Question

'Your manager states that if they change the depreciation policy on existing plant & equipment by increasing the useful life this can reduce depreciation expense and increase net income by 10%. Advise your manager whether this change is possible with reference to accrual accounting conventions.

Answer 1

ANSWER:

In the given question, the manager has adviced for a revision in the depreciation policy for existing plant & machinery. As per the accounting policies and conventions, the company has the rights to change the useful life of the asset if the same is justified over the period of time.

A depreciation estimate is calculated based on the chosen method of depreciation, and on estimates of an assets useful life and salvage value.

Of course both useful life and salvage value cannot be known at the time and it is often the case than one or the other or both need to be revised during the lifetime of an asset. Factors such as a change in how an asset is used, unexpected wear and tear, technological advancement, and changes in market conditions, may indicate that the salvage value or useful life of an asset has changed. In addition, the chosen method of depreciation may no longer be appropriate. The pattern of usage of the asset may change to such an extent that an alternative method of depreciation may need to be used.

When there is an indication that a change in depreciation method, salvage value, or estimated useful life is necessary, then the business should revise its depreciation estimates accordingly.

Estimates must be revised when new information becomes available which indicates a change in circumstances upon which the estimates were formed.

Changes in Accounting Estimates must be accounted for prospectively in the financial statements, i.e. the effects of the change must be incorporated in the accounting period in which the estimates are revised. Therefore, carrying amounts of assets and liabilities and any associated expense and gains are adjusted in the period of change in estimate.

Prospective application of changes in estimates prevents frequent revisions in prior period comparative figures which might cause unnecessary complications in respect of financial statement balances that are expected to be revised in future due to availability of new information or the experience of new events.

Hence, in the given situation, the said chance CAN BE done by the company. But, when the depreciation amount decreses from the coming year, the company will be able to show a higher Net Income for the year. This will boost the company's profitability and thereby the goodwill in the market. But as we closely see the matter, when the net income increases , gradually the net tax payable by the company will also increase and as a result the company will end up paying a higher amount as tax on Income.

Hence the company should take a good call on whether the revision need to be done, considering the need for change of useful life, impact of increased income and thereby increased tax payable by the company.