Earnings Management AP7-8 Edward L. Vincent is CFO of Energy Resources, Inc. The
ID: 2517575 • Letter: E
Question
Earnings Management AP7-8 Edward L. Vincent is CFO of Energy Resources, Inc. The company specializes in the exploration and development of natural gas. It's near year- end, and Edward is feeling terrific. Natural gas prices have risen throughout the year, and Energy Resources is set to report record-breaking performance that will greatly exceed analysts' expectations. However, during an executive meeting this morning, management agreed to "tone down" profits due to concerns that reporting excess profits could encourage additional government regulations in the industry, hindering future profitability. Edward decides to adjust the estimated service life of development equipment from 10 years to 6 years. He also plans to adjust estimated residual values on development equipment to zero as it is nearly impossible to accurately estimate residual values on equipment like this anyway Required: Explain how the adjustment of estimated service life from 10 years to 6 years will affect depreciation expense and net income Explain how the adjustment of estimated residual values to zero will affect depreciation expense and net income. In addition to heading off additional government regulations, why might Energy Resources have an incentive to report lower profits in the current period? 1. 2.Explanation / Answer
.1 REDUCTION OF ESTIMATED SERVICE LIFE
Assume,
Initial cost of depreciable Asset=C
Estimated Residual Value =R
Useful life in years=N
Annual Depreciation =(C-R)/N
As N decreases, the amount of annual depreciation increases.
If N is reduced from 10 to 6 annual depreciation will go up from (C-R)/10 to (C-R)/6
If C-R=$10,000,000
With N=10, Annual Depreciation=(10000000/10)=$1,000,000
With N=6, Annual Depreciation=(10000000/6)=$ $ 1,666,667
There is increase of depreciation expense by 66.7%
If the depreciation expense goes up, the net income will reduce since
Net Income=(Revenue) minus (Expenses)
.2.ADJUSTMENT OF RESIDUAL VALUES
Depreciation Expense=(C-R)/N
Where, C=Initial Cost
R=Residual Value
N=Useful life
If R is reduced , Depreciation expense will increase
If Residual value is reduced to zero,
Depreciation expense=C/N which will be higher.
For example,
Assume,
C=$1,000,000
R=$100,000
Useful Life=N=10 years
Depreciation expense=(1000000-100000)/10=$90,000
If residual value=Zero,
Depreciation expense=(1000000/10)=$100,000
Depreciation expense increased by more than 10%
This will reduce net income
.3 In addition to government regulation, the other incentive for reporting less profit is to reduce taxes. With lower income reported, the tax will be lower.
There may be other incentives like toning down the shareholders expectation
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