Question

Legitimate Decision or Ethical Violation

The following scenario and questions are adapted from page 397 in your textbook:

You are the owner of a small business and manage its accounting function. Your company just finished a year in which a large amount of borrowed funds was invested in a new building addition and in new equipment and fixture additions. Your banker has required you to submit semiannual financial statements so he can monitor the financial health of your business. He has warned you 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. You know that profit margins are likely to decline this year. As you prepare year-end adjusting entries, you decide 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 the purchase date.

You anticipate your banker may ask the following questions when you meet with him in a couple of weeks: Is your new rule an ethical violation or is it a legitimate decision in computing depreciation? How will the new depreciation rule affect the profit margin of your business?

Answer 1

Is your new rule an ethical violation or is it a legitimate decision in computing depreciation?

My purpose of the new rule is to portray an increase in the profit margin for the year by removing one month of the depreciation expense from the current financial year by holding them and posting it to the following month while the purchased assets are in use. This would make the bank not to increase the loan interest rate on the borrowed funds. This is an ethical violation and is a legitimate decision in computing the depreciation because as a owner of the business, I would try to maximize the profits of the business. My objective is to pay-off the loans instead of struggling with high interest rate and unable to pay-off the loan. The increased interest rate might reduce the profit margins considerably thus acts as a threatening factor of failure to the company. Rather I would apply the new rule as an ethical violation for the survival of the business and to pay-off the borrowed funds. However, if I know that the depreciation rule that I applied is misleading and does not reflect the purpose of the assets usage in the business, then it is considered as unethical.

How will the new depreciation rule affect the profit margin of your business?

While accounting, it is pertinent that all the assets are computed and shown in the balance sheet. For example, replacement of equipment when renovating the building, upgrades or regular repairs, etc. These are debited in the capital expenditure. And these are shown in the capital expenditure. I need to apply the depreciation rule which states that expenses of the assets in the period in which they are used. Instead, I used the depreciation rule: All asset additions are considered to be in use on the first day of the following month, which is ofcourse an ethical violation. Though I assume that the profit margin would reduce in the following year, the depreciation rule that I applied will not meet its purpose. This is because I need to compute the Balance Sheet and other monthly reports eventually resulting in complications in arriving at the profit margins.