Your company has recently decided to change its method of depreciating long-term

Question

Your company has recently decided to change its method of depreciating long-term assets to be consistent with major competitors. Your company has always used the straight-line method while most other companies in the industry use a declining-balance method. Preliminary computations indicate that changing this accounting principle will reduce Earnings per Share by about 10% in the current year. Naturally, those to whom you report would like to know if there is any way to lessen the impact of this change.

You know that other factors in computing depreciation expense are the estimates of useful life and salvage value. You reason that if the estimated useful life of long-term assets is reassessed with minor modifications to the estimated lives, then switching the depreciation method will not decrease net income this period.

1) Can the plan of reassessing the estimated lives of long-term assets achieve the desired result of allowing the company to change depreciation accounting methods to a declining-balance method without reducing net income this period?

2) Will the company have a higher cash inflow as a result of either the change in principle or the change in estimate?

3) Should the level of a company’s income determine the accounting methods that it uses and the accounting estimates that it makes? Why or why not?

Explanation / Answer

1) The plan of re-assessing the estimated lives of long term assets can achieve the desired result of allowing the Company to change depreciation accounting methods to a declining-balance method without reducing the net income in this period. This is because the re-assessment of the useful life will lead to a simultaneous change in the depreciation rates, which are dependent on the useful life of the asset. This will in turn spread the depreciation impact on a more reasonable basis, without affecting the income for the year(s) in which the spread occurs.

2) Technically, the Company's cash flow will only be affected by the impact of the change in the value of depreciation by switching from one method to another. Hence, the amount of margin in the cash flow will either be higher or lower, depending on the quantum of assets of the Company, and the rates of depreciation to which they have been subjected to.

3) The accounting methods and accounting estimates made by a Company are purely dependent on the policies followed by similar companies working in the Industry. The Company's income levels in no way can determine the base for the accounting methods followed. Income earned is Company specific, and does not in any way influence the accounting methods and estimates. It is more of a peer following, based on set nomenclatures for like companies in the same domain area.

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