The following document is my answer for Discussion Leasehold Improvements Ethics. Read and base on my comment, please answer the following two questions:
Discussion: Leasehold Improvements Ethics 5-1
1. How would increasing the depreciation period affect American Movieplex's income?
2. Does revising the estimate pose an ethical dilemma?
3. Who would be affected if Person's suggestion were followed?
1. If the theater depreciates an asset for $28 million for 12 years, and for reasons of simplicity, we'll assume straight-line depreciation, the depreciation expense per year would be $2,333,333 per year for each of the twelve years. If the theater depreciates it over 25 years, the depreciation amount would be $1,120,000, because we're extending the number of years. The higher the depreciation expense, the higher it makes total expenses. Even though depreciation is considered a non-cash expense, it affects the total expenses and the income statement the same as the other expenses. A higher depreciation will result in a lower net income. The theater is using 12 years, which is increasing total expenses, and dropping net income. Because it's dropping net income, the theater is paying less income tax. If the theater used 25 years, the depreciation expense per year would decrease, creating a higher net income. They have decreased the useful life to drop net income, in order to pay less tax.
2. Whenever depreciation estimates are revised, it always poses an ethical dilemma, because depreciation is a non-cash expense that management often manipulates, as they did here, to either increase or decrease net income. We see the same thing with large companies that are trying to keep net income high, to meet investor calls. The companies will improperly decrease depreciation by extending the useful life, which ultimately increases net income. When depreciation adjustments are made, they should be fully disclosed in the notes to the income statement. Reasons why the revision was necessary should be included, as well as how the adjusted amount affects the company's financial position. The main ethical dilemma lays in the fact that the company must scrutinize their own actions, and be able to justify that the depreciation changes are actually due to the realistic change in the useful life of an asset. If they are, it is ethically justified, as well.
3. If the asset is depreciated over the 25-year period, when the company is accustomed to depreciating over 12 years, it will create a higher net income. This will affect the owners of the franchise, because they will pay a higher amount in income taxes, respective to the ownership percentage. If the company is a corporation, the company will pay taxes on a higher net income. This may affect other aspects of the business, because there will be less money for other allocations, including raises, general operating expenses, and purchases of other assets.
QUESTIONS IN REFERENCE TO THE DISCUSSION POST
1. Questions from D. A.
Hi, Regarding your third point saying they will pay higher taxes. For GAAP that is true and it all equals out in the end, but they would likely depreciate faster for tax purposes and wouldn't see a higher tax bill.
2. Questions from K. L.
Hi Joseph,
Nice explanations of the effects of depreciation - your post is well laid out and clear enough that I think even "non-accounting people" could understand it. What would you do if you were in the Controller's position?