Flo Choi owns a small business and manages its accounting.?

Question

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 semiannual 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.)

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

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

Answer 1

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

This looks like a homework question and I guess your teacher expects you to say this is an ethical violation because the intention is to mislead the banker.

However this method of depreciation is not an uncommon practice in real life. Some companies start depreciating from the month of purchase regardless of when the purchase is made, but they make up for it by not depreciating at all in the month of disposal. Some companies start depreciating from the month after the purchase, but they depreciate a whole month in the month of disposal.

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

I suspect the effect will be negligible. Under the previous practice, assets were depreciated from the 1st day of the month nearest to the purchase date, so anything purchased in the 2nd half of the month would start depreciating in the next month anyway. So this new rule only affects assets purchased in the 1st half of the month, resulting in 1 month's depreciation less than the old rule. It's probably not going to amount to much. You don't purchase material items like land every month.