You are the owner of a small business and manage its accounting. Your company ju

Question

You are the owner of a small business and manage its accounting. Your company just finished a year in which a large amount of borrowed funds was invested in a new building addition and in new equipment and fixture additions. Your banker has required you to submit semiannual financial statements so he can monitor the financial health of your business. He has warned you that if profit margins erode, he might raise the interest rate on the borrowed funds to reflect the increased loan risk from the bank's point of view. You know that profit margins are likely to decline this year. As you prepare year-end adjusting entries, you decide to apply the following depreciation rule: All asset additions are considered to be in use on the first day of the following month—the previous rule assumed assets are in use on the first day of the month nearest the purchase date.

You anticipate your banker may ask the following questions when you meet with him in a couple of weeks: Is your new rule an ethical violation or is it a legitimate decision in computing depreciation? How will the new depreciation rule affect the profit margin of your business?

Explanation / Answer

This new depreciation rule is an ethical violation if the change is not applied retrospectively.

Both GAAP & IFRS requires that change in accounting policy or assumptions should be applied retrospectively to previous years' financial statements. If I only change the depreciation rule before year-end, it will be an accounting violation.

The new depreciation rule will overstate my profit margin by delaying the recognition of depreciation expense by one month. Lower expense will increase profit margin.

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