Question

Companies often are under pressure to meet or beat Wall Street earnings projection in order to increase stock prices and also to increase the value of stock options. Such pressure may cause some managers to alter their estimates for depreciation to artificially create desired results.

REQUIREMENT 1: From your understanding of the chapter, how can managements estimates affect the amount of depreciation expense on the company's financial statements?

REQUIREMENT 2: Are the decisions of investors and creditors affected by these accounting estimates?

REQUIREMENT 3: Should a company alter depreciation estimates for the sole purpose of meeting expectations of Wall Street analysts?

ADAPTED FROM AP 7-5 - Financial Accounting 5th Edition Spiceland

Please answer the requirements above using your knowledge of Long-Term assets from Chapter 7.

Answer 1

1. Yes.

Depreciation is affected by management’s choice of depreciation method (such as straight-line, double-declining-balance, or activity-based) and by management’s estimate of the asset’s useful service life and residual value. Depreciation expense is reported as an expense in the income statement. Accumulated Depreciation is reported as a contra asset in the balance sheet.

2. Yes.

Many amounts reported in financial statements are based on estimates by management, and these estimates are a crucial part of the information set used by investors and creditors to make decisions. To the extent that these estimates are materially misstated by management, financial reporting provides misleading information.

3. No.

Even though Wall Street analysts place extensive pressure on companies to meet earnings expectations, management and the company’s auditors have a legal and ethical responsibility to fairly report all estimates, including those for depreciation. A successful defense for misreporting financial performance cannot include pressure from external decision makers.