Question

Do you believe that the management of a public company (i.e. listed firm on a stock exchange) is able to manage the firm’s earnings and overstate its financial performance through the change of accounting estimates related to the depreciation policy? Explain your answer and provide examples of a hypothetical and/or a real firm that engaged in such accounting practices. Please also provide a brief discussion of the reasons that may explain the behavior and the accounting choices of the firm’s top management in the above described context

Answer 1

Depreciation expense and net income are both net income line items. An understatement of depreciation causes retained earnings to be overstated. Accounting estimates involve judgment regarding expected future benefits and obligations pertaining to the assets and liabilities (and the income and expense pertaining to such assets and liabilities). They are based on the information that best reflects the circumstances prevailing at the date of estimation. Since they are very subjective in nature, they might need revisions and re-estimation. They should be revised when changes occurs in the conditions and circumstances that were prevalent when the estimates were formed.

International Accounting Standard 8 (IAS 8) Accounting Policies, Changes in Accounting Estimates and Errors provides guidelines about handling changes in the accounting estimates. According to IAS 8:

The effect of a change in an accounting estimate shall be recognized prospectively by including it in profit or loss in:

• the period of the change, if the change affects that period only, or
• the period of the change and future periods, if the change affects both.

However, to the extent that a change in an accounting estimate gives rise to changes in assets and liabilities, or relates to an item of equity, it is recognized by adjusting the carrying amount of the related asset, liability, or equity item in the period of the change.

The change in accounting estimated affects only the current period in which the change is made and the future periods. Previous periods will not be affected by the changes in accounting estimates. Previous periods are affected only if correction of errors is required which is a separate case. The effects of changes in accounting estimates will take affect the financial statements prospectively, not retrospectively.

Accumulated Depreciation

Accumulated depreciation is the total amount of depreciation expense that has been recorded so far for the asset. Each time a company charges depreciation as an expense on its income statement, it increases accumulated depreciation by the same amount for that period. As a result, a company's accumulated depreciation increases over time, as depreciation continues to be charged against the company's assets.

A company can increase the balance of its accumulated depreciation more quickly if it uses an accelerated depreciation over a traditional straight-line method. An accelerated depreciation method charges a larger amount of the asset's cost to depreciation expense during the early years of the asset.