Flo Choi Owns A Small Business And Manages Its Accounting

Flo Choi Owns A Small Business And Manages Its Accounting Her Company

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

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Depreciation is a fundamental accounting process that allocates the cost of tangible assets over their useful lives. For managers like Flo Choi, making informed decisions regarding depreciation methods is critical because these choices directly impact financial statements, tax liabilities, and stakeholders’ perceptions. The decisions that managers face when applying depreciation methods involve considerations of timing, accuracy, and ethical standards that influence the reported profitability and financial health of the business.

One primary decision involves selecting the appropriate depreciation method. Common options include straight-line depreciation, which allocates an equal expense over the asset's useful life, and declining balance methods, which accelerate depreciation to recognize higher expenses earlier in the asset's lifespan. Managers must decide which method best reflects the asset's usage and economic reality; for example, assets that lose value more rapidly in the early years may warrant accelerated depreciation methods. This choice can affect net income, taxes payable, and ultimately, cash flows.

Another critical decision pertains to the useful life and residual value of assets. Managers must estimate these parameters accurately because overriding these estimates can misstate profits. Overestimating useful life or residual value could inflate earnings, potentially misleading stakeholders. Conversely, underestimating these figures accelerates expense recognition but may undervalue the company's assets. Therefore, managers often rely on industry standards, past experience, and professional judgment to set these parameters.

Additionally, managers like Choi must decide how to handle changes in depreciation estimates and the timing of depreciation recognition. Empirical evidence suggests that managers sometimes manipulate these aspects for financial reporting benefits, raising ethical issues. For instance, delaying depreciation till a later period to inflate current profits may violate accounting principles that emphasize honesty and transparency.

In Choi's case, she introduces a new depreciation rule that assets are considered in use on the first day of the following month after acquisition, differing from the traditional approach where assets are deemed in use on the first day of the nearest month to purchase. This decision raises important questions about its legitimacy and ethical standards. Ethically, this change may be justified if it better reflects economic reality and adheres to accounting standards. However, if the change is made solely to manipulate profits—by delaying depreciation expenses—it could be deemed a form of earnings management, thus violating ethical norms.

From an ethical perspective, the legitimacy of Choi's depreciation rule depends on transparency and consistency. Legitimacy is more assured if the new policy aligns with generally accepted accounting principles (GAAP) and is disclosed adequately in financial statements. If the rule accurately and fairly represents the in-use date of assets, it is a legitimate decision. Conversely, if it tends to artificially inflate profits or hide expenses, it could be viewed as ethical misconduct. The code of ethics in accounting emphasizes honesty, integrity, and transparency—standards that managers should uphold when choosing depreciation policies.

The impact of Choi's new depreciation rule on her business’s profit margin is significant. By considering assets to be in use only from the first day of the following month, depreciation expenses may be deferred, at least temporarily. This deferral reduces depreciation expenses in the current period, resulting in higher reported net income and, consequently, a higher profit margin. This increase could temporarily enhance the company's profitability metrics, potentially influencing stakeholder perceptions positively.

However, the deferred depreciation expenses will affect future periods as they are recognized later. Over time, this might lead to inflated profits in early periods and deferred expenses that could lower future profitability. Nonetheless, the immediate effect is a boost in profit margins, which could influence the bank's perception of the company’s financial health and potentially impact Choi's ability to secure favorable loan terms.

In conclusion, managers like Choi must carefully weigh the ethical implications and accuracy in applying depreciation methods. Their decisions should comply with established accounting standards and reflect the true economic realities of their assets. While flexible approaches might offer short-term advantages, such as improved profit margins, they should never compromise transparency or deceive stakeholders. Ultimately, the goal is to present a fair and accurate depiction of the company's financial position, fostering trust and supporting sound financial decision-making.

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