Investor Beware: How Depreciation can be Manipulated to Inflate Earnings
Financial statements have been manipulated for as long as they’ve existed. While some manipulations may not be material, others mask more complex problems. Management may resort to such malpractices for financial incentives or worse, to hide problems at the company. Firms have found ways to manipulate financial statements within the confines of GAAP regulations, while still avoiding scrutiny and punishment. Depreciation is a common target, and recording less depreciation to boost income is one of the oldest tricks in the book.
How depreciation is recorded
Depreciation is a non-cash charge meant to reflect the decrease in the value of physical assets.
When a physical asset is purchased, it is recorded in the assets section of the balance sheet with no corresponding expense entry on the income statement. As the benefits derived from the asset would extend to more than one reporting period, a portion of the asset’s cost is shifted from the balance sheet to the income statement periodically in the form of depreciation. While this periodic recording is better than recording the entire expense in the beginning, it does not always accurately reflect the amount on the balance sheet or the income statement.
How it can be manipulated
Depreciation can be used to manipulate earnings. By increasing the useful life or the residual value (the expected price at the end of its useful life), annual depreciation can be reduced to minimise its effect on net income.
In 2013, an SEC order found that Hertz, a global car rental company, failed to adequately disclose its decision to extend the planned holding periods (useful life) for substantial portions of its US rental car fleet. The change has the potential to increase risk as the fleet is relying on older vehicles, and stakeholders weren’t informed. This artificially boosted their net income by lowering their depreciation expense for the current quarters, while increasing maintenance costs in the subsequent quarters. Many of the company’s top models, for example, had their planned holding periods extended from 20 to 24 or 30 months 1-3.
How Hertz benefitted from extending their vehicle holding period is explained with the help of the following hypothetical example. There are three things that will determine the depreciation expense on Hertz vehicles:a) the cost to acquire the vehicle; b) how long the company expects to hold it (useful life); and C) the amount it would realise on its disposition at the end of its useful life (residual value).
If a vehicle is purchased for $28,000, and is expected to have a useful life of 4 years and a residual value of $8,000, the depreciation in each of the four years using the straight line method would be $5,000, calculated as follows: ($28,000-$8,000)/4. The amount recorded at the end of each of the four years on the balance sheet, known as the carrying value of the asset, would be $23,000, $18,000, $13,000 and $8,000 respectively.
Upon the disposal of the vehicle, the depreciation expense would need adjustment should a difference exist between the net proceeds it receives for the vehicle and its remaining net book value. If the vehicle is disposed of after four years for $6,000, the difference will be $2,000 ($8,000 book value minus $6,000 selling price). $2,000 would be added to the depreciation expense to account for the difference.
If Hertz increases the useful life of the aforementioned vehicle from 4 years to 5 years, assuming the same residual value of $8,000 at the end of its useful life, the depreciation expense would be calculated as follows : (28,000-8,000)/5 = 4,000. A mere change of one year in the useful life of a single vehicle would be decreasing their depreciation expense by $1,000 and increasing their income by the same amount.
An overstatement in the vehicle’s residual value will increase the loss recognised when a vehicle is sold, but until then, the net income will be boosted by a lower depreciation expense.
Hertz’s infractions did not escape the SEC’s notice. The SEC order required Hertz Global to pay a $16 million penalty for various accounting violations, including, manipulation of depreciation expenses. Without admitting or denying wrongdoing, Hertz CEO and chairman Mr. Mark Frissora agreed to reimburse Hertz $1,982,654, and also pay a $200,000 civil penalty. The settlement required a Judge’s approval4.
While Hertz increased the useful life of its vehicles, Waste Management Inc., an American waste management company, engaged in similar deceitful activities.
Disposing of expenses
Waste Management Inc was found to have inflated the salvage/residual values, and extended the useful lives, of the company’s garbage trucks from 1992 to 19975. In collusion with their auditors, Waste Management Inc. eliminated or deferred current period expenses by extending the useful lives of their garbage trucks and making unwarranted increases to the truck’s residual value. To put it simply, the more their trucks were used, the higher they’d be valued.
The company would get each of its operating units known as “Groups” to record their operating results. The depreciation expense would be recorded using an eight-year useful life and no salvage value. Unbeknownst to the Groups, management were making top-level adjustments. For example in 1993, management assumed a useful life of 12 years and a salvage value of $30,000. A macro calculation was then made to utilise the impact it would have on the operating income6, which artificially decreased quarterly depreciation expenses.
The Devil is in the Detail
As shown in the examples above, depreciation is a non-cash expense based on management discretion. But there are a few components that can be altered to decrease depreciation expense and boost income. While any changes to the calculation of depreciation should be adequately disclosed to stakeholders, it’s clear that this needs to be monitored.
Assessing the management of depreciation is a key element of the Blue Oceans analysis methodology. It sits alongside a range of other checks-and-balances that are used to unearth any potentially fraudulent activity, all focussed on protecting investors’ portfolios.
- SEC (2019). SEC.gov | SEC Charges Hertz with Inaccurate Financial Reporting and Other Failures. [online] Available at: https://www.sec.gov/enforce/33-10601-s [Accessed 16 Feb. 2021].
- ?Geller, R., Llp, D., Rudman, S., Kaufman, E. and Capeci, M. (n.d.). CLASS ACTION FOURTH CONSOLIDATED AMENDED COMPLAINT FOR VIOLATIONS OF THE FEDERAL SECURITIES LAWS DEMAND FOR JURY TRIAL. [online] . Available at: http://securities.stanford.edu/filings-documents/1051/HTZ00_01/201631_r01c_13CV07050.pdf [Accessed 16 Feb. 2021].
- Jackson, S.G. (2020). An Analysis of Fraud in the Context of Depreciation Manipulation. [online] PDXScholar. Available at: https://pdxscholar.library.pdx.edu/honorstheses/914/ [Accessed 16 Feb. 2021].
- Sweet, P. (2019). Ex-Hertz CEO to pay $2m over accounting fraud charges | Accountancy Daily. [online] Available at: https://www.accountancydaily.co/ex-hertz-ceo-pay-2m-over-accounting-fraud-charges [Accessed 25 Feb. 2021].
- AsiaOne. (2020). 3 famous stock frauds you may have never heard of… and key lessons for investors. [online] Available at: https://www.asiaone.com/money/3-famous-stock-frauds-you-may-have-never-heard-and-key-lessons-investors [Accessed 1 Mar. 2021].
- Sec.gov. (2021). Complaint: SEC v. Dean L. Buntrock, Phillip B. Rooney, James E. Koenig, Thomas C. Hau, Herbert A. Getz, And Bruce D. Tobecksen. [online] Available at: https://www.sec.gov/litigation/complaints/complr17435.htm [Accessed 1 Mar. 2021].