Question

ABC, Inc. purchased a machine for $11,000 that, in reality, would last 10 years and be sold for $1,000 at the end of its life. ABC, Inc.’s management was concerned about meeting analysts’ E.P.S. forecast so they opportunistically assumed that the salvage value would be $4,000 and it would operate for 20 years.

1. Assuming that management adopted its opportunistic assumptions when computing the asset’s depreciation expense, what would the financial statement implications (i.e., misstated accounts) over the asset’s actual life?

2. What would be the most effective way for the auditor to argue that the depreciation assumptions by the client were unrealistic during the first year in which the asset was depreciated?

Answer 1

Depreciation per SLM method = (Original cost - Salvage value) / Life of asset

Correct depreciation per year = ($11,000 - $1,000) / 10 = $1,000 per year

Incorrect depreciation per year charged by manage= ($11,000 - $4,000) / 20 = $350 per year

Financial implications over the asset's actual life are:

1. Depreciation has been undercharged in the books by the management, thus incorrectly inflating the net income for each year by $650 each year, for 10 years.

2. The net book value of assets at the end of each year is also inflated.

The auditor should challenge the life of the asset assumed by the management. This can be done by reviewing the peer companies operating in the similar industry as that of ABC Inc.

Also, the auditor should challenge the salvage value assumptions assumed by the management.