I am reading purchase method (Financial statement section) and found that companies tries to understate FMV of assets and over state liabilities to maximize good will. It also says that maximizing good will increase earnings because goodwill can never be amortized. I did not understand how maximizing goodwill will improve income statement. any ideas?
Havent touched FSA in a while but here’s what I recall: When doing a purchase price allocation, you allocate the purchase price to both tangible and intangible assets (inlcuding goodwill). The tangible assets are generally depreciated whereas goodwill is just tested annually for impairment. Therefore the more you have attributed to goodwill, the less that is in depreciable tangible assets. That depreciation finds its way into the income statement as depreciation expense, and thus lowers Net Income. So overstating goodwill can help lower depreciation expense and boost earnings.
That makes sense. I thought companies are willing to use depreciation to save tax dollars which is good for investor. I guess good long term companies who don’t care short term net income might prefer to use depreciation and don’t understate assets to get good will. Thanks for quick response.
chinni, Don’t confuse book income with tax. They don’t have to be the same. Most companies will use accelerated deprciation for tax and SL for book to maximize book income, but keep cash taxes paid low. The difference is what creates the DTL on the balance sheet.
I think Companies are allowed to use different methods for financial and tax reporting in this instance just as they can use accelerated methods for tax purposes yet straight methods for financial accounting with capitalized assets. Edit: agree mwvt9 - you beat me to it.
Thanks for replies. I will keep in mind that separate statements exists for tax purpose.