Sal Shirey is an owner of a small business. His company has recently borrowed a

Question

Sal Shirey is an owner of a small business.  His company has recently borrowed a large amount of funds to finance the construction of a large building addition, as well as, the purchase of equipment and machinery.  Shirey's banker requires him to submit quarterly financial statements so that he can monitor the financial health of his business.  The bank has warned that if profit margins decline, the interest rate on the loan may need to be increased in order to reflect additional risk.  Shirey knows that profit may decline this year.  As he is preparing the year-end adjusting entries, Sal decides, for depreciation purposes, to treat all long-term asset purchases as though they occurr on the first day of the month following the month of purchase. 

1. Is there an ethical issue with the implementation of this rule?  If so, what is it?

2. When should depreciation first be recorded?

3. What impact will Shirey's approach to recording depreciation have on the financial statements?

Explanation / Answer

1. Yes there is an ethical issue with the implementation of this rule as it will wrongly enable Sal Shirey to reduce the depreciation expenses in his books of accounts. As the depreciation amount is reduced his business’s profit margin will increase. This is an unethical practice because as per IRS depreciation calculation should begin on the service date of the asset i.e. from the date when an asset is placed in service. By treating the long-term asset purchases as though they occur on the first day of the month following the month of purchase Sal is wrongly reducing the amount of depreciation expenses.

2. As already mentioned depreciation is usually recorded from the service date onwards. Service date can be different from the purchase date of the asset. As per IRS an asset is considered to be placed in service when it is first put into a condition or state of readiness and availability for a specifically assigned function. Thus depreciation should begin either on the purchase date or on the service date (if it is different from the purchase date).

3. The impact on financial statements will be that the company’s profits will be higher due to lower amount of depreciation that has been recorded in books. As such in the balance sheet the amount of accumulated depreciation will be lower than the amount that should actually have been reported and the amount of retained earnings will be higher than the amount that should actually have been reported. In the income statement net income will be shored up as well due to lower depreciation amount recorded in books.

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