Question

Case #2

At the beginning of 2014, the Fancy 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 2014 and 2015. Late in 2016, 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 (2017 and 2018) and then discontinue the line. At that time, the equipment will be sold for minimal scrap values. The controller, Shannon Jones, was asked by Jerry Dent, the company's chief executive officer (CEO), to determine the appropriate treatment of the change in service life of the equipment. Shannon 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 (3 years). The CEO does not like Shannon’s conclusion because of the effect it would have on 2016 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, Shannon.” Required: 1. What is the difference in before-tax income between the CEO's and Shannon’s treatment of the situation? (Hint: calculate before-tax income the way the CEO would like and compare to Shannon’s method). 2. Why would the CEO have an incentive to not record the impairment? 3. Discuss Shannon’s ethical dilemma and give her advice on how to handle this situation.

Answer 1

1. Before tax income using the CEO’s treatment of the situation: Original cost = $42 million or $42,000,000. Thus annual depreciation amount as per the straight line method = $42,000,000/10 years = $4,200,000 per year (or $4.2 million per year)

Depreciation till date for 2014 and 2015 = $4,200,000 per year*2 years = $8,400,000 (or $8.4 million per year).

Thus book value = $42,000,000 - $8,400,000 = $33,600,000

Thus new amount of depreciation = $33,600,000/3 years remaining = $11,200,000 per year (for 2016, 2017 and 2018)

Thus under the CEO’s treatment of depreciation the income for 2016 will be reduced only by $11,200,000 which the depreciation amount for the year.

Before tax income using Shannon’s treatment of the situation: Original cost = $42 million or $42,000,000. Thus annual depreciation amount as per the straight line method = $42,000,000/10 years = $4,200,000 per year (or $4.2 million per year)

Depreciation till date for 2014 and 2015 = $4,200,000 per year*2 years = $8,400,000 (or $8.4 million per year).

Thus book value = $42,000,000 - $8,400,000 = $33,600,000

Amount of write down = $12,900,000. Thus new depreciable base = 33,600,000-12,900,000 = $20,700,000. This amount will now be depreciated using the straight line method for the next three years. Thus amount of depreciation = 20,700,000/3 = $6,900,000 per year.

Thus under Shannon’s treatment of depreciation and write down the income for 2016 will be reduced by $6,900,000 (this is the depreciation amount) and $12,900,000 (this is the write down amount). This will reduce the income by a total amount of $19,800,000.

2. The CEO will have an incentive not to record the impairment so as to report a higher amount of net income. By not reporting the impairment amount of $12,900,000 the CEO is effectively inflating the net income by that amount. This will work in favor of the CEO as variable pay and bonuses of CEO are directly related to net income. The higher the net income the higher will be the bonus that will be paid to the CEO.

3. The ethical dilemma facing Shannon is whether to record service impairment by partial write-down or to agree with the approach being suggested by the CEO.

To handle the situation Shannon should adhere to the professional code of conduct for accountants that require them to present a true, fair and unbiased picture of the financial position of the company. Thus Shannon should take into consideration impairment and write down the assets.