Question

At the beginning of 2019, the Healthy Life Food Company purchased equipment for $42 million to be used in the manufacture of a new line of gourmet frozen foods. The equipment was estimated to have a 10-year service life and no residual value. The straight-line depreciation method was used to measure depreciation for 2019 and 2020. Late in 2021, it became apparent that sales of the new frozen food line were significantly below expectations. The company decided to continue production for two more years (2022 and 2023) and then discontinue the line. 

At that time, the equipment will be sold for minimal scrap values. The controller, Heather Meyer, was asked by Harvey Dent, the company’s chief executive officer (CEO), to determine the appropriate treatment of the change in service life of the equipment. 

Heather determined that there has been an impairment of value requiring an immediate write-down of the equipment of $12,900,000. The remaining book value would then be depreciated over the equipment’s revised service life. 

The CEO does not like Heather’s conclusion because of the effect it would have on 2021 income. “Looks like a simple revision in service life from 10 years to 5 years to me,” Dent concluded. “Let’s go with it that way, Heather.” 

 

Required: 

1. What is the difference in before-tax income between the CEO’s and Heather’s treatment of the situation? 

2. Discuss Heather Meyer’s ethical dilemma.

 

 

Answer 1

Impairment of value

As per the guidelines of GAAP(Generally Accepted Accounting Principles), for recognition and measurement of impairment losses, property, plant, and equipment and finite-life intangible assets are tested for impairment only when evets and situations makes it possible that the book value of those assets may not be recoverable.

 

1.

In this case, the situation in which the purchased equipment has warranted an impairment loss has been understood differently by H, the controller and by M ,the CEO of the company H. Therefore the approach for computation of before-tax income differs accordingly, which is as below:

 

CEO’s approach:

According to CEO, the situation only changed the service life of the equipment from 10 years to 5 years. His method of calculation of depreciation expense of 2021 to be reported in the income statement would be:

= $42,000,000(cost) - $8,400,000(depreciation for 2019 and 2020)/3 years(balance period)

= $11,200,000

 

Working notes:

1. For 2019 and 2020, the depreciation is $42,000,000/10 × 2 = $8,400,000

2. Balance period left is 3 years (5 years – 2 years)

 

Controller’s approach:

According to the controller the depreciation to be reported in the income statement is computed as below:

$42,000,000(cost) - $8,400,000(depreciation for 2019 and 2020) - $12,900,000/3 years

= $6,900,000

 

Working notes:

1. For 2019 and 2020, the depreciation is $42,000,000/10 × 2 = $8,400,000

2. Balance period left is 3 years (5 years – 2 years)

 

But the total expense to be reported in the income statement is $19,800,000

$6,900,000(depreciation-2021) + $12,900,000(write-down value)

 

Hence, the difference between the two approach is $8,600,000 ($19,800,000 - $11,200,000) for which the before-tax income would be reduced, using the controller’s approach.

 

2.

The method of recognizing and recording impairment loss is subjective and differs from entity to entity, even though there are GAAP guidelines for treatment of impairment loss on partial write-downs of property, plant, and equipment and intangible assets in use. In the present case due to sales of the frozen foods were significantly below expectation and the situation warrants the company (the controller) to estimate $12,900,000 impairment of the equipment , possibly using best information available to him. On the other hand, the CEO being not very conversant with the impairment process, thought that the controller would simply revise the service life of the equipment from 10 years to 5 years.

 

By such act of the CEO would mean overstating the net income of the company.

 

Ethical dilemma:

The ethical dilemma for H, the controller is that whether he should oblige the wish and instruction of his boss(the CEO) and just revise the service life of the equipment from 10 years to 5 years thus helping the company overstate its net income, and ignore the impairment of the equipment which is warranted by the present situation, or should he ignore the wish and instruction of his CEO and record the impairment of the equipment maintaining his professional ethics and have the net income reflect true and fair view of the state of affairs of the business.

Impairment of value

As per the guidelines of GAAP(Generally Accepted Accounting Principles), for recognition and measurement of impairment losses, property, plant,