Pooling and Purchasing Method on Cash Flows

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boston_level2_c

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This is a reprint of another question that I had problems posting:
My question deals with Question 5.c on page 102 of the FSA book:
co. A used the purchase method and co. B used the pool method. This question asks you to calculate the Cash Flow difference.
My logic is that the cash flow would INCREASE for the purchase method. Why? Because:
CashFlow = (S - C - D)*(1-TR%) + D
And CashFlow *ALWAYS* increase with D. Solve and simplify the equation yourself using test variables (i.e. S=$10, C=$1, TR=33.333% —> this equation simplifies to CashFlow = 6 + Dep./3 —> the cashflow always increase with depreciation!
However, the answer in the back of the book says the exact opposite. It reads that “Cash flow is unaffected.”
Did AIMR screw up?
 
Cash flow is unaffected under both the methods. That’s true. Look at that equation again- Depr. appears in two places. You are subtracting Depr. from the revenue as well as adding it later.
 
CashFlow = (S - C - D)*(1-TR%) + D is the equation.
Suppose that we use some test numbers -
S = $100
C= $60
TR=35%
CF = (40 - D)(0.65)+D, which simplifies to 26+.35D=0.35D+26. As you can see, the CF increases with the Depreciation!!!
No matter values you plug in, the CF = (S-C)(1-TR) + TR*D, and S-C>0 always! Therefore, the CF is always bigger.
 
S-C is not always greater than 0. Costs might be greater than sales too. I came across a question where the first part of the equation was a negative number. I don’t have the energy to do number crunching, but I’m pretty sure tht the cash flows are unaffected.
 
*Pre tax* cash flows are unaffected.
If you write assets UP to fair value, then you are going to have greater depr under purchase, and so lower earnings.
So lower earnings = lower tax = higher after tax cash flows.
 
chrismaths Wrote:
——————————————————-
> *Pre tax* cash flows are unaffected.
>
> If you write assets UP to fair value, then you are
> going to have greater depr under purchase, and so
> lower earnings.
>
> So lower earnings = lower tax = higher after tax
> cash flows.
Amen! Thanks
 
The issue here is more like taxation of goodwill amortization which is a controversial part of the tax code (and frankly I’m not up on it except that I think they changed the law a couple of years ago to let it be deductible). It’s hard to believe that’s part of the curriculum. I think you should think that absent the complexities of a (temporary) tax code, cash flows are unaffected by purchase vs pooling and that means you don’t have to do lots of adjustments to the SCF.
 
THAT WAS IT!!!! *PRE-TAX* CASH FLOWS ARE UNAFFECTED! I believe that the question even asked about the pre-tax cash flows as well. Thank all of you beautiful people and best wishes!
 
Ruhi,
You’re subtracting a *reduced* D (it’s reduced by taxes), and then you’re adding back the *full* D. Effecitively, you’re adding back TR%*D back. So it taxes are 40% and D is $100, then you’re adding $40 back to CF.
 
Chrismaths,
I agree with you. There’s something wrong with the book’s explanation. Only you and I agree with this.
I agree 100% with what you’re saying.
The question reads:
5. Company A and Company B are identical in all respects other than how they account for intercorporate investments. Both made their first acquisition on Jan. 1, 20x1 (of Company C and D, respectively, which are identical in all respects). in each case, 100% of the outstanding stock of the investee was acquired. Company A accounted for its acquisition as a purchase whereas Company B used the pooling method. assume that the fair value of each investee’s assets exceeded book value by $100,000, which is assigned to assets that can be depreciated on a straight-line basis over 4 years. Compute the *DIFFERENCE* between Company A and Company B on each of the following measures on their year-end 20X1 financial statements.
a. Pretax earnings
b. Assets
c. Cash Flow
NOTE: They DID NOT say pre-tax cash flow!!!
Re: Pooling and Purchasing Method on Cash Flows
Posted by: chrismaths (IP Logged) [hide posts from this user]
Date: April 7, 2008 11:09AM
*Pre tax* cash flows are unaffected.
If you write assets UP to fair value, then you are going to have greater depr under purchase, and so lower earnings.
 
Hello Geniuses!
I actually got feedback from Wanda Lauziere of CFA Institute regarding my question posted on April 8th, 2008.
The question reads: “Co. A and Co. B are identical in all respects other than how they account for intercorporate investments. Both made their first acquisition on Jan. 1, 20x1 (of co. C and Co. D. respectively, which are identical in all respects). In each case, 100% of the outstanding stock of the investee was acquired. Co. A accounted for its acquisition as a purchase whereas Co. B used the pooling method. Assume that the fair value of each investee’s assets exceeded book value by $100,000, which is assigned to assets that can be depreciated on a straight-line basis over 4 years.
Computer the *DIFFERENCE* between Co. A and Co. B on each of the following measures on their 20x1 financial statements:
A. Pretax earnings
B. Assets
c. Cash Flow
My answer, as indicated earlier in this thread, was that the CFO would increase due to tax deductions from the depreciation, and this expert from CFA also agrees with me!
———————————————————————————————————
Thank you for your inquiry; the text is wrong as written in the text. The difference in depreciation would have an impact on the statements for financial reporting purposes. Because depreciable assets have increased, than so to does the depreciation, as you had astutely pointed out. I hope this helps.
Regards,
Wanda Lauziere
CFA Institute
 
Hello Geniuses!
I actually got feedback from Wanda Lauziere of CFA Institute regarding my question posted on April 8th, 2008.
The question reads: “Co. A and Co. B are identical in all respects other than how they account for intercorporate investments. Both made their first acquisition on Jan. 1, 20x1 (of co. C and Co. D. respectively, which are identical in all respects). In each case, 100% of the outstanding stock of the investee was acquired. Co. A accounted for its acquisition as a purchase whereas Co. B used the pooling method. Assume that the fair value of each investee’s assets exceeded book value by $100,000, which is assigned to assets that can be depreciated on a straight-line basis over 4 years.
Computer the *DIFFERENCE* between Co. A and Co. B on each of the following measures on their 20x1 financial statements:
A. Pretax earnings
B. Assets
c. Cash Flow
My answer, as indicated earlier in this thread, was that the CFO would increase due to tax deductions from the depreciation, and this expert from CFA also agrees with me!
———————————————————————————————————
Thank you for your inquiry; the text is wrong as written in the text. The difference in depreciation would have an impact on the statements for financial reporting purposes. Because depreciable assets have increased, than so to does the depreciation, as you had astutely pointed out. I hope this helps.
Regards,
Wanda Lauziere
CFA Institute
 
^ he is back!!!
Gazillion of AF’ers are waiting for the Goodies you commited. And thanks for making me a hero. I am daily getting 20 mails requesting the same!
 
oh DUH b/c you’re adding it back… never mind!!!
 
irrespective of response from CFA institute “expert” … … if the tax laws do not recognise the additional depreciation benefit to acquirer, the impact on cash flow is ZERO.
read this
http://www.referenceforbusiness.com/small/Mail-Op/Mergers-and-Acquisitio...
Purchase accounting usually results in increased depreciation charges because the book value of most assets is usually less than fair value because of inflation.
For tax purposes, however, depreciation does not increase because the tax basis of the assets remains the same.
Since depreciation under pooling accounting is based on the old book values of the assets, accounting income is usually higher under the pooling method. The accounting treatment has no cash flow consequences. Thus, value should be unaffected by accounting procedure.
and also if time permits
http://www.policylibrary.tax.virginia.gov/OTP/Policy.nsf/b4013b390328812...
I am more confused now though :-)
 
Rajiv75:
You’re a true genius, and you’re going to pass Level 2 with flying colours. I’ll make a wage with you.
Wanda’s, the CFA rep., had this to say: “Thank you for your inquiry; the text is correct as written. The difference in depreciation would have an impact on the statements for financial reporting purposes, but not necessarily for tax purposes. If there is no difference for tax purposes, then the cash flow would be unaffected. There is no difference in the treatment for tax purposes and thus no difference in the cash flow. I hope this helps.
Regards,
Wanda Lauziere
CFA Institute”
In my first post of her answer, I DELIBERATELY CHANGED HER RESPONSE TO SEE IF THERE WAS SOME “POWER-OF-SUGGESTION” WHICH AFFECTS PEOPLE’S ANSWERS HERE. Another words, if the “experts” say that 4+4=9, many people would agree with this assertion. I was trying to see if this “power-of-suggestion” had impacted people’s thinking on this group.
Thanks once again. You were right! Wanda was right as well! I was wrong.
I had no idea that CFO is not impacted.
 
Wow! That’s flattering really
Thanks Boston_Level2_Candidate ( do you have a shorter name?:-))
regards
Rajiv
 
boston_level2_candidate Wrote:
——————————————————-
> Rajiv75:
>
> You’re a true genius, and you’re going to pass
> Level 2 with flying colours. I’ll make a wage
> with you.
>
> Wanda’s, the CFA rep., had this to say: “Thank you
> for your inquiry; the text is correct as written.
> The difference in depreciation would have an
> impact on the statements for financial reporting
> purposes, but not necessarily for tax purposes. If
> there is no difference for tax purposes, then the
> cash flow would be unaffected. There is no
> difference in the treatment for tax purposes and
> thus no difference in the cash flow. I hope this
> helps.
>
> Regards,
> Wanda Lauziere
> CFA Institute”
>
> In my first post of her answer, I DELIBERATELY
> CHANGED HER RESPONSE TO SEE IF THERE WAS SOME
> “POWER-OF-SUGGESTION” WHICH AFFECTS PEOPLE’S
> ANSWERS HERE. Another words, if the “experts” say
> that 4+4=9, many people would agree with this
> assertion. I was trying to see if this
> “power-of-suggestion” had impacted people’s
> thinking on this group.
>
> Thanks once again. You were right! Wanda was
> right as well! I was wrong.
>
> I had no idea that CFO is not impacted.
I think I speak for the rest here when I say that we are all too edgy and tired to put up with that kind of crap right now. Someone probably came along while you were ****ing around and read that and now has incorrect information. Try your psychological crap after June 7th, please. Or not at all.
 
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