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Accounting

27th Edition
WARREN + 5 others
ISBN: 9781337272094

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BuyFindarrow_forward

Accounting

27th Edition
WARREN + 5 others
ISBN: 9781337272094
Textbook Problem

Ethics in Action

Hard Bodies Co. is a fitness chain that has just completed its second year of operations. At the beginning of its first fiscal year, the company purchased fitness equipment at a cost of $600,000 and estimated that the equipment would have a useful life of five years and no residual value. The company uses the straight-line depreciation method. The company reported ne t income for the first two years of operations as follows:

Year Net Income (loss)
1 $50,000
2 (2,000)

Mike Gambit, the company’s chief financial officer (CFO), has recently run financial models to predict future net income, and he expects net losses to continue at $(2,000) per year for the next three years. James Steed, the president of Hard Bodies, is concerned about these predictions, as he is under pressure from the company’s owner to return the company to Year 1 net income levels. If the company does not meet these goals, both he and Mike will likely be fired. Mike suggests that the company change the estimated useful life of the fitness equipment to 10 years and increase the equipment’s estimated residual value to $50,000. This will reduce depreciation expense and increase net income.

  1. 1. Evaluate the decision to change the equipment’s estimated useful life and estimated residual value to improve earnings. How does this change impact the usefulness of the company’s net income for external decision makers?
  2. 2. If Mike and James make the change, are they acting in an ethical manner? Explain.

(1)

To determine

Straight-line Depreciation: Under the straight-line method of depreciation, the same amount of depreciation is allocated every year over the estimated useful life of an asset. The formula to calculate the depreciation cost of the asset using the residual value is shown as below:

Depreciation cost = (Cost of the assetResidual value)Estimated useful life of the asset

To evaluate: the decision to change the equipment’s estimated useful life and estimated residual value to improve earnings.

Explanation

To estimate the factors that determine the value of depreciation expense in order to present an unique financial statement is a challenge for the company. This is because, the useful life and the residual value of plant assets are not actual but are estimated figures.

Thus, the company must have an effective analysis of its historical data to have a proper and fair estimation of the figures as per GAAP (G...

(b)

To determine

To explain: whether Mr. M and Mr. J are acting in an ethical manner.

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