Assume you work as an assistant accountant in the head office of a national movi

Question

Assume you work as an assistant accountant in the head office of a national movie rental business, a la Blockbuster Inc. With the increasing popularity of online movie rental operations, your company has struggled to meet its earnings targets for the year. It is important for the company to meet its earnings targets this year because the company is renegotiating a bank loan next month, and the terms of that loan are likely to depend on the companys reported financial success. Also, the company plans to issue more stock to the public in the upcoming year, to obtain funds for establishing its own presence in the online movie rental business. The chief financial officer ( CFO) has approached you with a solution to the earnings dilemma. She proposes that the depreciation period for the stock of reusable DVDs be extended from 3 months to 15 months. She explains that by lengthening the depreciation period, a smaller amount of depreciation expense will be recorded in the current year, resulting in a higher net income. She claims that generally accepted accounting principles require estimates like this, so it would not involve doing anything wrong.

Required: Discuss the CFOs proposed solution. In your discussion, consider the following questions. Will the change in depreciation affect net income in the current year in the way that the CFO described? How will it affect net income in the following year? Is the CFO correct when she claims that the change in estimated depreciation is allowed by GAAP? Who relies on the video companys financial statements when making decisions? Why might their decisions be affected by the CFOs proposed solution? Is it possible that their decisions would not be affected? What should you do?

Explanation / Answer

Change in the useful life of an asset is permitted under GAAP. Hence, the proposal of the CFO is admissible under GAAP. However, it should be technically justifiable.

The life of the DVD's is proposed to be increased to 15 months, which will mean that part of the depreciation will fall in the year (accounting year) of purchase and the balance will fall in the next accounting year and in some cases to the third accounting year also. To the extent the depreciation is postponed to the next year(s), there will be a higher reported income in the current year.

The impact of the increase in the life of the assets in the current year would depend on the time of purchase of the DVD's. If they are purchased in the beginning of the current year not much saving will result, as 80% (12/15) of the cost of the DVD's will be the depreciation charge). But, if the purchases are made towards the end of the year, then the charge for the current year would be less.

Assuming that DVD's are purchased continuously during a year, there would be higher reduction in depreciation charged in the current year in respect of DVDs purchased towards the end of the year. If the total amount spent on DVDs is substantial, there would be a substantial reduction in depreciation in the current year, which will boost the net income for the current year. But this will have higher tax consequences in form higher tax outflows in the first year, which is real.

However, as this change in life is from 3 to 15 months, the balance of the depreciation will get shifted to the second year. As DVDs are a regularly purchased item, the change in life will not result in any benefit from year 2 onwards. The next years and subsequent years' income would not get boosted.

The financial statements of the company would be relied upon by the bank with which the company is negotiating a loan in the current year as also the prospective investors whom the company intends to approach with its equity issue in the next year. The banks decision would definitely be influenced as the current year's income would get a boost because of this change. However, the results from the second year onwards will not get boosted. The banks would consider the future income also. Hence, the decision of the banks may not get totally affected by this change.

In the case of the prospective investors there won't be any effect, as from year 2 this change in method will not have any effect on the total depreciation.

I would not recommend the proposal because of its motive. It is unethical.

Related Questions

Navigate

• Browse (All)
• Browse A
• Subjects

Integrity-first tutoring: explanations and feedback only — we do not complete graded work. Learn more.