Ethics: Changes in Estimate

Mike Crane is an audit senior of a large public accounting firm who has just been assigned to the Frost Corporation’s annual audit engagement. Frost has been a client of Crane’s firm for many years. Frost is a fast-growing business in the commercial construction industry. In reviewing the fixed asset ledger, Crane discovered a series of unusual accounting changes, in which the useful lives of assets, depreciated using the straight-line method, were substantially lowered near the midpoint of the original estimate. For example, the useful life of one dump truck was changed from 10 to 6 years during its fifth year of service. Upon further investigation, Mike was told by Kevin James, Frost’s accounting manager, “I don’t really see your problem. After all, it’s perfectly legal to change an accounting estimate. Besides, our CEO likes to see big earnings!”

Answer the following questions in the Discussion Board:

1. What are the ethical issues concerning Frost’s practice of changing the useful lives of fixed assets?
2. Who could be harmed by Frost’s unusual accounting changes?
3. What should Crane do in this situation?

Just do response each posted # 1 to 3 down below only.

Posted 1

Hi Professor and class,

While I do not believe there are any ethical issues with changing the useful lives of fixed assets, Mr. James seems to be operating in a deceitful manner, rather than reporting changes appropriately or truthfully. “Under both GAAP and IFRS, changes in depreciation method and changes in useful life are treated in the current and future periods. Prior periods are not affected”, (Kieso, D. E., et al, pg. 601). Since Mr. Crane found unusual accounting changes, and had an awkward exchange with Kevin James, Frost’s accounting manager, it is pertinent that he brings it to the attention of his superiors at the accounting firm which he works for. If fraudulent activity is occurring and accounting information is being withheld or misrepresented, the business could be ruined. Mr. Crane should schedule to meet with all necessary parties to inform them as to what is going on, as well as what must be rectified and followed going forward.

Posted 2

If Frost has made any significant changes to an asset, this could influence the useful life. This will not affect depreciation previously recorded however this will affect deprecation in the future. Most often, useful life is common among assets creating a standard useful life but, in some cases, this isn’t the case and the useful life needs to be determined. The useful life has no impact on cash flow as depreciation is a non-cash expense. Some companies like to under state their useful life to improve the progress appearance while some companies may extend the useful life of an asset to reduce the depreciation expense and increase net income. In Cranes case, as a Senior Auditor, he has the obligation to disclose this discrepancy to upper management.

Posted 3

The ethical issue concerning Frost’s practice is when changing the useful lives of fixed assets when there wasn’t a legitimate reason to. (revalue, obsolete technology, etc.). Since they changed the useful life number halfway through from 10 to 6 during its fifth year of service it sends a red flag up that either the evaluation was wrong from the beginning or they are trying to get a higher depreciation expense in the last years to show a lower taxable income. This would show that the previous years were understated as well and with the new useful life of 6 years this could look like fraud. If this were a computer that could have a useful life of 5 years but only lasted 3 years you could use a revalue and depreciate the remainder, then set computer useful life to 3 years from now on so not to make a habit of over extending the useful life. Frost’s practice in this scenario being a dump truck is over depreciating assets where they can since “our CEO likes to see big earnings!”

Frost’s stockholders and creditors could be harmed by Frost’s unusual accounting changes since they are the investors, investors see a stock that is generating a normal amount of growth then suddenly a spike in growth, mainly due to a big depreciation write off. Investors who don’t look at the small details see the stock go up and want to ride the train then suddenly it stops and comes right back down. Market manipulation. Crane and his auditing firm could also be harmed by Frost’s unusual accounting changes since they know about the depreciation practices at Frost Corporation.

Crane is a senior auditor of a large public accounting firm, Crane needs to report his findings to the highest level of management of the Frost Corporation. Crane also needs to disclose all of his findings in the report including any out of the ordinary accounting practices. In this case it appeared to boost earnings and not revalue the dump truck. A talk with Kevin James, Frost’s accounting manager about how this could potentially backfire and hurt him and his reputation as well is needed. Everyone has an ethical boundary that they are not willing to cross, manipulate a number or two then it becomes more then at what point can is there no turning back.