Waste Management’s major assets are machine and equipment, and land (Operational Landfill’s). For several years they changed the values of useful life and/or salvage values of these assets. Most of these changes were made during the fourth quarter and applied to that full year, not the full life of the asset. These changes were unsupported and significantly reduced their depreciation expense and increasing their net income.
Assets such as machinery, vehicles, containers, equipment become obsolete or wear out over the years. The portion of the asset used up or worn out each year is referred to as depreciation. Under GAAP, depreciation expense should be determined by allocating the historical cost of the life of the asset, less the residual/salvage value
Based on the case information provided, Waste Management violated the expense recognition principle, when they made changes to the estimated useful life and/or salvage value of several assets such as trucks, containers, equipment, as a result depreciation expenses decline, ultimately resulting in overstated profit/income.
As under GAAP “The expense recognition principle” requires the amount of the depreciation expense of an asset to be recognized over its useful life so as to comply with matching principle.
The arbitrary changes made to increase the estimated useful life and/or salvage values directly violated the matching principle because the amount of depreciation expense recognized in future years would now be unrelated to profit or income in those related future years.
Any changes made to increase the useful life and/or salvage values can have a material impact on the financial statements of Waste Management as if affects the fair value of an asset and reduces the expenses and therefore affects the way a user of financial statements uses them. Therefore, Waste Management, is required by GAAP under the full disclosure principle to properly disclose these changes.
As per Paragraph 2 of PCAOB Auditing Standard 5. This paragraph requires that auditor shall obtain reasonable assurance regarding effective internal control over financial reporting which provides reliability of preparation and reporting of the financial statement of the company for the external purposes. Internal control of the company over financial reporting cannot be considered effective if one or more material/significant weaknesses exist.
In the given case Waste Management does not have a system of internal control that can be considered as effective and will result in ineffective control did not establish an effective system of internal control over the recording of depreciation expense in the financial statement.
Under GAAP, depreciation expense should be determined by allocating the historical cost of as life of the asset less the residual/salvage value. Changes made by Waste Management to increase the useful life and/or salvage value s can have a material impact on the way user a financial statement of Waste Management as it affects the fair value of an asset and reduces the expenses. Furthermore, Waste Management, must properly disclose as required by GAAP under the full disclosure principle which, in the given case of Waste Management, did not comply with.
In paragraph 5-6 of PCAOB Auditing standard 15 audit evidence deals with sufficiency and appropriateness of audit evidence. Sufficiency signifies that quantity of the audit evidence whereas the appropriateness signifies whether the evidence serves the purpose or not.
Under GAAP, A company is allowed to change the estimated useful life and/or the salvage value of its assets if events or circumstances reveal additional information that depicts the current market situation more accurately.
In this situation, an auditor should examine the following audit evidence in regard to the change of useful life and salvage value of its assets was appropriate under GAAP.
1. Examine the practices used in the industry for similar assets.
2. Compare the relevant information about useful life for such assets used in the industry and monitor the company’s actual experience.
3. Evaluate the appropriateness of GAAP’s rule regarding such change of useful life and/or salvage value of its assets.
4. Interviews with management and other knowledgeable personnel about the basis for subjective estimation.
5. Events or circumstances resulting in the need for such changes would have to be critically evaluated and corroborated by sufficient and competent evidence by the auditors.
After evaluation all the evidence, if the doubt still exists in the mind of the auditor he can take the help of the third party which is independent to evaluate the changes to the useful life and/or salvage value that are proposed.
Waste Management invested resources to obtain permits, development new landfills and expansion of existing landfills. These costs were capitalized to avoid recording the expense. When these landfills did not succeed, Waste Management continued to depreciate the capitalized asset by rolling the costs into another asset. This practice is netting, basketing, or bundling.
Netting. One generally accepted accounting principle is that the results of unusual transactions must be reported separately from those of recurring events. Basketing and bundling. Another generally accepted accounting principle is that, when a project subject to depreciation winds up sooner than expected, the remaining cost must be written off.
Suppose Waste Management invested $50 million in a landfill with an expected life of 20 years, and charged $2.5 million in depreciation annually against that asset. If Waste Management closed the landfill early (say, after 10 years), a capital value of $25 million would remain and, under GAAP, should be taken as an immediate loss.
As per paragraphs 6-7 of PCAOB Auditing Standard No 13. These paragraphs require the auditor is required to determine whether there is a need to change the nature, timing, or extent of audit procedures to adequately address the assessed risk of misstatement which can be material in the books of accounts.
They should involve the application of professional skepticism in evaluating and gather audit evidence, particularly fraud risks.
As the Auditors were not expecting to see one-time gains when examining the financial statement. As a result, auditor did not see any evidence of this transaction when examined the record. The practice of netting should have received additional audit attention.
As per paragraph of PCAOB Auditing Standard “Audit Evidence” auditor should evaluate the sufficiency and appropriateness of the information for the purpose of the audit while using the data provided by the company as an evidence for the audit.
The auditor may encounter difficulties to determine that a client is engaging in basketing, bundling, or netting since management are likely to be trying to conceal it. In order to detect whether the client is engaging in such activity, and an auditor, in conducting an audit, should perform the following audit procedures.
i. The auditor should obtain an understating of the company’s industry environment and investigate the pertinent factors affecting to the realization of landfill permits were becoming difficult to obtain.
ii. Inquire the management and other key personnel if any landfills were substantially impaired or abandoned during the year.
iii. Review relevant Board of Director’s minutes so that the auditor could vouch that amounts included in deferred asset accounts on the balance sheet corresponded to interest capitalization of landfills that were not abandoned or impaired.
iv. If a landfill was impaired or abandoned, trace the unamortized costs of that landfill to inclusion as an immediate expense and look for appropriate disclosure of asset in the financial statements.
v. Examine the asset disposal list for completeness and accuracy. For each disposition selected, corroborate the sale price for the asset.
vi. Calculate the gain or loss for the sale of the asset and trace any gain or loss into its proper recording in the income statement.
The aforesaid audit procedures would help the auditor to detect whether any gain was actually used to offset expenses, as opposed to being properly recorded on the income statement as a gain on sale of asset.
Clearly, there are a number of allowable answers to this question. The absolute key is for a student to try and justify his or her position. Consider the following acceptable sample answer from a student:
No, I do not believe that the decision to phase in the new GAAP method to capitalize interest expense over three year was in the best interest of the company’s shareholders’. Stated simply, the use of accounting methods that are not in accordance with GAAP provide a false and misleading picture of the company’s true financial position and results of operations. As a result, the use of these accounting methods was ultimately going to have a severe negative impact on shareholders’, which of course they do.