Question

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

1. How can a company increase earnings by changing its depreciation method?
2. How can a company increase earnings by changing the estimated service lives of depreciable assets?
3. How can a company increase earnings by changing the estimated residual value of depreciable assets?

• The initial post must consist of 150-200 words.

Answer 1

Earnings management is probably the most troubling outcome of accrual accounting. Earnings management can take two forms -

a)Changing accounting methods, which is a visible form of arnings management.

b)Changing accounting estimates and policies that determine accounting numbers ,which is hidden form of earnings management.

1) Company can fiddle with the method and rate of depreciation to increase its earnings. By changing depreciation method from Accelerated depreciating (Double declining) method to Streight Line method ,comapny can increase its earnings.In Accelerated method ,depreciation expense would be more in earlier years and less in later years. Thus earnings can be manipulated by changing method of depreciation for newly acquired asset from Accelerated to Streight Line and visa versa.

2) Company could also increase its earnings by changing the assets service life. Longer the assets life ,lesser would be the dpreciation per year. Eg. for an asset worth of $5,000 with useful life of 5 years would be having $1000 per year as depreciation under streight line method. But if we make it to the asset life from 5 years to 7 yeras ,the dpreciation would be $715 per year under streight line method. Thus we can increase earnings by decreasing depreciation expense in income statement while increasing the useful life of an asset.

3) Company can also increase earnings by increasing residual value of an asset. Normally depreciation is calculated on depreciable base, which is equal to the capitalized amount minus its salvage value (if there is salvage value for it) .So if we increase 'residual value ' or 'Estimated Salvage Value' of an asset would mean that the asset has lower depreciable base and lower depreciation expense per year. thus we can increase earnings by increasing residual values of a depreciable asset.

Periodic Depreciation = Depreciable base / Estimated useful life