An Acquisition Trick on Net Income

Posted in CFA by qmarks on April 20, 2010

When a firm acquires another, it pays a control premium which is recorded under goodwill. Internally generated goodwill is expensed as incurred. Goodwill is not amortized but must be tested for impairment at least annually. If impaired, goodwill is reduced and a loss is recorded in the income statement. The impairment does not affect cash flow.

Since goodwill is not amortized, firms can manipulate net income upward by allocating more of the acquisition price  to goodwill and less to the identifiable assets. The result is less depreciation and amortization expense, resulting in higher net income! Well they will also pay taxes on top of that, but think that if a firm is in need of an inorganic value creation, that goodwill trick is its rainy day friend.

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