EISEVIER Journal of Financial Economics 39 (1995) 353-378

An analysis of value destruction in

AT&Ts acquisition of NCR
Thomas Lys*~, Linda Vincentb
J.L. Kellogg Graduate School of Management, Northwestern University, Evanston, IL 60208, USA
Graduate School of Business, University of Chicago, Chicago, IL 6063 7, USA

(Received August 1992; final version received March 1995)

Abstract

AT&Ts $7.5 billion acquisition of NCR decreasedthe wealth of AT&T shareholders

by between $3.9 billion and $6.5 billion and resulted in negative synergies of $1.3 to $3.0
billion. We find that AT&T paid a documented $50 million and possibly as much as $500
million to satisfy pooling accounting, thus boosting EPS by roughly 17% but leaving
cash flows unchanged. We conclude that AT&Ts decision to acquire NCR in what the
market perceived as a value-destroying transaction was related at least in part to the 1984
consent decree with the Department of Justice that led to the break-up of AT&T.

Key words: Mergers; Acquisitions; Purchase; Pooling

JEL classijication: G34; M41

1. Introduction

After almost six months of hostile maneuvering, NCR agreed to be acquired

by AT&T in an all-stock transaction valued at $7.5 billion. This was the largest

*Corresponding author.
Financial support from Deloitte & Touche, KPMG Peat Marwick, and the Accounting Research
Center at the J.L. Kellogg Graduate School of Management, Northwestern University, is gratefully
acknowledged. We are indebted to Robert C. Holder, President of AT&T Computer Systems (and
previously head of the transition team for the purchase of NCR), for answering numerous questions
about this merger in discussions on December 6, 1991. We have benefited from the comments of
W. Bruce. Johnson, Steven N. Kaplan, Margaret Neale, Lawrence Revsine, Michael C. Jensen
(managing editor), Richard S. Ruback (editor), and William Fruhan and Victor Bernard (referees.)

0304-405X/95/%09.50 0 1995 Elsevier Science S.A. All rights reserved

SSDI 0304405X9500831 X
354 T. Lys. L. Vincent/Journal of Financial Economics 3Y (19951 353-378

public financial transaction in 1991 as well as the largest computer industry

merger to date. AT&T persisted in its pursuit of NCR despite the security
markets initial and consistently negative reactions to the proposed deal. AT&T
shareholders lost between $3.9 and $6.5 billion in market value during the
negotiations. Upon completion of the transaction, investors assessedAT&Ts
overpayment for NCR at between $60 and $101 per share on a final bid price of
$111 per share.
We explore the motivation behind AT&Ts strategy to acquire NCR as well
as its determination to proceed with what the market perceived to be a value-
destroying transaction. We also examine why AT&T was willing to pay as much
as $500 million extra for NCR to satisfy requirements to use the pooling-of-
interests (pooling) accounting method rather than the purchase method, even
though the accounting method had no direct cash flow implications for this deal.
Our analysis suggeststhat AT&Ts management initiated the acquisition of
NCR in order to save face for perceived past management mistakes stemming
from the 1984divestiture of the Bell operating companies. AT&Ts management
pursued the acquisition, despite NCRs resistance and the markets consistently
negative reaction to the deal, becauseof a combination of hubris, bad judgment,
and escalation of commitments. Although this assessmentis made with the
benefit of hindsight, we document that there were clear indications that AT&T
would have difficulty succeedingin this acquisition becauseof the dismal history
of similar mergers and managements limited experience in a competitive envi-
ronment. AT&T preferred the pooling method of accounting to avoid the
decreasein future earnings per share (EPS) that would result from the purchase
method. We also find that AT&T successfully lobbied the SEC to grant ap-
proval for pooling, despite several violations of the requirements for pooling.
The next section describes the background and motivation for AT&Ts
acquisition of NCR. Section 3 analyzes investors reactions to the acquisition as
well as the relative costs and benefits of the acquisition. Section 4 documents the
magnitude of the incremental costs of pooling as well as possible reasons for
AT&Ts willingness to pay for the opportunity to use pooling. Section 5 dis-
cussesexplanations for AT&Ts completion of this merger despite repeated and
unambiguous indications that investors did not view NCR as a value-enhancing
acquisition. Finally, Section 6 provides a summary and our conclusions.

2. AT&Ts motivation for purchasing NCR

AT&T was founded in 1885 and, as a regulated utility, enjoyed a virtual

monopoly of long-distance telephone service and equipment manufacture for
almost a century. In 1974, the Department of Justice (DOJ) brought a civil
antitrust action against AT&T for monopolizing telecommunications services
and equipment. This suit sought divestiture of AT&Ts equipment manufacturing
 T. Lys, L. Vincent/Journal of Financial Economics 39 (1995) 353-378 355

subsidiary (Western Electric Company, Inc.) and the separation of its long-
distance services (AT&T Long Lines Department) from the Bell operating
companies which would then provide only local telephone service. After fighting
the DOJ for several years, AT&T signed a consent decree in early 1982. The
decree required AT&T to divest the Bell operating companies, representing
about 75% of AT&Ts total assets, in exchange for the right to enter into
previously prohibited (except for internal activities), unregulated, computer-
oriented endeavors. The consent decree, effective January 1, 1984, allowed
AT&T to sell both computer equipment and enhanced services which em-
bodied data processing.
AT&Ts management was roundly criticized in the financial press for signing
the consent decree.This criticism intensified when the DOJ dropped its concur-
rent antitrust suit against IBM several months after AT&Ts capitulation.
However, AT&Ts management believed that its future lay in linking telecom-
munications with computer operations and considered the divestiture an oppor-
tunity to expand into new areas of information services as well as to capitalize
commercially on its accumulated expertise in both telecommunications and
data processing (e.g.,AT&Ts Bell Labs had pioneered significant developments
in computer science,including the UNIX operating system).Given the changing
nature of the telecommunications industry, as exemplified by not only the
antitrust action against AT&T but also the results of the FCCs Second Com-
puter Inquiry (in which the FCC ruled in 1981 that enhanced services and
customer premises equipment would be detariffed) and the courts 1974 ruling
that AT&T had to supply accesslines to its competitor, long-distance supplier
MCI, AT&Ts management believed that it had no choice but to alter its
strategy for the future.
AT&Ts management stressedthe net benefits to be obtained from signing the
consent decree in its external communications. For example, the 1984 Annual
Report (p. 9) stated that one of the most significant events of 1984was our entry
into the general purpose computer business. . . Computer hardware and soft-
ware systemsplay a major part in our strategy to provide integrated commun-
ications based office automation systems.AT&Ts Chairman of the Board and
CEO reconfirmed this commitment to the computer business in the 1985, 1986,
and 1987 Annual Reports, stating (1986 Annual Report, p. 2) that . . . computers
are an intrinsic part of our business. We will continue to sell them on a stand-
alone basis, but in a larger context we view computers as a vital element in the
development and implementation of information networks. Our vision is to link
computers and other customer premises equipment with public and private
network facilities . .. None of this was possible under the pre-consent decree
regime.
The current CEO, Robert Allen, took office in 1988 and part of his stated
strategic vision was to make AT&T a significant player in the computer
business.Allen wanted the company to be technology-driven and to provide an
356 T Ly. L. Vincent/Journal r$Financial Economics 39 (1995) 353 37X

outlet for the technological advances generated by Bell Labs (Verity and Cory.
1992).Thus, all three post-divestiture CEOs made major public commitments to
the computer industry as part of the justification for and strategy after signing
the consent decree.
AT&T experienceddifficulty in achieving the benefits foreseenfrom the divesti-
ture. Results for its computer operations are not disclosed separately, but the
financial pressestimated that AT&Ts computer operations lost at least $2 billion
between 1984and 1990,with lossesof between $100 million and $300 million on
salesof $1.5 billion for 1990alone (Keller and Wilke, 1990;Davis, 1991).AT&Ts
managementdid not deny the unprofitable nature of its computer operations, and
their unsuccessfulattempts to bolster computer operations included joint ventures
and investments in several high technology companies (Keller and Wilke, 1990).
AT&T had also considered several large candidates for acquisition.
In 1990, AT&Ts management concluded that continuing computer losses
dictated either a significant increase in its investment or divestiture of the com-
puter operations (Keller, 1990).Management elected to increase its commitment
to the business.Analysts speculated that AT&T chose to expand its investment in
order to savefacefor signing the consent decreeas well as for its subsequentpublic
confirmations of the divestiture-related strategy and its significant investment in
computer technology (Noll, 1991;Sloan, 1991a).Having tried other approaches,
AT&T decided to make a major acquisition. This decision was made despite the
consistently dismal history of computer mergers (e.g., Burroughs with Sperry
Corp. (UNISYS), Honeywell with Bull, Hewlett-Packard with Apollo Computer,
and IBMs 1984 purchase of Rolm) by a management with limited competitive
experience entering a highly competitive, rapidly changing industry. In addition,
AT&Ts acquisition candidate, NCR, had experienced recent setbacks, with
operating income before taxes declining in both 1989 and 1990 and revenues
increasing an averageof only 2% in each of those years. NCRs stock price was at
a three-year low just prior to the bid and NCR had just introduced a new line of
computers in an attempt to improve its lackluster performance.
AT&T first approached NCR as an acquisition candidate in July 1988. At
that time, NCR stated its preference to remain independent but told AT&T that
if it were ever under attack from another company, AT&T would be its favored
white knight. AT&T approached NCR again seeking a merger agreement in
June 1989 and was again rebuffed (Davis, 1991). AT&T considered NCR an
appropriate acquisition target for several reasons:

a) NCR and AT&T had compatible product lines and a similar philosophy
about open computer systems using the UNIX operating system. NCR was
also stronger than AT&T in networking.

This is according to our December 1991 conversation with Robert C. Holder.

 T. Lys. L. Vincent/Journal of Financial Economics 39 (1995) 353-378 351

b) NCR had a corporate culture compatible with AT&Ts, especially as com-

pared to some of the Silicon Valley firms which AT&T had considered as
merger candidates.
c) NCR had an international computer marketing presenceand customer base
which AT&T lacked.
d) NCR was a possible and practical acquisition whereas some other candidates
such as Hewlett-Packard had impediments to acquisition (e.g.,family trusts).

Perhaps concerned about its poor reputation in the computer business,AT&T

announced early in the negotiations with NCR that it planned to combine
AT&Ts and NCRs computer businesses under NCRs senior management
team, retaining NCRs name.
In summary, the decision to acquire NCR reflected AT&Ts continued efforts
to transform itself from a regulated monopoly to a successfulmarket competi-
tor. Unable to demonstrate profitability in its own computer operations, AT&T
went outside to obtain critical mass and management talent. The next section
examines whether investors agreed with AT&Ts strategy to acquire NCR and
whether the merger resulted in synergies as reflected by an increase in the
combined market values of AT&T and NCR as a result of the announced
merger.

3. Shareholder value implications

3.1. Total wealth implications

In order to assessthe wealth effect of the proposed merger, we compute

abnormal returns for AT&T and NCR using the market model (Fama, 1976)
and continuously compounded daily returns for AT&T, NCR, and the S&P 500
Composite Index. Becausethe negotiations extended over a six-month period,
encompassing many nonmerger events, we focus on the major, merger-related
events and calculate abnormal returns in two-day windows consisting of the
trading day prior to and the day on which each major merger-related event is
reported in the Wall Street Journal (WSJ). Table 1 summarizes the key events
and associated abnormal returns. Becauseof the short windows, we are reason-
ably sure that no other events were announced concurrently, allowing
attribution of any unexpected share price changes to the merger-related
announcements.
AT&T investors reacted unfavorably to the initial news of the proposed
merger and the market responsesto subsequent events were generally negative
for AT&T whenever the events implied an increase in the probability of
successfulcompletion of the transaction. Moreover, as indicated in Table 1, this
 358 T. Lys. L. Vincent/Journal of Financial Economics 39 (1995) 353 37X

Table 1
Chronology of major events in the acquisition of NCR by AT&T
The report date refers to the publication date of the Wall Street Journal in which the event was first reported
The abnormal return is calculated for the two-day window consisting of the trading date just before the repor
date and the report date. The t-statistic is calculated by dividing the abnormal return by its standard error fron
the estimation period, adjusted for out-of-sample predictions. For multiple event days. the t-statistic i
computed as the sum of the t-statistics for each individual day divided by the square root of the number of days

AT&T NCR
abnormal abnormal
return return
Report date (t-statistic) (t-statistic) Event description

I l/8/90 - 2.43% + 12.53% Unconfirmed report that AT&T and NCR were discuss
( - 1.39) ( + 6.61) ing a combination of their computer businesses.
- 3.96% + 3.97% AT&T proposed to acquire NCR in a tax-free merger (i
( - 2.27) ( + 2.11) stock for stock exchange) worth $85 per share to NCR
a premium of 80% over the pre-rumor trading price o
NCR stock of $47.25per share. NCR shareholders woulc
also receive a 140% increase in the dividend. AT&l
indicated that it would complete a cash transaction i
NCR preferred.
12/3/90 NCRs board unanimously rejected the AT&T offer
AT&T increased its bid to $90.
12/3/90 - 7.41% + 44.46% AT&T made a public bid for NCR at $90 per share o
( - 4.25) ( + 23.37) a total of $6.04billion. NCR stock price increased $24.7:
to $81.50in response.AT&Ts stock fell $2 per share tc
$30.125.
12/06/90 The board of directors of NCR rejected the AT&T bit.
but approved the strategy to enter into negotiations witl
AT&T if AT&T offered not less than $125 per share
NCRs shares closed at $86.625per share.
12/06/90 - 1.75% + 10.52% AT&T commenced a tender offer to purchase all out
( - 1.01) ( + 5.47) standing shares of NCR common stock for $90 per sharl
in cash.
02/20/9 1 - 1.46% + 3.62% NCR established the SavingsPLUS Plan, a qualifiec
( - 0.82) ( + 1.91) ESOP.
02/21/91 - 1.96% + 2.04% NCR announced a $1 per share special dividend am
(- 1.12) ( + 1.08) $0.02 per share regular dividend increase.
03/10/91 + 3.72% - 1.86% AT&T announced that it was prepared to raise its offe
( + 3.00) (-1.40) to $100 per share if NCR would negotiate a merge
agreement. NCR rejected this offer.
03/19/91 + 1.80% + 5.78% Federal Court invalidated NCRs ESOP.
( + 1.07) ( + 3.03)
03/27/9 1 + 1.51% + 2.23% NCR reduced its asking price to $110 per share fron
( + 0.88) ( + 1.18) $125 per share.
 T. Lys, L. Vincent/Journal of Financial Economics 39 (1995) 353-378 359

Table 1 (continued)

AT&T NCR
abnormal abnormal
return return
Report date (r-statistic) (r-statistic) Event description

04/19/91 AT&T increased its offer for NCR to $110 per share with
no collar or adjustment. The merger would be tax free
and, subject to SEC approval, accounted for as a pooling
of interests.
04/20/9 I - 1.32% + 5.81% NCR responded that it preferred a cash and stock deal
( - 0.74) ( + 3.09) but would negotiate an all-stock transaction if AT&T
insisted.
05/06/9 1 - 2.25% + 0.77% AT&T agreed to buy NCR for $110 per share, a total of
( - 1.29) ( + 0.41) $7.48 billion. This agreement was for an ah-stock merger
unless AT&T could not satisfy itself that an all-stock
merger could be accounted for as a pooling of interests, in
which case the merger would be converted to a cash
election merger with 40% of NCRs shares exchanged for
$110 cash per share and the remaining 60% exchanged
for $110 in AT&T stock. High and low collars were
added to the stock deal so that NCR shareholders would
be protected in case of a decline in AT&Ts share price
prior to the actual merger date.
08/13/91 - 2.29% - 0.37% AT&T filed NCRs proxy statement with the SEC for the
( - 1.31) ( - 0.19) shareholders meeting to approve the proposed merger.
This indicated that AT&T had received tacit approval
from the SEC to structure the acquisition of NCR as
a pooling of interests. However, the proxy states that if
AT&T is not able to satisfy the conditions necessary for
treatment as a pooling of interests, then it will revert to
the 40% cash and 60% stock purchase.
09/13/91 - 1.11% - 1.00% NCR shareholders voted to merge with AT&T.
( - 0.63) ( - 0.53)
09/19/91 - 1.63% - 1.73% (*) Merger between AT&T and NCR completed. AT&T
( - 1.34) (- 1.33) (*) issued 184.5 million shares for the merger. NCR no
longer traded on the NYSE. [(*) = oneday return for
NCR]
Total for - 13.33% + 120.29%
the 20 ( - 2.47) ( + 14.70)
event days
through
05/07/9 I
Total for - 16.26% + 117.29%
the 24 event ( - 2.82) ( + 13.96)
days through
09/l 6191
360 T. Lys, L. Vincent/Journal of Financial Economics 39 (1995) 353.-378

Table 1 (continued)

AT&T NCR
abnormal abnormal
return return
Report date (t-statistic) (t-statistic) Event description

Total for - 17.62% + 113.53%

the 25 ( - 3.03) ( + 12.68)
event days
through
09/19/91

10116/89 10/16/90 1111190 05/7/91 9/l 9/91

Negotietion Period
. . . .

t- Estimation period

I Acquisition Period

Fig. 1. Estimation, negotiation, and acquisition periods.

The estimation period, 10/16/89 to 10/15/90,is used to estimate the market model parameters used
to compute abnormal returns. The negotiation period of 1l/1/90 to 5/7/91 commencesjust prior to
the first bid by AT&T for NCR and extends through the announcement of the signing of the merger
agreement. The acquisition period is defined as the negotiation period plus the period from the
merger agreement announcement date to the actual completion of the merger on 9/19/91 when NCR
stopped trading.

negative reaction was consistent across the different structures that AT&T
proposed for the deal (e.g., the initial merger offer followed by a hostile tender
offer), offer prices (ranging from $85 to $110 per NCR share), and modes of
payments (cash or exchange of stock). These returns imply that (for the proposed
terms) investors viewed AT&Ts acquisition of NCR as a negative net present
value investment. The sums of the two-day cumulative abnormal returns (CARS)
over the negotiation period (see Fig. 1) of November 1, 1990 (just prior to the
initial rumors of merger talks between AT&T and NCR) to May 7, 1991 (the
date on which the signing of the merger agreement was announced) total
- 13.33% (t = - 2.47) for AT&T and + 120.29% (t = + 14.70) for NCR.
These abnormal returns translate to a total wealth loss by AT&T shareholders
of $4.9 billion for the 20 event days comprising the major events during the
negotiation period, computed by multiplying AT&Ts abnormal return of
13.33% by its pre-announcement (October 31,199O) stock price of $34 and the
1.092 billion shares outstanding as of the end of the year. In contrast, NCR
shareholders wealth increased by $3.7 billion, computed by multiplying NCRs
abnormal return of 120.29% by the pre-announcement (October 31,199O)stock
 T. Lys, L. Vincent/Journal of Financial Economics 39 (1995) 353-378 361

price of $47.25and the 64.5 million NCR shares outstanding as of December 31,
1990.The details of all calculations are shown in Table 2. Our abnormal returns
analysis concentrates on the six-month negotiation period rather than the entire
ten-month acquisition period (Fig. 1) because the negotiation period captures
the majority (88.6%) of the resolution of uncertainty associated with the merger
(Larcker and Lys, 1987).
While mitigating the influence of nonmerger-related events, the two-day
windows capture only the change in the probability of the merger directly
attributable to the announcements, thus underestimating the aggregate market
impact of the announcements (Lewellen and Ferri, 1983). Therefore, we also
expand the analysis to include all trading days within the negotiation period,
resulting in CARS of + 103.27% (t = + 15.30) for NCR and - 14.32%
(t = - 1.00) for AT&zT.~ NCRs CAR of + 103.27% translates to an overall
wealth gain of $3.1 billion for NCRs shareholders. AT&T shareholders, on the
other hand, experienced a decreasein wealth of approximately $5.3 billion, or
roughly $4.87 per share, over the same period.
AT&Ts market price decline implies that investors assessedthe value of NCR
to AT&T at between $28 and $35 per share, computed as the price paid by
AT&T of $110.74per share lessthe per (NCR) share decreasein AT&Ts market
value. For example, AT&Ts total market value decline of $4.9 billion for the
major events of the negotiation period translates to $76 per acquired NCR share
($4.9 billiom64.5 million shares).Therefore, the implied value to AT&T of each
NCR share was $110.74 less $76, or $34.74, substantially less than NCRs pre-
merger price of $47. Consistent with these computations, the synergies for the
negotiation period, computed as the sum of the changesin shareholder wealth of
the target and the bidder (Bradley, Desai, and Kim, 1988) are estimated at
between - $1.3 billion and - $2.2 billion. Extending the analysis to the entire
acquisition period (1 l/1/90 to 9/19/91) results in negative synergies of $3.0
billion for the merger-related events as AT&T shareholders wealth declined by
$6.5 billion and NCR shareholders wealth increased by $3.5 billion. This
translates to a per share value of NCR to AT&T of $10.
Investors negative response to AT&Ts acquisition of NCR was consistent
with AT&Ts poor performance in the computer business;that is, investors may

*The market-implied probability of completion is computed as (P - P&P, - I,.,,), where P is the

closing price of NCR stock on May 7, 1991, PNS is the closing price of NCR stock on October 31,
1990, and Ps is the final offer price [($103.50 - 47.25)/($110.74 - 47.25) = 0.8861.
3Because the negotiation period contains numerous nonmerger-related events and because AT&T is
roughly six times larger than NCR, it is not surprising that AT&Ts CAR within that period is
statistically insignificant at conventional levels. Indeed, AT&Ts CAR for the six-month period
would have to be roughly - 28% or - $10 billion in total market value in order to be significant at
the 5% level, an unlikely outcome in a $7.5 billion acquisition.
362 lY Lys, L. Vincent/Journal ofFinancial Economics 39 (1995) 353 37X

have believed that AT&T would dissipate its investment in NCR just as it had
previous computer investments. An alternative explanation for the negative
market reaction is that the market was responding to the effective announce-
ment that AT&T was not going to exit the computer business.For two reasons,
however, we believe that the negative response was due to the announced
acquisition of NCR. First, AT&T had previously pursued several potential
merger partners and had initiated joint ventures with companies including Sun
Microsystems and Olivetti, implying that the prior probability that AT&T
intended to exit the computing business was low. Second, if the negative market
responses were due to the announcement that AT&T was remaining in the

Table 2
Cumulative abnormal (i.e., market- and risk-adjusted) returns (CARS), continuously compounded
(neither market-nor risk-adjusted) returns, and shareholder wealth effects, for AT&T and NCR
during the negotiation and acquisition periods.
The continuously compounded returns are provided for comparison purposes so it is clear that the
useof the market model is not the sole source of the results. The wealth effectsfor the merger-related
events are computed using the sum of the abnormal returns for the events days given in Table I. The
wealth effects for the entire period are computed using the cumulative abnormal returns for all
trading days within the period, thereby including the effects of nonmerger-related events. The net
shareholder wealth effect (the sum of the change in wealth of AT&T and NCR) measures the
(negative) synergies for the merger. The (imputed) value to AT&T of each NCR share is calculated as
the price per share of NCR that AT&T could have paid without decreasing its own price per share.

Negotiation period Acquisition period

November 1, 1990 to November 1, 1990 to
May 7, 1991 September 19, 1991

Cumulative abnormal returns (merger-related events only)

AT&T (t-stat.) - 13.33% ( - 2.47) - 17.62% ( - 3.03)
NCR (t-stat.) 120.29% ( + 14.70) 113.53% ( + 12.68)

Cumulative abnormal returns (all trading days)

AT&T (t-stat.) - 14.32% ( - 1.00) - 10.49% ( - 0.51)
NCR (t-stat.) 103.27% ( + 15.30) 111.35% ( + 4.24)

Continuously compounded (nonmarket-adjusted)

AT&T 10.34% 16.81%
NCR 124.11% 129.50%
S&P 500 25.03% 30.47%

Merger-related events only

AT&T wealth loss - $4.949 billion - $6.542 billione
NCR wealth gain + $3.664 billionb + $3.459 billion
Negative synergies - $1.285 billion - $3.083 billion
Value to AT&T of NCR share $35 per shared $10 per shares
 T. Lys. L. Vincent/Journal of Financial Economics 39 (1995) 353-378 363

Table 2 (continued)

Negotiation period Acquisition period

November 1, 1990 to November 1, 1990 to
May 7, 1991 September 19, 1991

Entire period (a/l trading days)

AT&T wealth loss - $5.3 17 billion - $3.895 billion

NCR wealth gain + $3.146 billion + $3.392 billion
Negative synergies - $2.171 billion - $0.503 billion
Value to AT&T of NCR share $28 per share $50 per share

a - 13.33%CAR x 1,092 million shares outstanding as of 12/31/90x $34.00 per share price as of
1013l/90.
b120.29%CAR x 64.48 million shares outstanding as of 12/31/90x $47.25 per share price as of
10/31/90.
Wealth loss of AT&T plus wealth gain of NCR.
d$l 10.74 - ($4.949 billion + 64.48 million shares of NCR).
e - 17.62%CAR x 1,092 million shares outstanding as of 12/31/90 x $34.00 per share price as of
10/31/90.
113.53%CARx64.48 million shares outstanding as of 12/31/90x$47.25 per share price as of
10/31/90.
YS110.74 - ($6.542 billion + 64.48 million shares of NCR).
h- 14.32%CAR x 1,092 million shares outstanding as of 12/31/90x $34.00 per share price as of
10/31/90.
103.27%CAR x 64.48 million shares outstanding as of 12/31/90x $47.25 per share price as of
10/3 l/90.
$110.74 - ($5.317 billion + 64.48 million shares of NCR).
k- 10.49%CAR x 1,092 million shares outstanding as of 12/31/90x $34.00 per share price as of
10/31/90.
111.35%CAR x 64.48 million shares outstanding as of 12/31/90x $47.25 per share price as of
1o/3 I /90.
$110.74 - ($3.895 billion t 64.48 million shares of NCR).

computer business,then we would expect the market reaction to be immediately

negative and not spread out over additional events in the acquisition period that
offered no additional information about a change in strategy.

3.2. Was the markets assessment correct?

Although results for AT&Ts computer business are not broken out separ-
ately in its financial statements, AT&T discloses them in its quarterly earnings
announcements. Because of the consolidation of NCR and AT&Ts previous
computer operations, post-merger results are not directly comparable to NCRs
pre-merger results; however, the post-merger results should be greater because
they incorporate more than just NCRs assets.NCRs last full year financials for
1990 reported $6.3 billion in sales and $369 million in net income. NCRs 1991
364 T. Lys, L. Vincent/Journal @Financial Economics 39 (1995) 353-378

results were materially below projections made to AT&T of $6.62 billion in

salesand $386 million in operating income, with actual sales of $6.3 billion and
operating income of $103 million, including a $182 million charge due to merger
expenses(Keller, 1991b).AT&T reported 1992computer results of $7.1 billion in
sales and $288 million in operating income. The 1993 results indicated $7.3
billion in salesand a net operating loss of $99 million, including $190 million of
restructuring charges. The first quarter 1994 operating loss of $61 million
included restructuring charges of $120 million. Thus far, operating results have
not been impressive compared to NCRs historical performance, especially when
considered relative to a $7.5 billion investment.
In addition, in late 1993 NCR announced plans to reduce its work force by
15% or 7,500 employees during 1994. In early 1994, AT&T changed the name
from NCR to AT&T Global Information Solutions (GIS). NCR CEO Exley,
with 36 years of experience in the computing business, had departed, as prom-
ised, when the merger was completed and former NCR President Williamson
left AT&T during 1993.AT&T has thus not maintained its announced strategy
to retain NCRs name, reputation, and management following the merger.
Finally, in June 1994 the AT&T executive vice president and chief of its
multimedia products and servicesgroup who had launched all three of AT&Ts
attempts to acquire NCR left AT&T for another position (Rundle and Keller,
1994).In summary, while one may argue that sufficient time has not passedfor
the final assessmentto be made of AT&Ts acquisition of NCR, the evidence to
date is not encouraging.
This assessmentof the markets prescience with respect to the acquisition
of NCR is conducted with the benefit of hindsight. The market has not
always been correct in its evaluation of acquisition proposals. However,
indications that this acquisition would be difficult at best were provided by
AT&Ts lack of experience in a competitive environment, its lack of success
with its own computer operations, and the history of unsuccessful computer
mergers. These conditions do not imply that ex ante AT&Ts overall strategy
for merging telecommunications with computers was incorrect, AT&Ts
strategy was consistent with trends in the industry to integrate voice and
data processing capabilities. However, based on performance to date, inves-
tors correctly perceived AT&Ts implementation of the strategy as value-
destroying.

4. The costs and benefits of pooling

AT&T made pooling-of-interests accounting one of the central issues of the

merger with NCR. In this section, we estimate the incremental costs and discuss
the potential benefits from AT&Ts obtaining permission to account for this
transaction using pooling-of-interests accounting.
 T. Lys. L. Vincent/Journal of Financial Economics 39 (1995) 353-378 365

4.1. Requirementsfor pooling

Generally accepted accounting principles (GAAP) provide two methods for

recording business combinations: purchase and pooling-of-interests. The re-
quired method is dictated by the structure of the transaction and the history of
the two companies. The pooling method usesthe book value of net assetsof the
target. The purchase method uses the market value of the consideration paid,
with the difference between the market value paid and the book value of the
acquired net assets,or $5.69 billion in this case,to be amortized over the life of
the acquired assets.As a result, accounting net income in this case would be
lower under purchase accounting, although cash flows would be identical.4
GAAP prohibits any change in equity interests of the voting common stock of
either combining entity within two years of a combination accounted for as
a pooling. BecauseAT&T had made clear its strong preferencefor pooling early
in the negotiations, NCR used this requirement as part of its defense against
AT&T during the takeover battle. In February 1991,NCR established a quali-
fied ESOP with control of approximately 8% of NCRs voting shares and
declared a special cash dividend of $1 per share at the same time. Both of these
actions qualified as changesin equity interest, thus precluding the use of pooling
for the business combination. (To the best of our knowledge, NCRs use of
accounting issues in its acquisition defenseis unique.)
Two additional impediments to pooling, NCRs share repurchases in 1989
and 1990 and the cash-out provision of NCRs stock option plan, preceded the
merger negotiations, but AT&T believed there were precedents for reversing
them. In summary, the four impediments to AT&Ts obtaining SEC permission
to use pooling-of-interests accounting were:
1) NCRs share repurchases in 1989 and 1990,
2) the establishment of NCRs ESOP,
3) payment of the $1 special dividend by NCR, and
4) the cash-out provision in the NCR stock option plan.
Items l-3 violated the prohibition against any changesin equity interests. Item
4 violated another pooling requirement prohibiting the selective payment of
cash to some NCR shareholders but not to others.
AT&Ts accounting firm, Coopers & Lybrand (C&L), requested the SECs
concurrence on November 29,199Owith the reissuanceof treasury stock to cure
the taint of repurchased sharesso that the proposed businesscombination could

Vash flows could differ due to differential tax treatment. However, with the exception of the all-cash
offer made on December 6,1990, all offers made by AT&T were structured as tax-free acquisitions of
stock (IRC Sec. 368), regardless of whether the SEC allowed pooling.
366 T. Lys. L. Vincent/Journal of Financial Economics 39 (1995) 353. 37X

be accounted for using pooling, stating that the pooling issue is fundamental to
the proposed transaction. The Chief Accountant of the SEC responded on
December 6, 1990 that the SEC staff would not object to pooling under the
proposed circumstances. However, the SEC required the shares to be reissued
prior to the merger, and such reissuance would be impossible without the co
operation of NCR, an unlikely outcome in a hostile takeover. Had this transac-
tion not used the pooling method, there would have been no reason to reissue
these shares and incur the associated costs of a securities offering.
The SEC staff orally advised C&L on February 26 that if the court declared
the ESOP invalid, as a result of AT&Ts lawsuit, then the ability of AT&T and
NCR to account for the transaction as a pooling would not be impaired by the
attempted establishment of the ESOP. The Courts invalidation of the ESOP on
March 19, 1991 eliminated that impediment to pooling.
On February 25, 1991,C&L wrote to the SEC regarding the potential effect
on pooling of NCRs $1 special dividend (approved February 20). This item was
discussedin a meeting of representatives from both AT&T and NCR with SEC
staff on May 14. According to a July 5, 1991 internal SEC memorandum:

. . . the SEC staff determined the dividend would be considered to be in

contemplation of the business combination and a violation of the pooling
rules. The staff did not accept the argument that the $65 million dividend
was immaterial. However, the staff has previously allowed registrants who
have had an alteration of an equity interest to cure it by unwinding the
transaction within a short period of time after it occurs, resulting in the
transaction putting the entity in the sameposition it would have been prior
to the alteration.

Therefore, the SEC staff, while acknowledging that NCR deliberately violated
the requirements for pooling during the takeover activities, agreed to permit
pooling if NCR would cure the special dividend by forgoing the normal second-
and third-quarter dividends. Again, NCRs cooperation was necessary to ac-
complish the SECs requirements. To gain this cooperation, AT&T increased
the price of the deal from $110 to $110.74 so that NCR shareholders were not
hurt by the cancellation of the two normal quarterly dividends of $0.37 (a total
of $48 million).
Finally, NCRs stock option plan provided that during a change in control, all
outstanding executive stock options would immediately vest and the holders
would be entitled to receive the difference between the fair market value of the
stock and the price of the option in cash. There were approximately one milhon
such options outstanding with an aggregate value of $63.4 million; 336,000
additional shares were subject to the cash-out provision. A July 5, 1991internal
SEC memorandum stated that both the SEC and the Financial Accounting
Standards Board concluded that the cash-out provision violated pooling provi-
 T. Lys, L. Vincent/Journal of Financial Economics 39 (1995) 353-378 361

sions. SEC staff informed AT&T and NCR that the option provisions would
have to be amended so that NCR option holders would receive equivalent
AT&T options or exchange their options for AT&T shares. Thus, NCRs
cooperation was also necessary to accomplish this requirement for pooling,
illustrating the bargaining power afforded NCR by AT&Ts determination to
achieve pooling treatment.
The above discussion also indicates that a literal interpretation of SEC
requirements precluded AT&T from using the pooling-of-interests accounting
method. As Robert Willens, an accounting and tax expert with Lehman
Brothers, noted (Sloan, 1991b):If the [$l special] dividend is paid, it would be
very unlikely that AT&T could get pooling treatment. Similarly (Cowan, 1991):
All along, AT&T has indicated that it would prefer to account for the proposed
acquisition [of NCR] under the so-called pooling method, rather than the
purchase method. But NCR took steps(i.e., the ESOP and the special dividend)
that would make it hard for AT&T to use the pooling method. However, this
merger demonstrates that it is possible for a cooperating target retroactively to
reverse its own (hostile) actions in order to qualify a transaction for pooling.
NCR agreed to reissue 6.3 million NCR shares prior to the completion of the
merger, to withhold further dividend payments in 1991 so that the combination
of the regular February dividend payment of $0.37 per share and the special $1
dividend would represent the total normal dividend for the year, and to amend
the cash-out provision of the stock option plan.

4.2. The incremental costs of pooling

On August 9, 1991,the SEC releasedNCRs proxy statement for shareholder

approval of the merger with AT&T, indicating the SECs tacit approval of the
terms outlined in the proxy. On that sameday, AT&T filed a registration for the
shares it would issue in the stock swap to acquire NCR and NCR filed
a registration statement for the 6.3 million shares to be reissued prior to the
acquisition to satisfy one of the conditions for pooling. The NCR offering was
structured to sell the shares on the eve of the merger, after approval by NCR
shareholders at a meeting scheduled for September 13, and to convert automati-
cally from NCR to AT&T stock under the terms of the merger agreement.
Although three investment banks were named to comanage the issue, AT&T
arranged on August 29 for NCR to place the 6.3 million shares with Capital
Group, Inc., a California money manager, for $102.75 per share. This private
placement was at a 5% discount to the then market price of NCR shares and
permitted Capital Group to withdraw from the purchase if the merger was not
approved by NCR shareholders. Upon approval of the merger by NCR share-
holders, the 6.3 million shares of NCR stock would be exchanged for $110.74
worth of AT&T stock, an immediate profit to Capital Group of $50.3 million
and an offsetting cost to AT&T. (Our investigation of the placement of the 6.3
368 T. L,vs, L. VincentJJournal cf Financial Economies 39 (1995) 353--37X

million NCR shares did not reveal the existence of any compensating transac-
tions between Capital Group and either NCR or AT&T.)
The indirect costs of gaining SEC approval for pooling were even higher. As
mentioned above, AT&T needed the cooperation of its hostile target to reverse
actions NCR had taken which would prevent pooling. NCR had rejected
AT&Ts offer of $100 which was contingent on negotiating a friendly deal, but
finally agreed to be acquired for $110 and to work with AT&T in seeking
approval for pooling. At least part of this increase in price was offered to obtain
the cooperation of NCRs management. Indeed, at one point during the negoti-
ations, the financial press reported that AT&T offered to pay NCR an addi-
tional $55$7 per share ($325-$450 million in total, given the 65 million shares
outstanding) if NCR would cooperate in obtaining the SECs approval for
pooling:

AT&T has indicated it is prepared to pay as much as $102 a share in cash

to gain a friendly merger agreement, plus another $5 a share if AT&T pays
in stock and can treat the acquisition as a pooling of interests, avoiding
certain accounting charges. (Smith, 1991).

AT&Ts Robert C. Holder confirmed this willingness to pay for pooling in our
discussions on December 6, 1991. Furthermore, this amount was paid even
though AT&T had achieved effective control of NCR when shareholders ten-
dered 70% of their sharesin responseto AT&Ts $90 per share offer in February
1991. AT&T then captured 78% of the votes cast at a March 28 special
shareholders meeting, sufficient to replace immediately four of the twelve
directors, including both the CEO and the President. However, the deal, under
these conditions, would not have been friendly and would not have qualified for
pooling.
In summary, AT&T paid a confirmed $50 million for the reissuance of
NCRs treasury stock and was willing to pay another estimated $450 million
to gain NCRs cooperation in order to account for the transaction as a
pooling rather than a purchase. All of this was in the face of uncertainty
as to whether the SEC would permit pooling. Although NCRs share repur-
chases and the ESOP had been eliminated as impediments to pooling, the
SEC had not indicated its position on either the snecial dividend or the cash-out
provision of the stock option plan at the time the merger agreement was signed.
Because of the remaining uncertainty, AT&T indicated in the May merger
agreement and the final proxy statement that if pooling were not allowed,
it would shift to a 60% stock and 40% cash deal for the purchase; i.e., AT&T
signed the merger agreement and indicated that it would consummate
the transaction, even if the SEC disallowed pooling. Nonetheless, AT&Ts
preference for pooling was strong, as demonstrated by the costs incurred to
qualify for pooling.
 T. Lys, L. Vincent/Journal of Financial Economics 39 (1995) 353-378 369

4.3. Why was AT&T intent on achieving pooling treatment?

Although the choice between pooling and purchase accounting has no direct
cash flow implications, the effects on the combined financial statements are
significant. The following quote is representative of the concern expressedin the
financial press over the negative impact on AT&Ts EPS of the merger with
NCR if the purchase method of accounting were used:

If AT&T does not get permission from the SEC to use the pooling
accounting treatment, the resulting good will could hurt annual earnings to
the tune of 5% a year, said Joel Gross, an analyst at Donaldson, Lufkin
& Jenrette Securities Corp. The street has AT&T earning $2.90 this year
(i.e., 1991),but pooling could boost that to between $3 and $3.50 or cut it to
$2.75 if pooling isnt allowed. (Keller, 1991a)

Table 3 illustrates the effect on AT&Ts 1990EPS of the accounting alternatives

for the acquisition of NCR. AT&Ts preferred pooling-of-interests method
results in an EPS of $2.42.An all-equity purchase transaction would result in an
EPS of $1.97. The SO.45per share difference between an all-equity pooling and
an all-equity purchase is due to the amortization of goodwill. Because of the
nature of NCRs business and its rapidly changing technology, it is probable
that the goodwill would have been amortized over a maximum of ten years,
resulting in a $569 million annual decreasein earnings.5 We next discuss three
nonmutually-exclusive explanations for AT&Ts willingness to pay such a pre-
mium for pooling.

4.3.1. Shareholder communications

AT&T, with more than 75% of its stock held by individual investors, was
concerned about its shareholders reactions to two aspects of the financial
reporting results under purchase accounting. First, AT&T expressed concern
that shareholders would misinterpret the decreased earnings under purchase
accounting as decreased cash flow, resulting in a lower share price. Second,
AT&T was concerned about explaining a potential deficit in retained earnings
under purchase accounting.
As illustrated in table 3, purchase accounting would decreaseAT&Ts EPS by
more than 20%. AT&Ts assistant general counsel stated to us in a telephone

The SEC Staff Training Manual states that for high technology industries, amortization of
purchased goodwill over less than ten years is typically appropriate. AT&T amortized goodwill over
periods ranging from lo-15 years (AT&Ts 1990 Annual Report, p. 28). Also, see comments by
Robert Willens of Lehman Brothers in which he estimates that a ten-year amortization period would
be required (Sloan, 1991b).
370 T. Lys. L. VincentJJournal qf Financial Economics 39 (1995) 353 378

Table 3
Scenarios depicting possible values of AT&Ts EPS for the year of the acquisition assuming that the
acquisition took place on January 1, 1990
This simplifying assumption is necessary because once the merger was consummated on September
19, 1991, the results of AT&T and NCR were combined, making it impossible to construct separate
pro forma financials for 1991. Other assumptions are that the cash portion of any scenario is
financed with debt at an interest rate of 6%, goodwill is amortized over ten years, and net income is
reduced for the after-tax cost ofdebt using the federal statutory tax rate of 34% which approximates
AT&Ts actual 1990 rate. The stock-for-stock exchange ratio used is the actual one of 2.839 shares of
AT&T for each share of NCR.
_____.. --.-
Net income Number of shares EPS

AT&T EPS for 1990 (without NCR) $2,735,000,000 1,089,000,000 $2.51

Pooling-of-interests with 100% stock $3,104,000,000 1,285,ooo,000 52.42
Purchase with 40% cash and 60% stock %2,416,200,000 1,207,000,000 $2.00
Purchase with 100% stocka $2,535,000,000 1,285,OOQOOO $1.97
Purchase with 100% cashb $2,238,792,000 l,O89,OOO,OOG $2.06

This scenario resulted in the lowest EPS due to the greater dilution caused by the new shares. This
scenario could have been replicated with any of the partial cash scenarios if AT&T issued new shares
to retire the debt.
This transaction would not have been tax-exempt to either shareholders or the corporation and
therefore was not a likely alternative. It is included for purposes of comparison only.

interview that AT&T believes investors mechanically capitalize its accounting

earnings. Using AT&Ts P/E ratio of 15, the additional $5-$7 per share repor-
tedly offered by AT&T in exchange for pooling roughly corresponds to the
earnings increase of $0.45 per share achievable with pooling (for a description of
similar executive behavior, see Wilson, 1991).
In addition to concern over individual shareholders reactions to the de-
creased EPS, AT&T believed that in subsequent years even financial analysts
would forget the composition of earnings and penalize AT&Ts stock price for
the lower earnings. These concerns were expressedto us in telephone interviews
with spokesmen for AT&T. The financial press echoed this preoccupation with
EPS as illustrated in the following quote, suggesting that AT&T was justified in
paying a premium for pooling:

AT&T could save hundreds of millions of dollars in reported profits with

the flick of a pen by changing its hostile $6.12 billion cash offer for NCR
Corp. into a friendly stock swap, accountants say. The potential savings
would come from avoiding a tricky accounting item called good will, which
AT&T could dodge if it transformed the battle into a friendly deal. The
maneuver also could allow AT&T to pay a slightly higher price, according
to accountants. The marriage would be a lot happier and so would Wall
Street, if AT&T shifts to a pooling from a cash offer, says Janet Pegg,
 T. Lys, L. VincentJJournal of Financial Economics 39 (1995) 353-378 371

a certified public accountant who is an analyst and vice president at Bear

Stearns & Co. AT&T could boost its offer - and NCR shareholders
wouldnt be hit by taxes - under a pooling. (Cowan, 1991)

Further evidence of AT&Ts concern occurs in a May 17,199l memorandum

to the SEC staff indicating that if purchase accounting were required, then
AT&T management would be compelled to mitigate the double impact on EPS
of the increase in number of shares for a pure equity transaction and the
decrease in earnings due to goodwill amortization. AT&T maintained to the
SEC staff that the decrease in earnings caused by purchase accounting could
affect its accessto equity and debt capital in the future becauseof investors and
creditors perceptions. Thus, AT&T indicated it would change the structure of
the acquisition to 40% cash and 60% stock, increasing the amount of debt
outstanding even though AT&T did not want to compromise its flexibility for
making additional investments by taking on more debt.
AT&Ts concerns about the balance of retained earnings may have also
affected its accounting decision. AT&T had paid $8.52 per share in dividends
and earned $8.01 per share since 1984,thus depleting its retained earnings by the
difference and leaving a balance of $4.2 billion in retained earnings as of
12/31/90. Under pooling, this balance would be increased by NCRs retained
earnings of $1.5 billion, while avoiding the annual goodwill amortization ex-
pense of $569 million. Thus, compared to pooling, purchase accounting would
result in a lower, and possibly negative, balance of retained earnings. AT&T is
a New York corporation and while New Yorks BusinessCorporation Law does
not prohibit payment of dividends that exceedretained earnings, it does require
special written notice to shareholders when such excessive payment is made
(McKinneys, 1986).Dividend payments in excessof accumulated earnings and
profits (computed for tax purposes) are not taxable to the recipient at the time of
distribution but reduce the basis of the stock [IRC Sections 301(c) and 316(a)]
and would be a benefit to the tax-paying shareholders of AT&T. However,
AT&T intended to do a tax-deferred (IRC Sec. 368) reorganization even if
purchase accounting were used, so these benefits would not be available to
shareholders. In any case,AT&T may have worried that dividend payments out
of reported contributed capital would alarm its unsophisticated individual
investors.
On the surface, concerns with retained earnings as an explanation for pooling
appear inconsistent with AT&Ts announcement in November 1991 that it
would take a one-time charge of between $5.5 and $7.5 billion in the first quarter
of 1993 to recognize other post-employment benefits rather than spreading this
charge over the allowable maximum of 20 years [Statement of Financial
Accounting Standard (SFAS) # 1061. This one-time write-off in combination
with the amortization of purchased goodwill from the NCR acquisition would
likely result in negative retained earnings for AT&T by the end of 1993.
312 T. Lys. L. Vincent/Journal of Financial Economics 39 (1995) 353--378

However, when making that decision, AT&T was already assured that
the SEC would allow pooling. AT&Ts adoption of SFAS 106 in one step,
however, avoids annual charges against earnings that would have occurred
under the alternative method. Thus, the write-off of the post-employment
benefits and the avoidance of purchase accounting are consistent with
AT&Ts concerns about the importance of EPS and its belief that neither
investors nor financial and credit analysts remember the composition of earn-
ings from year to year, leaving AT&T with a preference for avoiding carrying
over deductions.

4.3.2. Bond covenants

Typically, bond covenants use financial accounting numbers (e.g.,net income,
total assets,or working capital) to define restrictions (Smith and Warner, 1979;
Holthausen and Leftwich, 1986; Watts and Zimmerman, 1986). Consequently,
management may select accounting procedures to avoid potentially binding
covenants and thus influence both firm value and the distribution of that value
between bondholders and shareholders. We examined 1990 AT&T indentures
with Bank of New York and Chemical Bank, neither of which had any restric-
tive covenants that would have been affected by the pooling/purchase decision.
Likewise, both Moodys Industrial Manual and Standard & Poors Corporation
Bond Guide indicated no restrictive debt covenants for any of AT&Ts other
outstanding issues.Therefore, debt covenants cannot provide an explanation for
AT&Ts preference for pooling and financial structure.

4.3.3. Incentive compensation (bonus) plans

Another possible explanation for AT&Ts preference for pooling is evidence
that accounting-based bonus plans influence management decisions (Healy,
1985; Dechow and Sloan, 1991). Unfortunately, no specifics of the relation
between compensation and accounting numbers such as earnings or EPS, or
any other plan details, are provided in public documents for the three incentive
compensation plans in effect at the time of the acquisition. Therefore, we
estimate the association between executive compensation and AT&Ts earnings
to assess the potential magnitude of the accounting choice on total cash
compensation by regressingcontemporaneous total cash compensation for both
the CEO and the top officers as a group on AT&Ts EPS for the years
1984-1990 (Healy, Kang, and Palepu, 1987). The slope coefficients are statist-
ically significant at the 10% level for the CEO and at the 5% level for the
executive officers as a group. Assuming that the Board does not adjust cash
bonuses for the effect of goodwill amortization, our estimates imply that the
$0.45 reduction in EPS resulting from the amortization of goodwill in 1991
would have reduced the CEOs cash compensation by $63,212 or 3.1% (using
the CEOs 1990 cash compensation of $2,021,000),and by $508,140 or 3.8%
for officers as a group (based on their 1990 total cash compensation of
 T. Lys. L. Vincent/Journal of Financial Economics 39 (I 995) 353-378 313

$13,530,000).6The decreasewould persist for the ten-year amortization period.

Assuming a 10% discount rate, the present value of such decreasesin compensa-
tion would total $427,245(i.e., the present value of $63,212per year for ten years
discounted at 10%) for the CEO (age 55 in April 1991) and $3,434,530for all
officers as a group.
To evaluate the wealth implications of the accounting method choice, we
compare the present value of the cash compensation effect to the reduction in
value of the stock and options held by the CEO and the corporate officers
caused by the estimated maximum $500 million incremental payment for pool-
ing. This computation is based on the assumption of no direct stock price
benefits from pooling.
AT&Ts proxy statement indicates that of the 1,092 million common shares
outstanding as of December 31, 1990, 1.8 million (including 1.2 million stock
options) or 0.162% were beneficially owned by directors and officers. The largest
individual shareholder was Robert E. Allen, Chairman and CEO, with 65,902
sharesand 239,414options. Assuming a corporate marginal tax rate of 34%, the
after-tax present value of the incremental compensation paid of $2.267 million
($3,434,530x (1.0 - 0.34)) along with our estimated cost of obtaining NCR
cooperation for pooling of $500 million, translates into a decreaseof AT&Ts
stock price by about $0.46 per share ($500 million + 1,092 million shares),
which, in turn, translates to a value loss of $140,445for Allen ($0.46 x 305,316
shares) and $811,468 ($0.46 x 1,764,063 shares) for all officers as a group.
Consequently, the (pre-tax) net wealth effect of the accounting choice is the
difference between the present value of the increase in cash compensation and
the offsetting decrease in stock price. These net effects are $286,800
($427,245 - $140,445) for Allen and $2,623,062($3,434,530- $811,468) for all
officers, an average of $131,153 per person in favor of pooling. If the costs of
pooling were less than $500 million, the estimated benefits to the CEO and all
officers would be even greater (i.e., at a cost of $50 million, the net benefits would
be $413,200 to the CEO and $167,667 on average to all officers).
Although we cannot conclude whether the magnitude of these net benefits of
pooling to individual officers and directors is sufficiently large to justify expend-
ing between $50 and $500 million of corporate assets,the magnitude of these net
benefits relative to total cash compensation and the wealth of these individuals
appears, albeit subjectively, to be small.
In summary, while there is evidence that there may have been some compen-
sation-related incentives to manage EPS, the more convincing reason for AT&T
managements preference for pooling is their belief that they can manage
investors and analysts perceptions via reported EPS, i.e., by avoiding a decline

% a private discussion, a compensation consultant indicated to us that AT&Ts short-term bonus

plan is based on earnings before extraordinary items (thus including the amortization of goodwill).
374 T. Lys, L. Vincent/Journal of Financial Economics 39 (1995) 353 378

in EPS due to purchase accounting. The issue then becomes whether an

expenditure of $500 million (less than $0.50 per share) or even $50 million (less
than $0.05 per share) can be justified on the grounds of improving communica-
tions with some shareholders since there are no direct cash flow benefits.
Justification would imply that the benefits from improving communications
with some shareholders in the form of higher EPS outweighed the costs to these
as well as to all other shareholders. One can also argue whether, in a transaction
of $7.5 billion, a $50 million additional payment is material. However, AT&T
has not considered even $10 million an immaterial amount in other contexts.
For example, in 1992,AT&T refinanced more than $2 billion in debt in order to
save $10 million in annual interest (or roughly $50 million on a pre-tax net
present value basis). Some benchmark, such as the shareholders relations
budget, would be helpful to assesswhether the expected benefits in the form of
shareholder understanding outweigh the costs; unfortunately, no such bench-
mark is publicly available.
AT&Ts argument that professional securities and credit analysts as well as
investors are unable to decomposeearnings under purchase accounting or to see
through the window-dressing effects of pooling accounting conflicts with the
notion of market efficiency. This view is consistent with mounting evidence on
market inefficiency (e.g.,De Bondt and Thaler, 1985).However, research directly
investigating the consequencesof purchase accounting on stock prices finds no
evidence of inefficiencies (Hong, Kaplan, and Mandelker, 1978).More recently,
Vincent (1995) investigates whether investors value mergers similarly regardless
of the accounting treatment and reports results consistent with the efficient
markets hypothesis. Absent evidence to the contrary, AT&Ts strong preference
for pooling, combined with its intention to complete the deal regardless of the
accounting method used, makes the additional amount paid for window dress-
ing even more curious.

5. Why did AT&T pursue this acquisition, ignoring the markets assessment?

In Section 3, we document that AT&T pursued this acquisition despite the

markets consistently negative assessment of the investment, resulting in
a wealth loss of $6.5 billion to AT&T shareholders. Section 4 documents that
AT&Ts insistence on the pooling-of-interests treatment may have contributed
$500 million to this wealth loss. In this section, we discuss three possible reasons
for AT&Ts persistence in acquiring NCR.
First, AT&Ts pre-merger performance was consistent with Merck, Shleifer,
and Vishnys (1990, p. 33) assessmentthat bad managers might make bad
mergers just because they are bad managers. Such bad mergers result from
managerial objectives that are not generally consistent with maximizing share-
holder wealth. In the Merck, Shleifer, and Vishny study, bidders with a three-
 T. Lys, L. Vincent/Journal of Financial Economics 39 (1995) 353-378 375

year income growth rate below their industry average are defined as badly
managed and experience an average stock market reaction of - 5.02%
in the four days ( - 2 to + 1) around the announcement of the initial bid,
calculated as the change in the bidders equity in the four-day window ( - 2 to
+ 1) around the initial bid announcement in the WSJ divided by the final
acquisition price of the targets equity. AT&Ts change in equity value, using this
calculation and December 3, 1990 as the date of the initial bid, was - 19.24%
( - $1.365 billion/$7.093 billion), or well below Merck, Shleifer, and Vishnys
result.
Second,AT&T managements disregard of the markets responseis consistent
with management overconfidence (or hubris; seeRoll, 1986).Part of the justifica-
tion for AT&Ts confidence was its belief that it had been given significant
private information by NCR early in the negotiations under a nondisclosure
agreement. AT&Ts Holder maintained that AT&T could have justified paying
even more than $110 per share based on this information. Furthermore, the
market has not been infallible in its assessment of acquisitions, justifying
ignoring its response.
A third explanation for AT&T managementspersistencein acquiring NCR is
provided by the results of behavioral research into escalation of commitments7
In essence,the argument is that once a decision maker takes action, there are
powerful psychological, environmental, and structural pressuresto continue the
course, regardless of subsequent information to the contrary. Salancik (1977)
and Keisler (1971) argue that individuals are more likely to become bound to
their prior actions when: (i) the action taken is explicit and unambiguous; (ii) the
action is not easily reversed; (iii) the action was taken freely; (iv) the action has
important ramifications for the individual initiating the action; and (v) the
action is public. CEO Allens decision to acquire NCR satisfied most of these
conditions. In addition, Allens public airing of his strategic vision to make
AT&T a significant player in the computer business may have intensified this
commitment to proceed. The environmental and historical pressures were also
significant becauseof the signing of the consent decreeby which AT&T gave up
its regulated monopoly status in exchange for the opportunity to pursue the
computer business. The criticism by the financial press and DOJs abandoning
the IBM suit increased the pressure to justify this tradeoff. AT&T felt compelled
to make its investment in computers pay off, and exiting the business was not
possible under these conditions.
Furthermore, structural factors encouraged commitment to the chosen
course. Research has shown that persistence is likely to occur in projects when
persistence is seen as costly but less catastrophic than withdrawing (Ross and

We thank Margaret Neale for helpful discussions on this topic.

376 T. Lys. L. Vincent/Journal ofFinancial Economics 39 (1995) 353-378

Staw, 1989).In explaining this escalation of commitment, Northcraft and Wolf

(1984, p. 226) suggest:

The decision maker may, in the face of negative feedback, feel the need to
reaffirm the wisdom of the time and money already sunk in the project.
Further commitment of resources somehow justifies the initial decision
(Staw, 1976),or at least provides further opportunities for it to be proven
correct. The decision maker may also treat the negative feedback as simply
a learning experience - a cue to redirect efforts within a project, rather than
abandon it (Connelly, 1978).Or perhaps, the decision maker will rationalize
away the negative feedback as a whim of the environment - a storm to be
weathered, rather than a messageto be heeded.

AT&Ts failure in the computer businessand its decision to increase its commit-
ment rather than exit the business are consistent with this explanation.
Finally, from an organizational perspective, research suggests that the
endowment effect can exist for property rights acquired by a variety of
means, even by court decree as in this case (Thaler, 1980).Having attained the
right to enter the unregulated computer business, implementing this right
was integral and compelling, further explaining AT&Ts persistence. [See
Kahneman, Knetsch, and Thaler (1990) for a discussion of the endowment effect
on organizations.]
Thus, AT&T may have felt pressured by the consent decree,its own numerous
public statements touting its computer strategy after the divestiture, and the
mounting losses of its computer operations to initiate and complete the NCR
acquisition. Because of these factors, AT&T disregarded the negative signals
from the market and relied on its internal valuations.

6. Summary and conclusions

AT&T persisted in acquiring NCR despite the markets consistently negative

reaction to major events during the negotiations. Our analysis indicates a result-
ing decrease in AT&T shareholders wealth of as much as $6.5 billion and
negative synergies from the merger of as much as $3.0 billion. The reasons for
AT&Ts persistence can only be conjectured, whether they be hubris, bad
management, or escalation of commitments. The patterns in this acquisition are
consistent with, but stronger than, those of large-sample studies: managers of
poorly performing corporations make bad mergers. Based on history, it appears
that AT&T wanted to redeem itself for the 1982 decision to divest its operating
companies, as well as to confirm its many public statements of commitment to
the computer business and to justify its significant investment in computers.
However, AT&T could have continued to pursue its strategy of combining
 T. Lys. L. Vincent/Journal of Financial Economics 39 (1995) 353-378 371

telecommunications and computer technology without remaining in the com-

puter manufacturing business.
We conclude that AT&Ts willingness to pay a premium for the pooling-of-
interests method of accounting was to avoid a sustained decrease in EPS
because of the importance of investors perceptions. AT&Ts management
believed that the reduction in EPS under purchase accounting by roughly $0.45
per share in each of the next ten years would be detrimental to its share price as
well as to its ability to raise capital. This concern with EPS was further
illustrated by AT&Ts plan to change to a 40% cash and 60% stock deal to
mitigate the EPS dilution if the purchase method was required. We cannot
dismiss the possibility that the preference was due to executive compensation
but we find no evidence that the choice was due to bond covenants. Pooling is
associated with a friendly acquisition and AT&T also desired to have the
market perceive this business combination as friendly, consistent with its long-
standing reputation as a benevolent monopoly (Ma Bell).
The question becomes whether the window dressing afforded by the
accounting choice was worth the price paid, be it $50 million or $500 million.
From an efficient markets perspective,this preoccupation with EPS, to the extent
of paying a higher price to obtain a pure accounting benefit, is difficult to justify.
However, if AT&Ts concerns about investor and analyst misinterpretation of the
reported EPS under purchase accounting were justified, then the additional
amount paid to improve shareholder communications could be directly related to
higher share prices. Clearly, this issuewarrants further analysis,contradicting as it
does the results of a significant body of research on this question.

References

Bradley, Michael, Arnand Desai, and E. Han Kim, 1988, Synergistic gains from corporate acquisi-
tions and their division between the stockholders of target and acquiring firms, Journal of
Financial Economics 21, 3-40.
Cowan, Ahson, 1991, NCR accounting tactic could hurt any merger, New York Times, March 22,
p. D2.
Davis, L.J., 1991, When AT&T plays hardball, New York Times Magazine, June 9, 16-20.
De Bondt, Werner F.M. and Richard Thaler, 1985, Does the stock market overreact?, Journal of
Finance 40, 793-805.
Dechow, Patricia and Richard Sloan, 1991, Executive incentives and the horizon problem: An
empirical investigation, Journal of Accounting and Economics 14, 51-89.
Fama, Eugene, 1976, Foundations of finance (Basic Books, New York, NY).
Healy, Paul, 1985, The impact of bonus schemes on the selection of accounting principles, Journal of
Accounting and Economics 7, 85-107.
Healy, Paul, Sok-Hyon Kang, and Krishna G. Palepu, 1987, The effect of accounting procedure
changes on CEOs cash salary and bonus compensation, Journal of Accounting and Economics
9, 7-34.
Holthausen, Robert and Richard Leftwich, 1986, The effect of bond rating changes on common
stock prices, Journal of Financial Economics 17, 57-89.
378 T Lys, L. Vincent/Journal of Financial Economics 39 (199.5) 353~ 378

Hong, Hai, Robert S. Kaplan, and Gershon Mandelker, 1978,Pooling vs purchase: The effects of
accounting for mergers on stock prices, The Accounting Review 53, 31 -42.
Kahneman, Daniel, Jack L. Knetsch, and Richard Thaler, 1990,Experimental test of the endowment
effect and the Coase theorem, Journal of Political Economy 98, 1325 1348.
Keisler, Charles A., 1971,The psychology of commitment (Academic Press, New York, NY).
Keller, John J., 1990,AT&Ts bid for NCR ended debate over whether to abandon computers, Wall
Street Journal, Dec. 10, p. A5.
Keller, John J., 1991a,AT&T believes merger to be called pooling of interest, Wall Street Journal,
July 2, p. C8.
Keller, John J., 1991b,NCR net to fall short of figure given to AT&T, Wall Street Journal, Sept. 9,
p. 83.
Keller, John J. and John R. Wilke, 1990, AT&T, NCR may combine computer lines, Wall Street
Journal, Nov. 8, p. A3.
Larcker, David F. and Thomas Lys, 1987,An empirical analysis of the incentives to engage in costly
information acquisition: The caseof risk arbitrage, Journal of Financial Economics 18, 111~126.
Lewellen, Wilbur G. and Michael G. Ferri, 1983,Strategies for the merger game: Management and
the market, Financial Management 12, 25-35.
McKinneys Consolidated Laws of New York, Annotated, 1986 with 1992 supplement, Book 6,
Businesscorporation law (West Publishing Company, St. Paul, MN).
Merck, Randall, Andrei Shleifer, and Robert W. Vishny, 1990,Do managerial objectives drive bad
acquisitions?, Journal of Finance 65, 3l-48.
Noll, Michael A., 1991,The failures of AT&T strategies, New York Times, March 31, Sec. 3, 9.
Northcraft, Gregory B. and Gerrit Wolf, 1984,Dollars, sense,and sunk costs: A life cycle model of
resource allocation decisions, Academy of Management Review 9, 225-234.
Roll, Richard, 1986,The hubris hypothesis ofcorporate takeovers, Journal of Business59,197-216.
Ross,Jerry and Barry M. Staw, 1989,Escalation and the Long Island Lighting Company: The case
of the Shoreham nuclear power plant, Working paper (Institute European dAdministration des
Affaires, Fountainebleau, France).
Rundle, Rhonda L. and John J. Keller, 1994,Creative Artists lures Kavner from AT&T, Wall Street
Journal, June 17, p. B3.
Salancik, Gerald R., 1977,Commitment and the control of organization behavior and belief, in:
Barry M. Staw and Gerald R. Salancik, eds.,New directions in organizational behavior (St. Clair
Press, Chicago, IL).
Sloan, Allan, 1991a,AT&T turns to cosmetic surgery to beautify its NCR buy, Washington Post,
July 16, p. C3.
Sloan, Allan, 1991b, NCR sets booby traps for AT&T, Los Angeles Times, March 14, p. D4.
Smith, Clifford W. and Jerold B. Warner, 1979, On financial contracting: An analysis of bond
covenants, Journal of Financial Economics 7, 117- 161.
Smith, Randall, 1991,NCR board, facing hard proxy fight, agrees to talks on AT&T merger offer,
Wall Street Journal, March 25, p. A3.
Thaler, Richard M., 1980, Toward a positive theory of consumer choice, Journal of Economic
Behavior and Organizations 1, 39980.
Verity, John and Peter Cory, 1992,Twin engines - can Bob Allen blend computers and telecommu-
nications at AT&T?, BusinessWeek,Jan. 20, 56-63.
Vincent, Linda, 1995, The equity valuation implications of accounting acquisition premiums,
Working paper (University of Chicago, Chicago, IL).
Watts, Ross L. and Jerold L. Zimmerman, 1986,Positive accounting theory (Prentice-Hall, Engle-
wood Cliffs, NJ).
Wilson, G. Peter, 1991,Future directions in taxation, Journal of the American Taxation Association,
Fall, 64473.