Final answer:
An increase in the estimated useful life of an asset can serve as an earnings management tool by reducing annual depreciation expense and temporarily increasing reported profits, potentially misleading investors about the financial health of the company.
Step-by-step explanation:
An increase in the useful estimated life of a resource can serve as an earnings management tool for a business. This accounting strategy involves extending the useful life of an asset, thereby reducing the annual depreciation expense on income statements. By doing so, companies can report higher earnings in the short term, which may improve the perceived financial health and stability of the firm.
When a company acquires an asset, such as machinery or a building, this asset will contribute to production and revenue generation over its functional lifespan. By increasing the estimated useful life, the company decreases the annual depreciation charge, which is a non-cash expense that reduces reported earnings. For example, if a machine with a 10-year life has its useful life extended to 15 years, the depreciation expense reported each year will decrease, thereby increasing the company's annual net profit.
However, reporting higher earnings through this method can be deceptive and might not reflect the actual economic reality. It may also mislead investors and other stakeholders regarding the company's performance and future cash flows. When a firm does this it is important to note that, while it may temporarily enhance earnings results, it doesn't change the cash flow generated from operations.