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# Earnings management

The company X has been in business for 100 years. For the last 3 years this company reported operating losses. The controller identified three areas in which company X has some flexibility in its accounting assumptions: depreciation, bad debts, and pension accounting. How the controller can use accounting assumptions in these 3 areas to improve company's X reported earnings? Which set of financial statement users is most likely to be influenced by this earnings management?

#### Solution Preview

Hi there,
First, here is some background information on the three stated accounting assumptions:

Depreciation is an estimate of the decrease in the value of an asset, caused by "wear and tear", obsolescence, or impairment. The use of depreciation affects a company's (or an individual's) financial statements, and, in some countries, their taxes.

In economics, depreciation is the decrease in value of the capital stock (physical depreciation).

There are several methods for calculating depreciation, generally based on either the passage of time or the level of activity (or use) of the asset.

Straight-line depreciation:
Straight-line depreciation is the simplest and most often used technique, in which the company estimates the "salvage value" of the asset after the length of time over which it is depreciated, and assumes the drop in the asset's value is in equal, yearly increments over that amount of time. The salvage value is an estimate of the value of the asset at the time it will be sold or disposed of; it may be zero. For example, a vehicle that depreciates over 5 years, is purchased at a cost of US\$17,000, and will have a "salvage value" of US\$2000 will depreciate at US\$3,000 per year. (17,000 - (5 x 3000)) = 2000

If the vehicle were to be sold and the sales price exceeded the depreciated value (net book value) then the excess depreciation would be considered as income by the tax office.

If a company chooses to depreciate an asset at a different rate from that used by the tax office then this generates a timing difference in the income statement due to the difference (at a point in time) between the taxation department's and company's view of the profit.

Declining-balance:
The declining-balance method is a type of accelerated depreciation, because it recognizes a higher depreciation cost earlier in an asset's lifetime. This may be a more realistic reflection of an asset's actual resale value, as well as the expected benefit from the use of the asset: many assets are most useful when they are new. In the U.S., a form of declining-balance depreciation, MACRS, is used for tax purposes.

In declining-balance depreciation, each period's depreciation is based on the previous year's net book value, the estimated useful life, and a factor. The factor is commonly two; this is known as double declining-balance.

Activity:
Activity methods are not based on time, but on a level of activity. This could be miles driven for a vehicle, or a cycle count for a machine. When the asset is acquired, we estimate its life in terms of this level of activity. Assume the vehicle above is estimated to go 50,000 miles in its lifetime. We calculate a per-mile depreciation rate: (\$17,000 cost - \$2,000 salvage) / 50,000 miles = \$0.30 per mile. Each year, we then calculate the depreciation expense by multiplying the rate by the actual activity level.