Impact of changing depreciation method on financial statements

The article discusses the impact of changing depreciation method from straight line to sum of years' method on financial statements. It explains how this can affect profits and share prices, and why companies may resort to such practices. The potential risks and ethical concerns associated with such practices are also highlighted.

FINANCIAL ACCOUNTING
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C) In the given case, the general manager Peter is asking Marion the accountant to alter the
depreciation method that has been used in the current year. The act of altering the
depreciation method from the currently prevalent straight line method to sum of years’
method would ensure that the depreciation in the starting years would be higher while in the
later years, the depreciation would be lower. This is because in case of straight line
depreciation, the amount of depreciation charged each year remains the same. However, this
is not the case in sum of digits depreciation system which is essentially a diminishing
depreciation system where the depreciation expense is skewed towards the beginning and
hence relatively lesser depreciation expense would be witnessed in the later years
(Damodaran, 2015).
The impact of this would be that in the current year depreciation expense would be higher
and it would gradually taper towards lower values in the future. This would lead to under-
reporting of profits in FY2016 and FY2017 and over-reporting of profits in FY2018 and
FY2019. This is because in the income statement one of the expenses pertains to
depreciation and since it is essentially a non-cash charge, hence the amount of depreciation
reflected in the income statement is dependent on the underlying method deployed by the
company. As a result, the actual profits of FY2016 and FY20917 would be higher than
reported while that of FY2018 and FY2019 would be lower than reported (Northington,
2015).
However, this shifting of profits from the present to the future would be immensely
favourable for the company. This is because the company expects that while the current year
has been good for the company, in the future there could be turbulence for the industry as a
whole. This can potentially lead to a sudden fall in the profits of the company which would
lead to missing street expectations and thereby would lead to downfall of the share price. In
order to avoid the same, the changes in depreciation method have been effected (Parrino &
Kidwell, 2014).
Since FY2018 and FY2019 are expected to be worse than FY2016 and FY2017, this practice
would ensure that the profits in FY2016-FY2019 do not show any abrupt change. The net
result would be that the share price would remain healthy as no disappointment would be
handed over to the shareholders and the analyst community. However, such an action could

prove to be disastrous in the future especially when such a practice becomes public and raises
issues related to corporate governance. Also, entertainment of such unethical practices can
potentially lead to more such future unethical practices which can lead to more serious
misrepresentation of the financial statements (Brealey, Myers & Allen, 2014).

References
Brealey, R. A., Myers, S. C., & Allen, F. (2014) Principles of corporate finance, 2nd ed. New
York: McGraw-Hill Inc.
Damodaran, A. (2015). Applied corporate finance: A user’s manual 3rd ed. New York:
Wiley, John & Sons.
Northington, S. (2015) Finance, 4th ed. New York: Ferguson
Parrino, R. & Kidwell, D. (2014) Fundamentals of Corporate Finance, 3rd ed. London:
Wiley Publications