Financial Quality - Straight line vs Accelerated dpn

Hey guys,

I was under the impression that changing to a straight line depreciation method from a declining is poor financial quality?

This is a question from a schweser item set where the company changed from accelerated to straight line

"Which of the following is more indicative of lower earnings quality?

a) the change in discretionary expenses

b) the change in the company’s depreciation method

c) the company’s use of LIFO inventory cost flow assumption

In the answer it states:

“the change to the straight line depreciation method is certainly less conservative. However measuring earnings quality based on conservative earnings is an inferior measure as most accruals will correct over time”

Can somebody please explain?

It is less conservative - by changing depreciation methods you are lowering expenses and raising Net Income, since accelerated depreciation shows higher depreciation.

The point that the CFA text is trying to get across is that management tries to make themselves look better by increasing Net Income (which changing depreciation would do) but is bad for earnings quality because the company is manipulating earnings through accounting tricks. They more than likely still use accelerated depreciation for tax purposes (most firms would), so it seems as though they are lowering reported expenses.

LIFO inventory - usually higher COGS since costs rise. This is the recommended approach for COGS expense.

Change in discretionary expenses - they dont tell you if DS is up or down, so you don’t necessarily know

Was the answer “A” and did the question mention that discretionary expenses decreased?

I think the point that the answer explanation is trying to make is that both straight-line and accelerated depreciation will report the same expense over time. So while accelerated depreciation is more conservative (more expense up front), being more conservative is not necessarily better as analysis that is both too conservative or aggressive is flawed.