Purchase Versus Pooling of Interests: The Search for a Predictor

The question I am concerned with in this paper is the following: Is it possible to predict whether a merger will be accounted for as a purchase or as a pooling? Different predictors have been suggested in accounting literature; how do they compare in terms of their forecasting ability? If the accounting treatment is predictable, it may be possible to infer the decision rule that underlies the choice of treatment. Such knowledge would facilitate the interpretation of accounting data and suggest criteria to appraise auditing procedures. The question is important for the public accounting profession. Let us consider two possibilities: suppose we examine the population of reporting decisions made by business firms and find that the distribution behaves as if decisions were generated by a random process. One possible explanation would be that business men, as a group, do not really consider reporting decisions to be important, and accountants would then have to reconsider their own basic assumption, that reporting decisions have a discernible influence on the behavior of capital markets. Alternatively, let us assume that capital markets impose severe penalties upon firms which do not their reported income. Then, we would expect executives to behave accordingly and we should be able to uncover evidence of such smoothing behavior. Recommendations leading to an increase in the variability of reported earnings would have little chance of being followed.' It has been argued that managers of large firms smooth reported income in order to keep the stockholders happy.2 Such behavior has been