Warning Signs in Accounting Choices: Depreciation, Non-operating Income, and Other

There are many potential warning signs to watch for when performing financial statement analysis. Consider the choices surrounding depreciation estimates. If a company used lower salvage values and shorter useful lives, than the industry average, how would that affect net income?

No. These choices will push income in the same direction.

No. Consider that a lower salvage value will increase depreciation expense, which reduces net income.

Right! Both the lower salvage value and shorter useful lives serve to increase depreciation expense, which will cause net income to be lower. Doing the opposite would artificially inflate net income, as assets would be booked as having lives that are too long and values that are too high when those lives are over.

In order to increase earnings in a given period companies may be motivated to include non-operating gains in revenue. To illustrate, assume a cleaning firm sold some old equipment that had been fully depreciated. The firm recorded USD 30,000 received for this equipment as sales revenue when preparing the financial statements. Total revenue reported with these sales was USD 120,000 resulting in net income of USD 35,000 after expenses. How do you think this choice impacted the quality of the earnings reported?

"Fourth quarter surprises" can be either good or bad. In some cases, companies will use aggressive techniques to boost sales in the fourth quarter to meet earnings expectations. Significant transactions with related parties may cause concern about whether transactions may be biased. Transactions that benefit management and other "related-party transactions" should also be examined carefully.

Incorrect. Earnings quality is affected when transactions are not appropriately recorded or disclosed.

Right. The inclusion of the gains as sales revenue results in sales revenues being overstated by USD 30,000.

Incorrect. The inclusion of the gain as sales revenue won't cause higher quality earnings. Consider that this is not a sustainable source of revenue.

When presenting non-GAAP financial measures, exclusions often include items that are labeled nonrecurring, infrequent, or unusual. Of course things look better if some expenses are classified this way, and so analysts should evaluate whether these items truly are nonrecurring or whether the expenses were labeled as such to project a better picture of performance. Similarly, when restructuring charges are shown on financial statements, often times they are presented as a one-time occurrence and may be excluded in pro-forma reports. Although these charges are shown at only one point in time, it is unlikely that the circumstances that warranted the restructuring charges occurred in one fiscal period, but more likely over a number of periods.

Assume that Big Blue Tractor Company had acquired Big Red Tractor Company five years earlier. In the current year, Big Blue reports impairments of USD 500,000 related to assets acquired from the acquisition. In order to evaluate the historical earnings of Big Blue, how do you think an analyst might make pro forma adjustments to prior years' earnings?

Correct. The analyst would most likely allocate the impairments over the five years since acquisition to establish a trend of earnings for the five-year period.

Incorrect. A reduction in earnings in only the year of acquisition would not establish an earnings trend.

Incorrect. To establish a trend, the analyst would not only focus on the most recent two years.

Finally, the culture of management may have an impact on accounting choices and the way financial information is presented. One situation that should be carefully analyzed is when younger companies start to reach maturity. At this point, management may find it more difficult to meet growth and earnings projections than in the early years, which could result in aggressive practices or other decisions in an effort to continue positive reporting.

Perhaps the company aims for extensive growth from acquisitions. This company is acquiring another large firm in the current year and is concerned about the impact on earnings from the revaluation of the assets acquired. Management is considering undervaluing the depreciable assets acquired and allocating more of the purchase price to goodwill. How do you think this will impact earnings reported?

Incorrect. Lower value on depreciable assets results in less depreciation expense.

Correct. If less of the purchase price is allocated to depreciable assets, depreciation expense will be lower resulting in higher earnings. Another warning sign is intentionally overstating the amount of liabilities from an acquisition. Overstating the liabilities increases the allocation to goodwill. When the liability is reduced in a later period, earnings will be increased. Overstating the liabilities at the time of acquisition essentially banks earnings to be used at a later time.

Incorrect. The allocation of the purchase price between goodwill and depreciable assets will impact earnings.

To summarize: [[summary]]

These two choices have competing effects

These would both serve to increase net income

These would both serve to decrease net income

No impact because earnings are the same

The earnings reported are low quality since revenues include the gain

The earnings reported are high quality because earnings reported are positive with the inclusion of the gain

Reduce the previous two years earnings by USD 250,000 each

Reduce the earnings from the year of acquisition by USD 500,000

Reduce the earnings of each of the last five years by USD 100,000 each

Earnings will be lower

Earnings will be higher

Earnings won't be impacted.

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