Now we'll say a few words about accounting treatment of M&As. Here there are quite a few details, but we will concentrate on one aspect that will remind us something that we saw in a third accounting course. Namely, the various approaches to treatment of something that at some point in time are treated by FASB as a, As maybe conflicting, and then as a result they make a decision to leave only one. I am talking about two approaches of M&A transactions, namely pooling versus purchase. Now what we're talking about here? So pooling, Versus purchase. I'll give an example. Let's say this is Company A. And its grossly simplified balance sheet looks like this. Total tangible assets of $800 million, total liabilities of 400, and then net worth also of 400. That obviously makes 800, so this is Company A. Now, Company B. So this Company A will be the, let's put it this way, I will put Company B, so this is the bidder. And then the other will be the target, Company T. Again, here we have total tangible assets of 300, and then total debt of 100, and the net worth of 200. So these are the participants in the transaction. And now let's say that B, Buys, T for $400 million in stock. $400 million in stock. Now, this is the set up. So what we can see is that the book value of net worth of Company T is just $200 million. So we pay a premium to the book value. So clearly there are two approaches to that. One is that we just, pooling means that we take total tangible assets, total liabilities, they put that together and that results in the net worth. And purchase is different. So let's say what happens under pooling. Under pooling, We have company BT, which is together. And that is total tangible assets of $1100 million now, and then total debt of 500, and then total net worth of 600. So we had 400 of Company B and 200 of Company T. So we just put that all together, and the resulting thing will be 1100. And here we sort of keep the original, Historical, Cost. So basically, you can see right away that in pooling the whole idea of an acquisition, of a purchase, it is not reflected. That is what we will see in just a few minutes, was the main objection of the accounting regulatory bodies that said that this is actually skewing the information. Now, under purchase, it's different. So what do we have under purchase? Let's analyze this. Again, this is the same company, BT, but now we have total tangible assets are still 1100. Now debt, we also put it together, this is 500. But now, see what happens. Our net worth under purchase is higher, it's 800. Why? Because this is 400 from Company B plus 400 for Company T. So that is what we purchased. And now you can see that the result is here, 1300. Here we have something that is missing, and that something is goodwill. Which is 200. So now we can see that the asset basis is stepped up, it's higher. Because we, Company B, when we decided to buy Company T, we agreed to pay a premium for something that is special in this company. And it's reflected by this goodwill. And therefore, we can say that now we have new historical cost. So that is the general description on this small example. Now, let's see how we can compare these two approaches. So this is pooling, This is purchase. And we will study the effect of this approach first of all on net income, on cash flow, and on leverage. Well, we can say that under purchase the net income is lower because we pay a premium. Well, at the same time we can see that because of this new stepped up basis, because of the amortization of goodwill, we can actually compensate some of this. And therefore cash flow, Is let's say equal, Or higher. Well, this is, I would not go deeper in that because it depends upon higher to what? But the idea is that when you purchase, although you pay this premium, but you can have some savings on the depreciation of that. Remember, we talked about depreciation in much greater detail in our corporate finance course and in our accounting course. And then we said that because this is not a cash expense, that by producing amortization tax shields in this case of intangible assets, that contributes to cash flow. But the most interesting thing is the effect on leverage, because obviously for purchase the leverage is lower. Why is that? Because in pooling, this is just the sum of the liabilities of both companies. But here we pay with stock. So the net worth part, because of the premium, is higher. So maybe it's one of the ideas that these things, they contribute to the fact that purchase then was preferred. Now, in 1999, FASB 1999 rule, they said that we leave only purchase. So pooling was claimed to be a poor way of treatment. Why is that? So some observations, they said pooling, Provides less information. Now pooling, Ignores, I will put ignores quotedly, acquisition, And premium. And basically the idea was that purchase, Provides more, And better, Information. So that was the key story. And remember, well, this is just, it's not an analogy, it's just some metaphoric analogy, if you will. Remember, when we talk about accounting, we compared FIFO and LIFO treatment of inventories. And then we said that for a long time people could use one for showing the income and the other for tax purposes. And that would be sort of a mix, and that would be misleading the investors. Here the situation was not as bad. But again, as we saw in our previous episodes, the main headache of regulators, and the main goal, is to make sure that there are no abuses of the participating investors, specifically those who do not have a lot of resources and potential to protect themselves. Therefore, the idea of more and better information is key in the fact that, after all, purchase was preferred to pooling. Now that was just an example. And in what follows in the next final episode, we will also say a few words about tax factors that play an important role in M&A transactions. And we will see how people account for taxes in terms of taxable, non-taxable, or deferred tax transaction.
