Question

Imporia Container Ltd. is suffering from declining sales of its main product, non-biodegradable plastic cartons. The president, Benny Benson, instructs his controller, Yeoh Siew Hoon, to change estimates relating to a processing line of automated plastic extruding equipment, purchased for $3 million in January 2016. The equipment was originally estimated to have a useful life of five years and a residual value of $200,000 and straight-line depreciation has been recorded for two years on that basis. Benny wants the estimated useful life changed to a total of seven years and the residual value raised to $500,000 in order to reduce the annual depreciation expense. Yeoh Siew is hesitant to make the change, believing it inappropriate to "manage" profits in this way. Benny says, "I'm under a lot of pressure from the shareholders to maximize net income. Don't you want your bonus, which is based on net income, to be as high as possible? Just go ahead and make the change the useful life and residual value are only an estimate, anyway." Question: What impact will the proposed change in useful life and residual value have on the company's profit margin and asset turnover ratios? Discuss whether the proposed change described above is unethical or simply a good business practice by an astute president.

Answer 1

Impact on profit margin

Increase in residual value and useful life will decrease the depreciation expense.

Decrease in depreciation will increase the net profit and company's profit margin.

Impact on asset turnover ratios

Decrease in depreciation does not affect sales but increase fixed asset and therefore increasing total assets on balance sheet.

As asset turnover ratio = Sales / Average total asset

Now increase in denominator will decrease the ratio.

Therefore proposed change will result in increased profit margin and reduced asset turnover ratio.

Is proposed change ethical?

First we need to understand long term impact of this decision -

In the initial years it will increase non-cash profit and may increase tax expenses also resulting in decrease in cash profits.

In case asset becomes useless at the end of 5 years as estimated originally the will salvage value expected originally, it will result in sudden write off of assets value.

This sudden write off at the end of useful life will decrease the profits significantly and unexpectedly for shareholders, reducing the value of company and shareholders wealth.

Though residual value and useful life are only estimates, the estimates should be based on assets uses and not on profit requirement.

For these reasons proposed change is unethical.

Summary

1. Profit margin will increase
2. Asset turnover ratio will decrease
3. Proposed change is unethical