Question

Companies are often under pressure to meet or beat Wall Street earnings projections in order to increase stock prices and also increase the value of stock options. Some resort to earnings management practices to artificially create desired results.

Discuss how a company can manage earnings by changing its depreciation method. Is this an effective technique to manage earnings? Please explain your response to this question.

Using a fictitious example and numbers you make up, describe in your own words how asset impairment losses could be used to manage earnings. How might this benefit the company?

Answer 1

Ans : - Depreciation plays an important part in deciding the financial results of any enterprise. Depreciation on asset does not equate actual outflow of resources but acts as a deduction while computing total income. By changing its depreciation policy, company can artificially alter its results. By increasing the depreciation claim, Company can reduce its Profits after depreciation , thereby reducing its tax expense at the same time. Similarly, the vice versa of the beforementioned scenario also works out. Hypothetically speaking, where there is a pressure on the company to show higher results, company can resort to showing less depreciation, thereby increasing profits. Increased profits in turn show increased share prices. Thus, altering depreciation policy is an effective way to create artificial results.

Similarly, asset impairment losses could also be used to manage earnings. For example, Company wants to show reduced earnings this year to avoid dividends. It can resort to impairment of its assets which will lead to recognition of impairment losses which in turn will be reported in the income statement as an expense and lead to reduction of profits.