Driscoll Disposall is a waste disposal company Its managemen

Driscoll Dispos-all is a waste disposal company. Its management has done the following: Assigned unsupported and inflated salvage values and extended the useful lives of company garbage trucks. Assigned arbitrary salvage values to other assets that previously had not salvage value Did not record expenses required to write off the costs of unsuccessful and abandoned landfill development projects Improperly capitalized a variety of expenses. Did not establish sufficient liabilities for income taxes and other expenses. 7-7. Explain the effect these actions would have had on Driscoll\'s reported earnings and its balance sheet. What impact would this have on ratio analysis? Consider specifically current ratio, return on assets, return on equity, profit margin on sales. debt-to-asset ratio. See page 232 in Chapter 5 Appendix 5A. Would there be any impact on CFFO? 7-8. 7-9. What motivations could have driven management to engage in these actions? WHY? 7-10. To identify these tricks, at what relationships could you examine in the comparative financial statements and notes? 7-11 Which external stakeholders would be affected by this earnings manipulation and WHY?

Solution

Ans:7-7:

Unsupported and Inflated salvage values of garbage trucks will reduce the depreciable amount of asset and with the reduced depreciation base and extended useful lives of trucks, depreciation expenses will reduce significantly. This will increase both the net income (reduce the net loss) reported by income statement and the amount of assets on the balance sheet

Assigning the arbitrage salvage value to other assets will have the same effect as above i.e. reduced depreciation expenses that result in high profits (reduced losses) and assets value.

Failure to write-off unsuccessful and abandoned landfill development projects would result in overstated net income and assets.

The improper capitalization of a variety of expenses will also increase the profit and assets of the business because capitalized expenses are written off over a number of years gradually instead of revenue expenses that written off fully in the same year in which they are incurred.

Failure to provide for the provision of income taxes and other expenses reduces the expenses of the business that results in increased earnings as well as decreased in liabilities

Ans 7-8:

Current ratio = Current Assets / Current Liabilities; By not providing adequate provision for income taxes and other expenses, the company has understated its current liabilities (denominator), It will increase its current ratio.

Return on Assets: Net Income/ Total Assets; All the actions taken by company results in increased earning and assets as well as total assets. It will increase the return on assets.

Return on Equity: Net Income/ Shareholders Equity: Increase in the net income (numerator) would also increase the return on equity.

Profit Margin on Sales: Net Profit/Total Sales: Keeping the sales unchanged any increase in net profit (numerator) by reducing expenses will raise the profit margin.

Debt to Asset Ratio: Total Liabilities/ Total Assets: As by reducing depreciation expenses assets (denominator) are overstated and current liabilities have been reduced (numerator) by not establishing sufficient liabilities for income taxes and other expenses. It will reduce the debt to asset ratio.

Cash Flow from Operations (CFFO) will remain unaffected as depreciation is a non-cash expense.

Ans. 7-9

Performance-based compensation is one of the reasons for the above-mentioned action taken by the management. To achieve the profit target and present a rosy picture of financial performance could have driven management to engage in these actions.

Ans. 7-10

These tricks can be identified in the comparative financial statements. Like due to above tricks depreciation expenses of the company have been decreased and comparison of depreciation expenses with the previous year will reveal this change. Any significant change in number is a sign of something fishy. Further, change in the value of net assets over the years also depicts the depreciation accounting of the firm.

Ans 7-11:

Shareholders are main stakeholders who would be affected largely by this earnings manipulations. Manipulated financial statement present rosy picture of firm’s performance which led the investor to invest money and eventually raise the market price of the shares. But, when this fraud will be unearthed, market value of the firm will decline significantly leaving the shareholder in the crunch.