David, supervisor for the ABC Corporation, is preparing the companys income statement at year-end of 2014. He notes that the company had decided and replaced one of its equipment and lost $60000 on the sale of that equipment which was costs 150000 and its depreciation is $50000. Since the company has sold equipment routinely in the past with amount of $40000, David knows the losses cannot be reported as unusual. He also does not want to highlight it as a material loss since he feels that will reflect poorly on him and the company. He reasons that if the company had recorded more depreciation during the useful life of the assets (increasing the depreciation with 80%), the losses would not be so great. Since depreciation is included among the companys operating expenses, he wants to report the losses along with the companys expenses, where he hopes it will not be noticed.
1. Is there an earnings management problem in the above case study? If so specify which type of earnings management and Explain the problem in details.
2. If the supervisor record more depreciation during the useful life of the assets in 2014, what is the value of the increase in depreciation, would this be counted as a violation to the generally accepted accounting principles? Identify and discuss the accounting principle that would be violated, if any.
3. Assume that the operating net income for the year 2014 is $300000, what is the effect of the loss on the operating net income before and after increasing depreciation.
4. What is the effect of the proposed accounting treatment on balance sheet of 2014? Specify exactly where the effect will be.
5. How David proposal will affect the net cash flow from operating activities? Explain and determine the value of the change.
6. What should David do? Discuss in any of financial statement should be reported the losses arising from the sale equipment, specify the section of financial statement.
7. Discuss the negative consequences that might be caused by the earnings management practices.