Documentation for recording business transactions is the general rule under the

Question

Documentation for recording business transactions is the general rule under the historical cost principle. There are principles and rules in accounting governing depreciation and amortization applications, but there is plenty of room for management to be creative in applying these rules. Discuss the different decisions and assumptions management can make regarding depreciation/amortization applications and how each will affect financial statements. Is there potential for fraud or misleading the users of financial statements?

(Simple examples please, thank you.)

Explanation / Answer

Depreciation and amortization are the process of allocation used costs of assets over the life of the assets. The estimation of life of assets and salvage value should be accurate otherwise they lead to the misstatement of financial statements depending upon the method of depreciation management decided to use.

For example, the choice of depreciation method between straight line method and double declining depreciation method allocates different amount of depreciation over the life of the assets. The depreciation amount under double declining depreciation method will be double of the depreciation amount under the straight line depreciation method.

The allocation of inappropriate depreciation is misstatement of financial information and leads to fraud. The over allocation of depreciation increase expense of business and in result reduces the net profit of business which directly impact the earnings per share and does not disclose the true picture of firm’s profitability.

In order to attract investors management reduces depreciation expense to increase profitability and earnings per share, by using the depreciation method which allows allocating lesser depreciation.

The Waste Management Company scandal of 1998 is the suitable example of inflating earnings through increasing the life of depreciable assets, the Waste Management Company reported fake earnings of 1.7 billion by increasing the life of depreciable assets.

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