Question

Assume you work as an assistant accountant in the head office of Netflix. With the increasing popularity of online movie streaming, your company has struggled to meet its earnings targets for the year due to the high cost of creating programming content unique to your company. It is important for the company to meet its earnings target this year because the company is renegotiating a bank loan next month that is necessary for international expansion, and the terms of that loan are likely to depend on the company’s reported financial success. Also, the company plans to issue more stock to the public in the upcoming year, to obtain additional expansion funds . The chief financial officer (CFO) has approached you with a solution to the earnings dilemma. She proposes that the programming costs which have been capitalized (reported as an asset) be depreciated over a period extended from 4 years to 10 years.   She claims that generally accepted accounting principles (GAAP) require estimates like this, so it wouldn’t involve doing anything wrong.

Question 1: How will the change in depreciation period impact reported net income in the current and future reporting periods?

Question 2: Is the CFO correct in stating that GAAP allows changes in estimates? Do you think it appropriate in this situation?

Answer 1

Question 1;

It is true that depreciation period have direct connection with net income in the current and future reporting periods. Let’s take an example; Suppose depreciation period of an asset is increased then total usable cost of the assets will be allocated to more time period hence depreciation for current period and future period will be lower. And we know that when depreciation expenses for current and future period are low then net income will be higher because depreciation expenses are deducted from sales revenue to arrive at net income.

If depreciation period in decreased then total usable cost of the assets will be allocated to the shorter time period hence depreciation for current period and future period will be greater, as a result net income will be lower.

Thus it is true that change in depreciation period affects reported net income in the current and future reporting periods.

Question 2;

Yes, the CFO correct in stating that GAAP allows changes in estimates because as per GAAP under following situations changes in accounting estimates are allowed;

·        Allowance for doubtful accounts

·        Reserve for obsolete inventory

·        Changes in the useful life of depreciable assets

·        Changes in the salvage values of depreciable assets

·        Changes in the amount of expected warranty obligations

As per information of the question, it is clear that firm is facing poor conditions of earnings hence with the help of a period extention from 4 years to 10 years, this firm can minimize annual depreciation expenses in current period and in future period too. And when depreciation costs are reduced then net income will be higher and it will lead to higher EPS as well. Thus it is appropriate in this situation.