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Fixed assets and earnings management
January, 08th 2007

Fixed assets are assets that companies use for production or administration. They recover the cost of fixed assets by using it to produce goods and services, which they sell in the market. They do not intend to sell fixed assets to generate cash flows. They may be tangible or intangible. 
 
Usually, accounting for tangible fixed assets does not pose much problem. The accounting principles and rules are well established. There have been some changes in them recently, but they have not been major ones. However, accounting for fixed assets assumes importance because the determination of whether expenditure represents an asset or an expense can have a material effect on an enterprises reported results of operations. An expenditure that is capitalised, i.e. expenditure which is recognised as a fixed asset is allocated over the periods which are likely to benefit from that expenditure. As a result, capitalisation of expenditure improves reported operating result for the year in which the expenditure is incurred. Therefore, accounting for fixed assets provides ample motivation and scope to bend accounting rules to manage earnings. For example, one of the two tricks that the WorldCom played to manage their earnings was to treat the costs of excess (unused) networking capacity as a capital expenditure, on the plea that the contracted excess capacity gave the company an opportunity to enter the market quickly at some future time when the demand would be stronger than current levels. The accounting was inappropriate because the expenditure (lease rental) would not have benefited the company in future. WorldCom blatantly violated accounting principles. Others may not be that blatant, but may well bend accounting rules to the advantage of the management. 
 
The accounting principles are simple. Expenses that are directly attributable to the acquisition of the asset (or a new project) should be accumulated against the asset (or the project and subsequently allocated to assets included in the project). Subsequent expenditure against an existing fixed asset should be capitalised only if the expenditure increases the service potential of the asset beyond the originally estimated service potential. For example, if the expenditure increases the useful life of the asset or increases its utility or capacity beyond the originally estimated useful life, utility or capacity, it is added to the cost of the asset. The cost of the asset less estimated residual value (known as depreciable amount) is allocated over its estimated useful life. Estimated useful life is the period for which the company intends to use the asset. Therefore, useful life of an asset is specific to a company that controls the asset and it depends on the companys experience of using similar assets and the strategy of the company. If the book value of an asset is lower than its recoverable amount, an impairment loss is recognised and the book value of the asset is written down to the recoverable amount. Recoverable amount is the higher of the net selling price of the asset and value in use (the present value of the net cash inflow that the asset is expected to generate over its useful life). 
 
Although the accounting rules are straight forward, their application requires interpretation and judgement. Application of the rules requires that preliminary stage expenditures, such as expenditure on exploration of opportunities for acquisition and cost of engineering studies, should not be capitalised and should be recognised as expenses for the period in which the expenditures are incurred. Pre-acquisition stage expenditures, that is the expenditure incurred before the company takes ownership or control of the asset, should be capitalised only if they are attributable to the specific asset. Appropriate accounting requires a company to form a judgement on when the preliminary stage ends and the pre-acquisition stage begins and whether expenditure is attributable to a specific asset. This provides a significant scope for earnings management. 
 
On many occasions, it is difficult to assess whether the expenditure on an existing asset has increased the service potential of the asset. In such situations, it is prudent that the company recognises the expenditure as an expense for the period in which the expenditure is incurred. However, many companies take a decision looking at the effect of capitalisation on the bottom line. They capitalise the expenditure if that is necessary to match performance with the market expectations or if the managers compensation is partly based on the reported result and capitalisation helps to meet the target. 
 
Estimate of the residual value is left to the best judgement of the management. Estimate of the useful life depends on the corporate strategy. Therefore, both the estimates involve management judgement. In India, the Companies Act provides a depreciation schedule. Depreciation calculated using the depreciation schedule is the minimum depreciation to be provided by a company. Most companies in India charge no more than the minimum depreciation required by the Companies Act. This leaves a doubt regarding whether companies estimate the residual value and the useful life realistically. 
 
Accounting for impairment loss provides significant scope for earnings management. An individual asset seldom generates a cash flow independently of cash flows being generated by other assets. Therefore, testing assets for impairment loss requires grouping of assets. Assets are grouped at the lowest possible level in the organisation. Such an asset group is known as a cash generating unit (CGU). The accounting principle is to test each asset for impairment loss, if there are indications in the internal as well as external environment that the asset might have been impaired. Grouping of assets at the higher level defeats the purpose, because impairment of certain assets in the group is camouflaged by superior expected performance by other assets in the group. For example, if a company has more than one business or manufacturing facility, grouping of assets at the enterprise level may not disclose any impairment loss even though one of the business/manufacturing facilities may be impaired. Determination of the CGU is left to the management's judgement. Companies have the temptation to determine the CGU at as high a level as possible without attracting adverse comments from the auditor. The projection of cash flows and determination of the discount rate is according to the management's judgement as well. Therefore, there is ample scope for earnings management. 
 
Disclosure of accounting policy does not really serve any purpose. As observed by the Financial Reporting Review Panel of UK in its preliminary report on the implementation of IFRS that there is a tendency to use boiler plate for disclosure of accounting policies, irrespective of whether those policies had been applied in accounts. The panel further observed that disclosures relating to subjective or complex judgements made by management were sometimes bland and uninformative. The situation in India is no different. Therefore, whether the management has applied appropriately the simple accounting principles for accounting for fixed assets cannot be judged by users of financial statements. They depend on the audit committee of the board of directors and auditors, who have the responsibility to ensure that implementation is proper. Disclosure in corporate financial reports should improve. This will help users to understand the quality of earnings. This will also enhance the accountability of the audit committee and the auditors. Accounting professionals in the board of directors and auditors should take the lead to impress upon the management that disclosure of corporate practice is a check against the temptation to manage earnings and it benefits the company in the long run. It also enhances investors confidence and perhaps reduces the cost of capital. 

Asish K Bhattacharyya 
The writer is a professor, Finance Control, IIM-C

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