Everybody knew Ed McAlister was a brilliant businessman. He had taken a small garbage collection company in Kentucky and built it up to be one of the largest and most profitable waste management companies in the Midwest. But when he was convicted of a massive financial fraud, what surprised everyone was how crude and simple the scheme was. To keep the earnings up and the stock prices soaring, he and his cronies came up with an almost foolishly simple scheme: First, they doubled the useful lives of the dumpsters. That allowed them to cut depreciation expense in half. The following year, they simply increased the estimated salvage value of the dumpsters, allowing them to further reduce depreciation expense. With thousands of dumpsters spread over 14 states, these simple adjustments gave the company an enormous boost to the bottom line. When it all came tumbling down, McAlister had to sell everything he owned to pay for his legal costs and was left with nothing.
1. If an asset has either too long a useful life or too high an estimated salvage value, what happens, from an accounting perspective, when that asset is worn out and has to be disposed of?
2. Do the rules of GAAP (generally accepted accounting principles) mandate specific lives for different types of assets? What is the role of the outside auditor in evaluating the reasonableness of depreciation lives and salvage values?3. How might either too long a useful life or too high an estimated salvage value affect key performance indicators such as return on investment and residual income?