Question

Assume you are the accountant for a small business. Consider the following situation.

On January 2, 2017, the business purchased a large piece of equipment for $500,000. At that time, you used straight line depreciation, with no salvage value to depreciate the equipment over 10 years. It is now January 2, 2020 and you realize that your estimate on the useful life was inaccurate. You now estimate that the equipment will only be useful for 7 years from the date of acquisition.

Write a message to the President, Janice Brownie, describing how this change will affect the 2020 financial statements, both the income statement and balance sheet. Explain how you calculated the new depreciation expense and accumulated depreciation. Also, discuss how this change will affect prior years’ financial statements.

Remember your audience. Your message must be concise and completely free of spelling and grammatical errors. Refer to the textbook, Change in Estimates for Depreciation. Try to be unique from the others in getting your message across.

(USGAAP for the treatment of depreciation and prior period items)

Answer 1

January 02, 2020

Janice Brownie

President

Dear President

I am writing this message to you for describing the impact of a change in accounting estimate on financial statements. For reference, details are; we have purchased a large piece of equipment for $500,000 as on January 02, 2017, and estimated useful life of 10 years with no salvage value as depreciated by Straight Line Method (SLM). But recently we come to know that today i.e. January 02, 2020, useful life of asset seems to be 7 years from the date of acquisition and remaining useful life of the asset will be 4 years.

As per US GAAP provisions “ A change in an accounting estimate, such as useful life or salvage value, is put into effect in the current period and prospectively.” That is, the change in estimate is applied to the asset’s carrying (book) value and depreciation is calculated going forward using the new estimate. The previous periods are not affected by the change.

Depreciation calculations:

Particulars	Amount ($)
Acquisition cost	500,000
Less: Total Depreciation from January 02, 2017, to January 02, 2020, i.e 3 years by SLM	(150,000)
Carrying (book) value as on January 02, 2020	350,000
Depreciation for the next 4 years (SLM) per annum	87,500

Effect on Financial Statements:

Earlier we were charging depreciation of $50,000 per annum but because of reduction in estimated useful life we have to charge entire remaining carrying value of equipment in remaining 4 years and that will result into higher depreciation of $87,500 per annum. Profit will be less by $27,500 per annum in comparing with earlier years.

As per US GAAP provisions, there will be not any effect on financial statements of earlier years i.e. 2017, 2018, 2019. Because a change in accounting estimate like the useful life of an asset will only impact financial statements prospectively i.e. future years. Hence there will be no need of any prior period items adjustments.

Thank you for your time.