You are the accountant for a small business. On January 2, 2014, the business pu

Question

You are the accountant for a small business. On January 2, 2014, the business purchased a large piece of equipment for $500,000. At that time, you used straight line depreciation, with no salvage value to depreciate the equipment over 10 years. It is now January 2, 2017 and you realize that your estimate on the useful life was inaccurate. You now estimate that the equipment will only be useful for 7 years from the date of acquisition.

Write a memo to the President, Janet Brown, describing how this change will affect the 2017 financial statements, both the income statement and balance sheet. Explain how you calculated the new depreciation expense and accumulated depreciation. Also, discuss how this change will affect prior years’ financial statements.

Explanation / Answer

Solution:

Cost of equipment = $500,000

Originally estimated life = 10 years

Salvage value = 0

Annual depreciation = $500,000 /10 = $50,000

Accumulated depreciation from 2014 to 2016 = $50,000 * 3 = $150,000

Book value on 2 jan 2017 = $500,000 - $150,000 = $350,000

Total useful life estimated on Jan 2, 2017 = 7 years

Remaining useful life = 7 - 3 = 4 years

Depreciation expense for next 4 years = Book value / 4 = $350,000 / 4 = $87,500

Memo to Presidne Janet Brown:

Dear Sir

We have purchased equipment on Jan 2, 2014 for $500,000. originally estimated life was 10 year and we are charging $50,000 annual depreciation on equipment. Till Jan 2, 2017 we have accumulated depreciation of $150,000 and bookd value of equipment is $350,000. Now we have again estimated useful life of equipment, and it come to our knowledge that total equipment life is 7 years only, therefore remaining useful life of this equipment is only 4 years. Therefore remaining booke value will be depreciation over remaining useful life of 4 years resulting annual depreciation expense of $87,500. Thus it will result in increase in depreciation expense in income statement by $37,500 ($87,500 - $37,500) and book value of equipment will decrease by $37,500 more every year in balance sheet. Further change is estimated useful life of asset is considered as change in accouting estimates and its effect is taken in books prospectively, Therefore it will not affect prior year's financial statements.

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