Question

At the beginning of 2016, 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 2016 and 2017. Late in 2018, 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 (2019 and 2020) 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 2018 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: What is the difference in before-tax income between the CEO’s and Heather’s treatment of the situation? Discuss Heather Meyer’s ethical dilemma.

Answer 1

2018 expenses using CEO approach to revise the service life of the equipment
Cost of Equipment	$42,000,000
Previous depreciation (cost /useful life)	$4,200,000
Depreciation for 2 years	$8,400,000
Book value in 2018	$33,600,000
Revised remaining useful life in years	3
Revised depreciation (bookvalue/revised remaining useful life)	$11,200,000
Income will reduce by depreciation expense of $11,200,000 in 2018
2018 expenses using Heather Meyer approach to revise the service life of the equipment
and write down impairment value
Cost of Equipment	$42,000,000
Previous depreciation (cost /useful life)	$4,200,000
Depreciation for 2 years	$8,400,000
Book value in 2018	$33,600,000
Write down	$12,900,000
New depreciable value	$20,700,000
Revised remaining useful life in years	3
Revised depreciation (bookvalue/revised remaining useful life)	$6,900,000
Income will reduce by depreciation expense of $6,900,000 and an asset impairment value
of $12,900,000 totaled to $19,800,000 in 2018
Before tax income would be lower by $8,600,000 ($19,800,000-$11,200,000)
with Heather's approach
Heather Meyer's ethical delimma is whether he follow his boss and show a favourable net
income or question the application of revision in service life without taking into account
impairment loss.
If an asset is not able to recover its full book value due to decrease in product demand, the
asset is impaired