In this video, learn about how depreciation life assumptions can be used as a tool for earnings management.
- [Instructor] Depreciation expense is the accountant's estimate of the value of long-term assets consumed in doing business this year. - For many companies, depreciation expense is an important component of net income. - The amount of the depreciation expense is impacted by the accountant's assumptions about how long the long-term assets will last. - [Instructor] Is that computer server going to last two years or four years? The amount of depreciation expense reported this year depends on what you assume about how many years over which to spread the asset cost. - Company managers sometimes strategically make these depreciation life assumptions in order to reduce reported depreciation expense, and, as a consequence, increase reported net income! - This is an example of earnings management using accounting assumptions. - Let's illustrate this with one of our favorite depreciation cases, Blockbuster Video. - Okay, now these days, with online streaming of video content, it's tough to find a physical video rental location. - [Instructor] In fact, as of 2019, there is only one remaining Blockbuster Video location, in Bend, Oregon, located right in the middle of the state of Oregon. - At its peak, there were more than 9,000 Blockbuster Video locations worldwide. - Blockbuster Video was the largest video rental chain in the United States, and everyone carried a blue and yellow Blockbuster Video membership card. - [Instructor] Okay, now back to depreciation accounting. On May 8th, 1989, a Wall Street investment analysis report was released that was critical of some of Blockbuster's accounting practices, particularly its depreciation policies. - The report suggested that the 40-year life Blockbuster used for depreciating intangible assets was much too long. - To quote from the report, "Have you ever seen a 40-year-old videotape store?" - Five years was suggested as a more reasonable depreciation period. - The report also criticized Blockbuster for increasing the depreciation period for its videotapes from nine months to 36 months. - [Instructor] Revising both of these items to use the shorter depreciation periods would've cut Blockbuster's 1988 net income almost in half, from 57 cents a share to 32 cents a share. - [Instructor] Release of this Wall Street investment analysis report caused Blockbuster's share price to drop from $34 to $26 in just two days, a drop of almost 25%! - [Instructor] This represented a decline in market value of approximately $200 million, all because of a disagreement about, of all things, depreciation accounting. - Now why would the release of the Wall Street investment analysis report cause Blockbuster's share price to decline by 25%? - The share price decline was likely caused by a number of factors. First, if investors were convinced that they had previously been valuing Blockbuster's shares based on artificially-inflated earnings, the share price would drop on the realization of that fact. - [Instructor] In addition, if this expose caused investors to doubt the integrity of Blockbuster's management, the share price would drop in the anticipation of the uncovering of even more bad news. - Well, Blockbuster's CEO was livid! - In a meeting with stock analysts, he showed a letter from the SEC ordering Blockbuster to switch to the longer 36-month videotape depreciation period, rather than continuing to use the shorter, nine-month period advocated in the investment report. - The CEO criticized the Wall Street investment report researchers for not understanding his business, and said that their report wasn't "worth the powder to blow it to hell." - Within two weeks of the release of the inflammatory report, Blockbuster's CEO was vindicated. - More careful thinking by investors about Blockbuster's depreciation practices convinced them that Blockbuster's depreciation assumptions had been reasonable all along! - Blockbuster's share price regained the 25% lost in the depreciation scandal frenzy. - As seen in this Blockbuster example, the amount of depreciation expense is impacted by the accountant's assumptions about how long the long-term assets will last. - The amount of depreciation expense impacts the amount of net income, which can then influence a company's share price. - Auditors, bankers, and investors need to carefully consider whether company managers have strategically made depreciation life assumptions in order to boost reported net income to reach targets, enhance income trend lines, and boost company valuations.
- Differentiate types of expenses and costs.
- Identify assets that are goodwill.
- Describe the reason underlying the choice between depreciation methods.
- Determine whether an asset is impaired.
- Describe the revaluation option available using IFRS rules.