Officials believe that the management of Farsight is attempting to understate its net income in order to avoid making any concessions in the labor negotiations. Which of the following actions by management will most likely result in low quality earnings? A) Lowering the discount rate used in the valuation of the company’s pension obligations. B) Lengthening the life of a depreciable asset in order to lower the depreciation expense. C) The recognition of revenue at the time of delivery rather than when payment is received. Your answer: A was incorrect. The correct answer was B) Lengthening the life of a depreciable asset in order to lower the depreciation expense. Certain GAAP rules can be exploited by companies in order to achieve specific goals, while still remaining within the letter of the law. Aggressive assumptions, such as lengthening the depreciable life of an asset, that are utilized to boost earnings results in a lower quality of earnings. (Study Session 7, LOS 26.d) I thought PBO assumptions were the most manipulated by management. Why would A apply in this case?
when you reduce discount rate - you are increasing pension expense, reducing Net Income ( earnings ) - so you are more conservative. Lengthening depreciable life - on the other hand - reduces depreciation expense, increases earnings. So you are being AGGRESSIVE. - which is bad. Recognizing revenue at the time of delivery is consistent with the accrual method, so by itself it is not bad. So in this case - manipulation of earnings is only with B.
I agree with cp’s reasoning, but in this case management’s intention is to understate net income. Earnings manipulation can go either way, depending on the intended outcome. Although the assumption is to manipulate net income upward, companies can also try to manipulate earnings during the year to have a blowout year end number.
answer B by POE on the others
This does not make sense. The company would want to report a lower net income to show labor that we are not generating income. By lengthening the year of depreciation we are actually increasing the income. Answer A makes perfect sense over here. Or is the first sentence of the question not related to the actual question?
This is a shock! and quite misleading, both conservative and aggressive approach can be termed low quality depending on management objective. firms who don’t want to give staffers increase or pay commensurate tax tend to understate income.
piggybacking on what CP said - the action will result in higher earnings but read into the question - these boosted earnings will be lower QUALITY earnings. As an analyst you will determine that these are not good quality earnings.
Beanz Wrote: ------------------------------------------------------- > piggybacking on what CP said - the action will > result in higher earnings but read into the > question - these boosted earnings will be lower > QUALITY earnings. As an analyst you will > determine that these are not good quality > earnings. Please explain to me how intentionally lowering the discount rate in order to boost up pension expense is “high quality.”
bp - they never mentioned anything about “intentionally” lowering discount rate. also - if they did - they lose. So no one would “intentionally” do that… but once established - changing the salvage value, depreciable life etc. is intentional…
CP - in this case they want to “lose.” Lowering their NI is the name of the game. In and of itself, B would be correct. However, how can you discredit the 1st sentence in this case?
I’d say the question is meant to be misleading. It does not mentions that they are trying to lower Net Income. But, the questions doesn’t ask which is the best method to do so. The question is asking which would lower earnings quality. Changing PBO assumptions does not affect the earnings quality ratio; and recognizing revenue at the time of delivery is consistent with accrual accounting. B, lengthening the depreciable life decreases CFO while increasing NI. Thus, earnings quality ratio will fall. Earnings Quality = (CFO + Cash Payments for Interest and Income Taxes)/(Net Income + Interest Expense + Income Tax Expense)
question – why would CFO reduce because of Depreciable life increasing? Depreciation is non-cash. Got removed while getting Net Income which increased - is added back for CFO… NO IMPACT…
My bad, it would not affect CFO. It would, however, increase NI, lowering the overall ratio. Thanks for noticing. Bryan