Question

Flo Choi owns a small business and manages its accounting. Her company just finished a year in which a large amount of borrowed funds was invested in a new building addition as well as in equipment and fixture additions. Choi’s banker requires her to submit semi-annual financial statements so he can monitor the financial health of her business. He has warned her that if profit margins erode, he might raise the interest rate on the borrowed funds to reflect the increased loan risk from the bank’s point of view. Choi knows profit margin is likely to decline this year. As she prepares year-end adjusting entries, she decides to apply the following depreciation rule: All asset additions are considered to be in use on the first day of the following month. (The previous rule assumed assets are in use on the first day of the month nearest to the purchase date.)

Required

1. Identify decisions that managers like Choi must make in applying depreciation methods.

2. Is Choi’s rule an ethical violation, or is it a legitimate decision in computing depreciation?

3. How will Choi’s new depreciation rule affect the profit margin of her business?

Short answer

1. The business entity must use thestraight-line method.
2. Ethics of rule book are violated.
3. Change in depreciation will have a slight effect on the profit margin of the business entity.

Step-by-step solution

Definition of Depreciation

A non-cash expense reported by the business entity for recovering the capital cost incurred in the acquisition of the fixed asset is known as depreciation. It is calculated using various available methods such as the straight-line method, declining balance method, and double declining balance method.

Decision for applying the depreciation method

If the business entity uses the asset equally or proportionally during the life of asset then it will be better to use the straight-line method of depreciation.

Violation of ethics

The business entity has previous rule that the business entity uses the asset on the first date of the month which is nearest to the purchase date and now the rule is changed for making profit looks better and reducing the depreciation expenses. This change in rule will violate the ethics of rule book.

Effect of depreciation on the profit margin

The decision made by Choi will reduce the depreciation expenses of the business entity and increase the profit margin. It will have a very small effect on the profit margin and the depreciation expense. The change in the method will affect the depreciation of the newly acquired assets only and it will also not affect the assets acquired in the second half of the month i.e., after 15^th of the month.