Chapter 7, Problem 7.8APEM

Earnings Management

Edward L. Vincent is CFO of Energy Resources, Inc. The company specializes in the exploration and development of natural gas. It’s near year-end, and Edward is feeling terrific. Natural gas prices have risen throughout the year, and Energy Resources is set to report record-breaking performance that will greatly exceed analysts’ expectations. However, during an executive meeting this morning, management agreed to “tone down” profits due to concerns that reporting excess profits could encourage additional government regulations in the industry, hindering future profitability.

  Edward decides to adjust the estimated service life of development equipment from 10 years to 6 years. He also plans to adjust estimated residual values on development equipment to zero as it is nearly impossible to accurately estimate residual values on equipment like this anyway.

  Required:

  1.    Explain how the adjustment of estimated service life from 10 years to 6 years will affect depreciation expense and net income.

  2.    Explain how the adjustment of estimated residual values to zero will affect depreciation expense and net income.

  3.    In addition to heading off additional government regulations, why might Energy Resources haw an incentive to report lower profits in the current period?