergers on June 30, one might have thought that the drugmaker would want to get in another pooling deal in under the wire, right?

Not according to Robert Willens, Lehman Brothers’ tax and accounting analyst. This is because FASB’s proposal for the non- amortization of goodwill puts J&J “in a better position” from an earnings perspective, he says. “I’m sure that had some effect on their decision,” he adds.

Indeed, in the past J&J has accounted for its deals using both the pooling and purchase methods.

Granted, there are technical reasons why the J&J-Inverness deal would be accounted for as a purchase pact. Inverness is doing a spin-off of its non-diabetes business into a new publicly traded company before the merger. “That in and of itself blows [away the possibility of using] pooling,” Willens says. Why? One of the stipulations for pooling is that there can’t be an unusual distribution before the treatment.

“In the past, they would have held onto the assets that were being spun off,” Willens adds. “That was more to their liking.”

In a CFO.com interview in March, J&J CFO Robert Darretta indicated that he has mixed feelings about the anticipated new rules.

“Some people would argue that pooling shows transactions in too positive a light while the purchase method shows them in too negative a light,” Darretta said. “These new regulations are more favorable for where we use purchase accounting but unfavorable compared to pooling.”

Certainly, the new M&A rules are not perfect for the company. “The impact [to J&J] will be initially positive because of the goodwill aspect,” he said. “But over time it will be adverse compared to an environment where you could have had pooling.”

Based on the proposed rules, which are expected to be implemented next quarter, J&J estimates the Inverness deal would dilute earnings by 2 cents per share in both 2001 and 2002.

There are also strategic reasons for J&J not to fret over the purchase accounting and simply allow the spin-off. “Part of it is that they didn’t want the other assets,” says Michael N. Weinstein, a J.P. Morgan analyst. “They’re keeping the technology part they wanted, which is the profitable part of the business.”

However, Willens believes that in other deals such as PepsiCo and Quaker Oats, companies have actually been willing to hold onto assets for the sake of pooling. “In the Pepsi case,” he says, “they’re taking on all the assets, even though some people say they are not that interested in the food assets, and they’re doing that to make sure they get pooling treatment.”