Question

Assume you are one of three members of the accounting staff working for a small, private company. At the beginning of this year, the company expanded into a new industry by acquiring equipment that will be used to make several new lines of products. The owner and general manager of the company has indicated that, as one of the conditions for providing financing for the new equipment, the company's bank will receive a copy of the company's annual financial statements. Another condition of the loan is that the company's total assets cannot fall below $250,000. Violation of this condition gives the bank the option to demand immediate repayment of the loan. Before making the adjustment for this year's depreciation, the company's total assets are reported at $255,000. The owner has asked you to take a look at the facts regarding the new equipment and work with the numbers to make sure everything stays onside with the bank." A depreciation method has not yet been adopted for the new equipment. Equipment used in other parts of the company is depreciated using the double-declining-balance method. The cost of the new equipment was $35,000 and the manager estimates it will be worth at least $7,000" at the end of its four-year useful life. Because the products made with the new equipment are only beginning to catch on with consumers, the company used the equipment to produce just 4,000 units this year. It is expected that, over all four years of its useful life, the new equipment will make a total of 28,000 units. 1. Calculate the depreciation that would be reported this year under each of the three methods shown in this chapter. Which of the methods would meet the owner's objective? 2. Evaluate whether it is ethical to recommend that the company use the method identified in requirement 1. What two parties are most directly affected by this recommendation? How would each party benefit from or be harmed by the recommendation? Does the recommendation violate any laws or applicable rules? Are there any other factors that you would consider before making a recommendation?

Answer 1

the major problem is of the selection of the method of depreciation although the co. are free to decide the method of depreciation it still needs to follow the basic principles and sometimes the laws of accounting need to be followed. in the given case there can be three methods of calculating depreciation.

1. double-declining balance: under this method, the depreciation is the double of what is under the straight-line method.so the depreciation will be 2* ($35000-$7000)/ 4 formula being the cost of the machine minus salvage value and divided by expected life. depreciation being $14000

2. Straight-line method: exactly the same as the double-declining method but we do not double it thus the depreciation will be $7000,

3. as per the usage: this method is most difficult to establish but as the data is given in the question we can safely implement this method. under this method, the depreciation will be (($35000-$7000)/28000)*4000 formula being total cost minus salvage value divided by the total production possible multiplied by the number of units produced thus the depreciation = $4000

now as per the demand of the question, we need to select the best-suited method of depreciation.

as the total asset needs to be maintained at $250000 there is little room to allow depreciation, thus the last method is best suited in this situation.

total assets before the new machine $255,000

add mew machine $35000

total   $290000

minus dep on the new machine(3rd method) $4000

total assets after depreciation on new machine $286000   

keeping in view these numbers the co can claim depreciation as per the given strategy and will be able to maintain the total assets value @ $250000 for the period of the loan.

second part:

is it ethical?

the co has the freedom to select the method of depreciation thus selecting the method that best suits them is completely ethical. although in certain cases the co need to follow certain rules and regulations in case of filling the accounts to the SEC and income tax regulations but for the internal calculations, it can use whichever method it deeps fit.

how would each party benefit or harmed?

as per the recommendation, the co will be able to fulfill the demands of the loan approval department whereas the lending firm might find this adjustment not as per their requirements so the matter will have to be discussed with the bank in order to keep the matter in check. a lot also depends on the agreement signed between the two parties does the agreement specify any certain method to be followed.

does it violate any rules or regulations?

no as per the rules the co can follow any method of depreciation

Are there any other factors to be kept in mind before making such a recommendation.

there are many, as to how following this method will impact the taxation department and how it will affect the profits. as lower depreciation will lead to increased profit and this might lead to higher taxes thus lowering the shareholder's wealth.