Question

Is the management able to influence the amount of depreciation and amortization? What are the motivations behind possible manipulation of depreciation?

Answer 1

Yes, it is possible for the management to influence the amount of depreciation and amortization. This is generally achieved by modifying/changing the depreciation rate, reducing/increasing the economic life of the asset, changing the method of depreciation and revaluing assets on a regular basis. Through all of these methods, the management might be able to alter the value of its annual depreciation expense, thereby, having a direct impact on the company's financial statements. For Instance, the economic life of an asset having a value of $50,000 may be increased from 5 years to 8 years. This will reduce the annual depreciation expense from $10,000 (50,000/5) to $6,250 (50,000) assuming straight line method depreciation. This change will have a direct impact on the company's profitability as it will increase the company's income by an amount of $3,750 (pre-tax). Such a change may be made anytime during the life of the project. Some of these methods of influencing depreciation expense may even go undetected and may appear to be in compliance with GAAP.

A reduction in the value of depreciation charge would increase the company's income and an increase in the depreciation expense would reduce its taxable income. The basic objective behind such an alteration would be demonstrate higher profitability for the company (if a lower depreciation expense is reported in the income statement) to the shareholders or to reduce the company's tax liability (if a higher value of depreciation is reported in the income statement). Showing higher profitability may be required in order to satisfy the investors with the company's performance (when infact it is not the case) or/and to earn performance based incentives (when management's compensation is linked to company's financial performance).