Stephen Contractors, Inc. owns several buildings, a large amount of machinery an

Question

Stephen Contractors, Inc. owns several buildings, a large amount of machinery and five vehicles. The company is looking to expand in the near future by purchasing more buildings and equipment. In April, the board of directors meets to look over interim financial statements to make decisions about the timing and size of the expansion. Depreciation is only recorded at year-end so the interim statements (January, February and March) do not include any depreciation expense. How would the missing deprecation impact the financial statements? Does the board need to know that information? How might the information or lack of information change the outcome of the board decisions?

Explanation / Answer

(a) Depreciation is included in a cost of operations, which lower net income. So, unreported depreciation will overstate the net earnings in income statement, overstate assets in balance sheet and understate the net cash flow in cash flow statement.

(b) To ensure precision in decision making, the board should know the impact (dollar amount and % of understatement/overstatement) caused by the "missing" depreciation.

(c) However, this information, even though may be disclosed in the footnotes or MD&A of the annual reports, is not likely to much impact the expansion decision. That's because expansion is a capital project which spans for more than one year, so the effects of lower depreciation in current year will keep rolling to the next year, smoothing out any fluctuations.

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