Question

Earning Management Decision Grid

Classification	Accounting Choices Within GAAP
Conservative	Overly aggressive recognition of provisions or reserves Overvaluation of acquired in-process R&D in purchase acquisitions Overstatement of restructuring charges & asset write-offs
Neutral	Earnings that result from a neutral operation of the process
Aggressive	Understatement of the provisions for bad debts Drawing down provisions or reserves in an overly aggressive manner
	Accounting Choices That Violate GAAP
Fraudulent	Recording sales before they are realized Recording fictitious sales Backdating sales invoices Overstating inventory by recording fictitious inventory

Assessment of Reporting Strategy

Approach	Classification
Accelerated depreciation (for financial & tax reporting) of new equipment pursuant to Internal Revenue Code Sec. 179	Conservative
Failure to fully write down impaired non-operating assets	Fraudulent
Understatement of loan losses by a bank	Fraudulent
Reduced estimate of the useful lives of intangibles recorded as a result of business combination	Conservative
Capitalization of ordinary period expenses	Fraudulent
Capitalization of internally developed software costs	Neutral
Reducing the actuarially determined discount rate to compute the pension liability	Conservative

Do you agree with these classifications? Why or why not? What is the consequence of each method-understating or overstating income? When do they cross the line of conservation?

Answer 1

a. Accelerated depreciation of new equipment pursuant to Internal revenue code - This approach in financial reporting crosses the line of conservation and hence, disagree. This would result in high value of assets with balance useful life not recorded in the financial statements and understated of income due to high depreciation charge.

b. Failure to fully write down impaired non-operating assets - Agreed, this results in overstating the income/ understating expense hence fraudulent

c. Understatement of loan losses by a bank - Agreed, this results in overstating the income/ understating expense hence fraudulent

d. Reduced estimate of the useful lives of intangibles recorded as a result of business combination - Agreed, this would result in understating the income but is a conservative approach

e. Capitalization of ordinary period expenses - Agreed, this results in overstating the income

f. Capitalization of internally developed software costs - Agreed

g. Reducing the actuarially determined discount rate to compute the pension liability - Disagreed, this approach is not conservative as reducing the discount rate would result in higher pension liability than actual based on time value of money and this crosses the line of conservative.