Understanding corporate earnings manipulation

Question

While reading earnings manipulation on investopedia, I came across following sentences:

Another form of manipulation is to change company policy so more costs are capitalized rather than expensed immediately. Capitalizing costs as assets delays the recognition of expenses and increases profits in the short term. Assume, for example, company policy dictates that every expense under $1,000 is immediately expensed and costs over $1,000 may be capitalized as assets. If the firm changes the policy and starts to capitalize far more assets, expenses decrease in the short term and profits increase.

I dont have academic background in finance, economics or accounting. Hence I am struggling to grasp meaning of the above lines. To be precise I am not able to understand the meaning of following excerpts:

• costs are capitalized
• costs are expensed immediately
• more costs are capitalized rather than expensed immediately
• Capitalizing costs as assets delays the recognition of expenses and increases profits in the short term
• example which follows

So basically it seems that I am struggliung with financial terms and not able to understand anything of above.

Answer 1

Imagine that I run Justin's Lawnmowing Inc. In the first year of operation I make $1,000. I spend $100 on gas and other consumables to run my lawnmowers. I also spend $1,200 on a new lawnmower for the business.

From a cash perspective, the business lost $300 ($1,000 came in, $1,300 went out).

From an accounting perspective, though, I have some flexibility to manipulate how I report my company's earnings. In reality, there are a variety of tax and accounting regulations that try to limit this flexibliity so that companies report things in a more uniform manner. But in reality there are a number of gray areas where companies can do this sort of thing.

If I want to show the lowest possible earnings, I can count all $1,200 of the mower purchase as an expense this year and report a loss of $300. This comes in handy if I'm trying to minimize my taxes. It also minimizes the amount of record keeping I need to do. I just need to look at money in and money out.

If we assume that the business will be using the mower for a number of years, however, then it may make sense to capitalize this expense by recognizing it over time. In this model, the I turned an asset of $1,200 in cash into an asset of a $1,200 mower. I then used this mower for a year. Now I have a used mower that is worth something but less than the $1,200 I paid. So it makes sense to treat this loss of value (depreciation) as an expense in the first year and to spread the expense out over the life of the mower.

In theory, I could go out and get someone to appraise the mower at the end of the year. If they say it's worth $900, I could recognize an expense of $300 (the loss of the value of the mower). So I would report earnings of $1,000 (income) - $100 (expenses for things I used up this year) - $300 (expenses for wear and tear on the mower) = $600 (profit).

Having someone individually appraise every asset a company owns would be incredibly costly and would introduce terribly burdensome record keeping on the company so no one actually does this. Instead, they simplify their lives by depreciating an asset in a standard way over its lifetime. The easiest way of doing this is straight-line depreciation-- if I expect an asset like the mower to last for 3 years, I recognize one third of the expense every year. If I do that, I would recognize a $400 expense for the mower every year for three years. That would mean that in the first year, I'd report a profit of $500 ($1,000 income - $100 consumables - $400 depreciation = $500 profit). This also simplifies the record keeping-- I just need to know how much I paid originally for the asset, its expected lifetime, and how many years I've had it to calculate the expense for the year.

If I manipulate the expected lifetime of the asset or choose an accelerated depreciation schedule (i.e. I say that an asset loses 40% of its value in the first year, 30% in the second, 20% in the third, and 10% in the fourth) I can manipulate how much of the expense I recognize this year vs. how much I recognize in the future. Depending on how much of the expense gets recognized, I can change how much profit I report.

As I mentioned earlier, though, there are a number of different regulations that limit my ability to make these sorts of choices in order to minimize how much I can manipulate the earnings I report. The more common the object I'm buying is, the more likely that there is going to be a very clear regulation telling me how to expense it or limiting what options I have to recognize the expense over time. So Justin's Lawnmowing in practice doesn't have a lot of room to manipulate earnings. Justin's Giant Multinational Manufacturing Company, on the other hand, will tend to have lots of very specialized assets and lots of unusual situations where there isn't an obvious answer and they have to make a judgement call about recognizing the expense. That makes it easier for them to manipulate earnings.

Answer 2

To stay in your example, say your company buys a printer for $800.

It exchanges $800 for an object that is worth $800 so actually no money was lost. You could theoretically sell the printer and get some of your money back, so it is an asset. Now, the printer looses it´s value over then next few years. So the correct way would be to write off the value over the next say tree years until the Printer is essentially worthless by the books.

In contrast, if you buy a one-month´s toilet paper supply for all the employees restrooms for $800, That money is spent and gone.

This distinction is not always as clear, so companies have some leeway how they book their expenses, so they can decide to move such expenses into the future by this mechanic. Often there is a threshold under which an object is not individually judged for depreciation, but just written of immediately.

Note that a lot of financial authorities regulate the depreciation of common objects. For example in Germany you have to write of Buildings over 50 years and Computer over 3 years. If you want to deviate from these rules you´ll have to explain why (computer broke, for example)