American Movieplex, a large movie theater chain, leases most of its theater faci

Question

American Movieplex, a large movie theater chain, leases most of its theater facilities. In conjunction with recent operating leases, the company spent $28 million for seats and carpeting. The question being discussed over breakfast on Wednesday morning was the length of the depreciation period for these leasehold improvements. The company controller, Sarah Keene, was surprised by the suggestion of Larry Person, her new assistant. Keene: Why 25 years? We've never depreciated leasehold improvements for such a long period. Person: I noticed that in my review of back records. But during our expansion to the Midwest, we don't need expenses to be any higher than necessary. Keene: But isn't that a pretty rosy estimate of these assets' actual life? Trade publications show an average depreciation period of 12 years. Reflect on the following: How would increasing the depreciation period affect American Movieplex's income? Who would be affected if Person's suggestion is followed? Does revising the estimate pose an ethical dilemma?

Explanation / Answer

It is a problem on depreciation of the capital improvement cost of leasehold asset. In the problem, a theater complex has been taken on lease. In the hall capital improvment cost has been incurred in the form of improving seats and carpat arrangements. Benfit of this improvment will be enjoyed for many years to come. Hence it is capital expenditure.

As the benefit is enjoyed for many years, it is improper to write off entire capital expenditure in the year of incurrence. In that situation profit of the year of incurrence will be worslt affected. Hence the write off procedure is extened over the periods of benefits receivable.

In this problem average depreciation of such expenditure in trade publication is 12 years. But company wants to spread the procedure on next 25 years. If the new strategy is adopted then depreciation charged in each year will be almost half of the previous amount charged. Thus profit after depreciation will increase. company will be able to show better profitability.

Suppose movie complex is charging depreciation on straight line basis. Total capital expenditure is $28 million. If depreciation is extended for 25 years, then in each year depreciation will be $28/25=$1.12 million. If actual publication period of 12 years is adopted, then depreciation will be $28/12=$2.33million. Thus profit will go up by $2.33-$1.12=$1.21 million per year.

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Answer 2:

From ethical point of view, revenue stement and balance sheet must give a true and fair view of the state of affair of the concern. By extending the depreciation period beyond the normal time period, you are showing higher profit to the users of annual accounts. Thus outsiders are getting a rosy picture on profitability. It is not ethically justifiable.

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Answer 3:

Since trade publications are showing 12 years life for this project, it is expected that after 12 years movie complex authority may have to incur such costs again afterr this period. But almost 50% of the previous expenditure will still appear in the book. As you know accumulated fund in depreciation can be used y the concern when such improbvment is required. Hence authority has to pay the needed money from other areas. It may cause liquidity crisis.

Thus temporary betterment of profitability will ultimately agffect the financial health of the concern in future.

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