CFAI text book says that ROE is lower under purchase method (lower earning and higher equity) Book 7 practice exam 2 morning session question 27 says that acquiree’s equity, including retained earnings is eliminated in the consolidated balance sheet under purchase method, but combined under pooling of interest method. If the answer to the above question is correct, shouldn’t equity under purchase method be lower and result ROE undertermined compared to pooling of interest method? Please explain, thx a lot
acquiree’s equity is eliminated- acquirer takes it all on. more assets (you write them up to mkt value), more depreciation (this is all assuming your assets at mkt are above book value), lower net income. more assets at fmv, more equity (b/c book value of equity replaced by purchase px)… CFAI text has that all right. when pooling, you treat the 2 co’s as equals- no goodwill or anything, no treated like one acquiring the other really- but you’d keep all of those old book values there so stuff like assets and equity lower, while NI, profit margins, ROA and ROE all higher… (more net income and lower assets/equity so it’s a double whammy on the ratio- all moves the same way). hope that helps a little.
I agree with u. But then I still don’t get why acquiree’s equity is combined in the consolidated balance sheet under pooling while eliminated under purchase method. Shouldn’t it be the other way around?
Equity is higher under the purchase method because the book value of equity in the acquired company is replaced by the amount of the purchase price. Maybe “replaced” is a better word than eliminated.
because with pooling, it’s like you unite the 2 companies but it’s not treated like an acquisition. so you carry forward all of the assets, liabilities, etc at the historical cost as if the 2 firms didn’t really combine… you combine the I/S and B/S but again, it’s not like company A acquires company B for some acquisition price or anything. under purchase, it’s like a real acquistion, A gobbles up B- B no longer exists. B is now A. einhorn is finkle, finkle is einhorn! but you have to all of the fun stuff like goodwill in purchase and marking up Assets, etc to fair mkt value.
A couple of points. Even tho you are comparing two methods you still need to compare apples and apples, not apples and oranges. Pooling is/was ALWAYS a 100% stock for stock deal. If you compare that to a cash purchase method vs. a stock purchase method where new equity is issued the analysis of ROE would give diferent results, even if the purchase is at book value. The other point is that saying “acquiree’s equity is combined” is true in substance, but not in form. The acquiree will dissapear along with its equity, but the value of its equity is reflected in the value fo the new shares issued to acquire the company.
so basically pooling is based on historical value and purchasing is based on market value. Since Market value is usually higher than historical value, then the assets and liabilities of purchasing will be higher than pooling. Could I think of it that way - its simple so I can remember it lol
thx super- one question i have- cash flows- so pooling there are no real cash flows that arise from the actual transaction itself, yes? vs purchase method- where would the CF’s be? if bought with debt- CFF woud go up, what would be the offset of buying the company, in CFI? if the company had the cash to buy another co- would it then be CFI up, CFO down?
bannisja - You’re right… with pooling there are no material acquisition related cash flows (ignoring legal fees, M&A fees, and other out of pocket) at the time the deal is consummated. With Purchase, under a typical LBO scenario you have the source of funds which is debt and maybe other cash equity infused into the purchaser (CFF inflows), and the cash purchase which is all CFI out flows. Not sure what you mean with your last line. Cash flow statements don’t balance like blance sheets. If you buy a company using cash on hand its just CFI down, and if you had no other cash activity from CFO of CFF from the year your total cash flow for the period would be a net use which would match the drop in cash caused by the purchase.
bannisja Wrote: ------------------------------------------------------- > acquiree’s equity is eliminated- acquirer takes it > all on. Do you know the case when acquiree’s equity is not eliminated completely? Based on my understanding, it is completely eliminated in all three method: equity, proportionate consolidation and consolidation
Not under Equity. only under proportionate consolidation and consolidation. Equity is a one liner both BS and IS.
ymc - The acquiree’s equity is no more eliminated in the “equity method” than in the cost method. It’s never picked up anywhere in the first place.