Question

Use the following case in answering Problems 9– 11:

Hatfield Industries is a large manufacturingconglomerate based in the United States with annual sales in excess of $300 million.

Hatfield is currently under investigation by the Securities and Exchange Commission (SEC)for accounting irregularities and possible legal violations in the presentation of the company’sfinancial statements. A due-diligence team from the SEC has been sent to Hatfield’s corporateheadquarters in Philadelphia for a complete audit in order to further assess the situation.

Several unique circumstances at Hatfield are discovered by the SEC due-diligence teamduring the course of the investigation:

• Management has been involved in ongoing negotiations with the local labor union, of which approximately 40% of its full-time labor force are members. Labor officials are seeking increased wages and pension benefits, which Hatfield’s management states is not possible at this time due to decreased profitability and a tight cash flow situation. Labor officials have accused Hatfield’s management of manipulating the company’s financial statements to justify not granting any concessions during the course of negotiations.
• All new equipment obtained over the past several years has been established onHatfield’s books as operating leases, although past acquisitions of similar equipmentwere nearly always classified as capital leases. Financial statements of industry peersindicate that capital leases for this type of equipment are the norm. The SEC wantsHatfield’s management to provide justification for this apparent deviation from“normal” accounting practices.
• Inventory on Hatfield’s books has been steadily increasing for the past few years incomparison to sales growth. Management credits improved operating efficiencies in itsproduction methods that have contributed to boosts in overall production. The SEC isseeking evidence that Hatfield somehow may have manipulated its inventory accounts.

The SEC due-diligence team is not necessarily searching for evidence of fraud but of possiblemanipulation of accounting standards for the purpose of misleading shareholders and otherinterested parties. Initial review of Hatfield’s financial statements indicates that, at a minimum,certain practices have resulted in low-quality earnings.

Question: Labor officials believe that the management of Hatfield is attempting to understate its netincome to avoid making any concessions in the labor negotiations. Which of the followingactions by management will most likely result in low-quality earnings?

a. Lengthening the life of a depreciable asset in order to lower the depreciation expense.

b. Lowering the discount rate used in the valuation of the company’s pension obligations.

c. The recognition of revenue at the time of delivery rather than when payment is received.

Short answer

Option a.

Step-by-step solution

Definition of understating income 

A reported amount being less than the actual amount is called as understatement..

Explanation on immediate effects on operating cash flow

Certain GAAP rules can be exploited by companies in to achieve specific goals, while still remaining within the law. Aggressive assumptions, such as lengthening the depreciable life of an asset, that are utilized to boost earnings results in a lower quality of earnings. Hence the correct answer is option A.