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.

Address the following:

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? Please explain your response.

Answer 1

1. Depreciation is a measure of the wear and tear of the asset and does not involve actual cash outflow. There are two primary methods of depereciation available for use i.e. the straight line method and double declining method. Suppose a company is using the double declining method in the first year of its operation. By switching to straight line method, a company can increase its profits as the depreciation charge under staright line method is much less. This is not an effective method to manage earnings. It is a merely a window dressing method. A depreciation method once chosen should be followed consistently unless there is a valid reason to change it.

2. Suppose, a company has an asset whose book value is $10000 , however the expected earnings over remaining life of the asset are only $2000, the asset can be impaired by $8000 to decrease the profitability. Vice-versa , an asset impairment decision can be delayed to show increased profitability. An impairment decision when based on logical calculations can be beneficial to the company as the asset is then stated at a value which is accurate. However, asset impairment should not be used as a ploy to report manipulated profits as per convenience.