MACRO RESEARCH
Accounting & Tax Policy
Quantitative Research
Portfolio Strategy
April 4, 2014
ACCOUNTING TOP 10: HOW TO SPOT PP&E EARNINGS MANAGEMENT

This is our third report on the Top 10 accounting items to watch for and how to spot them.
Over the coming weeks and months, we will publish a new topic each Friday. Previous report
topics include Cookie Jar Reserves and Pensions (click for links).

How Do Companies Use PP&E and Depreciation to Manage Earnings? Capital spending
is closely monitored by investors for its implications to not only future company profitability,
but also overall economic activity. What we find less scrutinized is the “Day 1” accounting for
such spending as this will have long lasting implications for reported earnings. In fact, in an
era of computer power with Excel spreadsheets, investors faithfully assume a depreciation
expense calculation is simple with little opportunity to manage earnings. However, the three
primary inputs into depreciation expense (depreciation method, asset life, and residual value)
are rife with management assumptions. In this regard, companies have various levers that
may be used to boost earnings and, in this note, we explain each in turn.

Watch for Changes in Depreciation Policies and Assumptions. There is typically little, if
any, economic benefit to changing a depreciation accounting method and, therefore, any
changes impacting future depreciation expense should be viewed skeptically. Companies
may try to mask real problems in the underlying business through a reduction in depreciation
expense. Potential ways in which companies manage depreciation expense lower include:
changing from a more conservative depreciation method (e.g. accelerated depreciation) to a
less conservative method, extending estimated useful life assumptions, and/or increasing
residual (salvage) value assumptions.

How to Detect PP&E / Depreciation Earnings Management. Reading the accounting
policies and PP&E footnote sections of company filings is vital to identifying aggressive
policies and/or assumption changes. Additionally, our two favorite ratios used to detect
potential depreciation earnings management include Gross PP&E to LTM Depreciation
Expense (average estimated asset life) and LTM Depreciation to LTM Sales. We use these
ratios for historical comparison and across companies within the same industry.

In this report, we illustrate how to interpret the aforementioned pension accounting issues
using historical disclosures from Weis Markets (WMK) and Yellow Roadway (YRCW).
Chris Senyek, CFA, CPA
Adam Calingasan, CFA, CPA
Clinton Chang, CFA, CPA
(646) 845-0759
csenyek@wolferesearch.com
(646) 845-0757
acalingasan@wolferesearch.com
(646) 845-0756
cchang@wolferesearch.com
Chip Miller, CFA, CPA
Natalie Capasso
(646) 845-0752
(646) 845-0753
cmiller@wolferesearch.com ncapasso@wolferesearch.com
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disclosures.
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HOW COMPANIES MAY USE PP&E TO BOOST EARNINGS
We are always mindful (read: skeptical) when companies make voluntary changes to their accounting
policies or estimates. Most times, there is little economic benefit gained from making the changes and
it entails an internal burden to the firm’s accounting staff. However, the change may result in a
material impact to earnings going forward.
Companies may boost future earnings by changing PP&E depreciable lives, residual values, and/or
depreciation methods. Over the years, we’ve found that these types of changes often signal trouble
around the corner. After all, what CFO would initiate a voluntary accounting change to lower earnings!
GAAP requires that PP&E’s cost to be allocated as depreciation expense in earnings over the asset’s
estimated useful life in a “systematic and rational manner.” The most common method of allocating
costs is straight-line depreciation. Other forms of depreciation are allowed, notably methods that
result in an accelerated depreciation amount (recognizing more depreciation expense during the
earlier portion of the assets’ life). These so-called accelerated depreciation methods include sum of
the year’s digits and double declining balance. Over 90% of companies use straight line depreciation.
Companies must disclose the depreciation period and method for each material asset group. We
suggest reviewing a company’s Form 10-K accounting policy section for any changes or unusual
depreciation policies. Over the years, we’ve observed that a change in an asset’s depreciable life has
sometimes been a precursor to deterioration in the company’s business fundamentals. GAAP also
requires disclosure of any material changes in depreciable lives, residual values, or depreciation
methods. Oddly, PP&E’s residual value amounts are not required disclosures.
As an example of a company changing its depreciation policy, below is an excerpt from the filings of
Weis Markets (WMK). In 2012, the company changed from an accelerated to straight-line
depreciation method, resulting in a $0.06 increase to EPS in the quarter the change took place.
Example of Depreciation Methodology Change: Weis Markets
In the ‘Q1 2012, the Company changed its accounting policy for property and equipment. Property and equipment continue to be
recorded at cost. Prior to January 1, 2012, the Company provided for depreciation of buildings and improvements and equipment
using accelerated methods. Effective January 1, 2012, the Company changed its method of depreciation for this group of assets
from the accelerated methods to straight-line. Management deemed the change preferable because the straight-line method will
more accurately reflect the pattern of usage and the expected benefits of such assets. Management also considered that the
change will provide greater consistency with the depreciation methods used by other companies in the Company's industry. The
change was accounted for as a change in estimate. The net book value of assets acquired prior to January 1, 2012 with useful lives
remaining will be depreciated using the straight-line method prospectively. Depreciation expense in the first quarter 2012 would
have been $2.9 million greater if the company had continued using accelerated methods. Had accelerated methods continued to
be used, after considering the impact of income taxes, the effect would decrease net income by $1.6 million or $0.06 per share.
Source: Wolfe Research Accounting & Tax Policy Research; Company filings.
CHANGING DEPRECIATION ASSUMPTIONS
Changing assumptions used to calculate depreciation expense is one method to increase earnings
and has been the underlying cause of numerous historical accounting restatements. Two ways to
lower annual depreciation expense are to extend an asset’s depreciation period (life) or increase its
residual value. Under GAAP, residual value or depreciable life changes are accounted for
prospectively, and increasing an asset’s depreciable life does not change the total depreciation
expense amount recognized. Instead, it defers a portion of current depreciation into future periods as
a smaller annual amount of the asset is expensed over a longer time period. Similarly, an increase in
an asset’s residual value will reduce the depreciable amount of the asset (original cost less residual
value) and, therefore, lower depreciation expense.
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April 4, 2014
CHANGES TO ESTIMATED LIVES AND SALVAGE VALUES
Changing an asset's depreciable life or residual value is uncommon and, therefore, we use it as a
strong signal of possible deeper issues at a company. Below, we review Yellow Roadway's (now YRC
Worldwide [YRCW]) accounting issues and the financial ratio warning signs.
First, YRCW lowered its 2006 earnings guidance in March 2006. Approximately six months later,
beginning in ‘Q3 2006, the company changed equipment depreciable lives from 3-14 years to 7-20
years and modified certain salvage values. This change increased EPS by $0.27 in 2006 ($26 million
pre-tax). YRCW disclosed the accounting changes in the footnotes of its 'Q3 2006 10-Q. However,
the average depreciable life ratio (gross PP&E divided by LTM depreciation expense) also flagged
possible issues. As shown below, this ratio jumped from 11.1 years to 13.0 years in 'Q3 2006, the
quarter in which the depreciable life changes occurred.
Yellow Roadway's Depreciation Changes
“In 2006, the Company revised the estimated useful lives and salvage values of certain classes of property and equipment to more
appropriately reflect how the assets are expected to be used over time. During 2006, the Company increased revenue equipment
lives to a range of ten to twenty years from three to fourteen years and modified certain salvage values. If the Company had not
changed the estimated useful lives and salvage values of such property and equipment, additional depreciation expense of
approximately $26.3 million would have been recorded during the year ended December 31, 2006. Accordingly, the changes in
estimates resulted in an increase in income from continuing operations of approximately $26.3 million (a $16.0 million increase in
net income) for the year ended December 31, 2006. The change in estimate also increased diluted earnings per share by $0.27 for
the year ended December 31, 2006.”
Yellow Roadway
Stock Price (000s of USD)
$400
Lowers 2006
earnings guidance
1,800
$350
1,600
1,400
$300
$250
2,000
1,200
1,000
10-Q disclosure of
depr. change (11/9)
$200
$150
Volume
Average Depreciable Life (Yrs)
'Q1 2006 'Q2 2006 'Q3 2006 'Q4 2006 'Q1 2007 'Q2 2007
10.9
11.1
13.0
13.6
14.6
14.6
800
600
400
200
$100
Jan-06 Apr-06 Jul-06 Oct-06 Jan-07 Apr-07 Jul-07 Oct-07
0
Source: Wolfe Research Accounting & Tax Policy Research; Company filings; Standard & Poor’s; FactSet. Securities and Exchange Commission.
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April 4, 2014
RATIOS TO DETECT POTENTIAL PP&E / DEPRECIATION EARNINGS MANAGEMENT
In addition to reading the accounting policy sections for any material changes, we recommend
investors review a few financial ratios that help detect changing depreciation policies and residual
values.
Gross PP&E and Accumulated Depreciation balances may not always be readily available on a
quarterly basis. However, 10-K annual reports provide the most detailed disclosures on PP&E
balances and depreciation.
The ratios below should be analyzed in comparison to companies within the same industry as well as
year-over-year changes to determine if there has been a more subtle undisclosed change in asset
lives, mix shift in asset types, or aging of asset base.
The average asset depreciable life ratio is helpful in spotting changes in assumptions (either useful
lives or residual values). Within a sector or industry group, comparing depreciation expense to sales
assists in identifying companies with more lenient depreciation expense policies.
Detecting Potential Earnings Management through PP&E
𝐴𝑣𝑒𝑟𝑎𝑔𝑒 𝐴𝑠𝑠𝑒𝑡 𝐷𝑒𝑝𝑟. 𝐿𝑖𝑓𝑒 =
𝐷𝑒𝑝. 𝑡𝑜 𝑆𝑎𝑙𝑒𝑠 𝑅𝑎𝑡𝑖𝑜 =
𝐺𝑟𝑜𝑠𝑠 𝑃𝑃&𝐸
𝐷𝑒𝑝𝑟𝑒𝑐𝑖𝑎𝑡𝑖𝑜𝑛 𝐸𝑥𝑝𝑒𝑛𝑠𝑒
𝐷𝑒𝑝𝑟𝑒𝑐𝑖𝑎𝑡𝑖𝑜𝑛 𝐸𝑥𝑝𝑒𝑛𝑠𝑒
𝑇𝑜𝑡𝑎𝑙 𝑆𝑎𝑙𝑒𝑠
% 𝑜𝑓 𝐴𝑠𝑠𝑒𝑡𝑠 𝐷𝑒𝑝𝑟𝑒𝑐𝑖𝑎𝑡𝑒𝑑 =
Lower ratio when comparing two companies
with similar profiles may indicate more
aggressive depreciation policies / assumptions
𝐴𝑐𝑐𝑢𝑚𝑢𝑙𝑎𝑡𝑒𝑑 𝐷𝑒𝑝𝑟𝑒𝑐𝑖𝑎𝑡𝑖𝑜𝑛
𝐺𝑟𝑜𝑠𝑠 𝑃𝑃&𝐸
𝑅𝑒𝑚𝑎𝑖𝑛𝑖𝑛𝑔 𝐷𝑒𝑝𝑟𝑒𝑐𝑖𝑎𝑏𝑙𝑒 𝑌𝑒𝑎𝑟𝑠 =
Longer depreciable life = lower
depreciation expense = higher earnings
𝑁𝑒𝑡 𝑃𝑃&𝐸
𝐷𝑒𝑝𝑟𝑒𝑐𝑖𝑎𝑡𝑖𝑜𝑛 𝐸𝑥𝑝𝑒𝑛𝑠𝑒
Higher % of assets depreciated = more
potential need for upcoming capex
Fewer remaining depreciable years =
greater potential need for upcoming capex
Source: Wolfe Research Accounting & Tax Policy Research.
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April 4, 2014
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