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Ethics And Governance In Depreciation Policy: Financial

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Question:

Discuss about the Ethics and Governance in Depreciation Policy for Financial.

 

Answer:

Introduction: 

The financial statements are prepared in accordance with the conceptual framework of accounting embedded with the accounting standards and the generally accepted accounting principles. In the given case study, emphasis has been placed on depreciation part of the accounting. In the first case, the change in the method of depreciation from Straight Line Method to Sum of year digit method has been discussed with compliance to the Australian Accounting Standard 116. In the second case, the depreciation has been calculated with different methods and the advantages and the disadvantages of each depreciation method have been provided. In the third case, the consolidated financial statements of the Wesfarmers Company has been analysed in regard to the depreciation if the valuation of the property, plant and equipment. The report is then ended up with the conclusion and recommendation.  

Meaning Of Depreciation And Its Uses 

The term depreciation is referred to as the amount set aside from the value of the asset regularly every year on account of the normal loss, wear and tear of the assets of the company. The depreciation is the non cash item and is charged to the Statement of Income.

Its major use is that the company will be able to match the cost of the assets with the benefits that the company has derived from the asset over the period of time. Apart from this matching concept, the company will be able to report the value of the assets in the true and fair manner. The third use of the depreciation is that it helps the company in saving the tax component as the tax laws provides that the depreciation is the allowable expenditure while calculating the taxable income (AASB, 2011 and 2014). 

Ethics And Givernance - Changing Depreciation 

Stakeholders:

Stakeholders are the persons who are vital to the survival of the company. Stakeholder includes shareholders, employees, government authorities, financial institutions and the customers. In the given situation, the first stakeholder is the shareholder of the company (Fontaine, Haarman and Schmid, 2016). Shareholders have invested in the company in order to have the dividends and the increase wealth. Since in the given case, the profit has been deferred from year 2016 and 2017 to the year 2018 and 2019, the return on the investment of the shareholders has been declined.

Another major stakeholder is the taxation authorities as less tax will be paid by the company on the declared profits of the year 2016 and 2017.

Ethical Issues:

Ethics are the rules and principles comprised of the moral beliefs which conduct the behavior of the individuals involved in the working of an organization like employees, top management officials, etc (Andrews, 2011). Following are the ethical issues which is present:

  • Financial Statements of the company has been misrepresented by deferring the profit of the company. Thus, ethics in Finance has been violated.
  • The decision has been made with the consent of employees. Thus, ethics in personnel have been violated (Harsen, 2004).
  • The professional, Marion, has agreed in order to save his professional engagement with the company.
  • The change in method of depreciation has been done without informing shareholders of the company and other stakeholders (Arjoon and Gopal, 2003).
  • Non compliance with the requirement of the accounting standards as the company has not disclosed the fact of change in the method of depreciation in the notes to the financial statements of the company (Badaracco, 2005 and Longstaff , 2008).    

Objective of the Company Met by Change in Method 

The company has been advised by Marion to change the accounting method from the straight line method to Sum of Years digit method.

In the straight line method, equal amount is charged over the useful life of an asset whereas under the sum of year’s digit method, the higher depreciation is charged in the nearer periods and the lower depreciation is charged in the future periods (Australian government official website, 2014).

By changing the depreciation method the company will be able to generate lower profits in the earlier years and higher profits in the future years and thus in this way the change in method of depreciation has been able to meet the objective.

 

Marion’s Action Compliance 

The International Accounting Standard 16 and Australian Accounting Standard 116 provide that the company shall disclose all the facts relating to the assets of the company that has happened during the year (EC Europa, 2009). This standard prescribes that the following shall be disclosed:

  • Carrying amount of asset  
  • Depreciation method
  • Useful life of an asset
  • Value of Impairment Loss and
  • Reconciliation statement showing each head of the Property Plant and Equipment (IFRS Official Website, 2012)

Also as per the accounting standard 108, the company is required to disclose the change in method of depreciation as the change in an accounting estimate.

From the above, Marion fails to comply with the said provisions.

Decision Analysis – Depreciation Of Machinery 

Depreciation Schedules

DEPRECIATION SCHEDULES UNDER DIFFERENT METHODS

S. No.

Method

Year Ending 30th June

Annual Depreciation Expense

Accumlated Depreciation

Carrying Amount at end of Year

1

Straight Line

2016

 $        110,000

 $       110,000

 $     1,090,000

   

2017

 $        110,000

 $       220,000

 $         980,000

   

2018

 $        110,000

 $       330,000

 $         870,000

   

2019

 $        110,000

 $       440,000

 $         760,000

   

2020

 $        110,000

 $       550,000

 $         650,000

2

Diminishing Balance

2016

 $        264,000

 $       264,000

 $         936,000

   

2017

 $        205,920

 $       469,920

 $         730,080

   

2018

 $        160,618

 $       630,538

 $         569,462

   

2019

 $        125,282

 $       755,819

 $         444,181

   

2020

 $           97,720

 $       853,539

 $         346,461

3

Sum of Years Digit

2016

 $        200,000

 $       200,000

 $     1,000,000

   

2017

 $        180,000

 $       380,000

 $         820,000

   

2018

 $        160,000

 $       540,000

 $         660,000

   

2019

 $        140,000

 $       680,000

 $         520,000

   

2020

 $        120,000

 $       800,000

 $         400,000

4

Units of Production Method

2016

 $        205,224

 $       205,224

 $         994,776

   

2017

 $        184,701

 $       389,925

 $         810,075

   

2018

 $        225,746

 $       615,672

 $         584,328

   

2019

 $        238,060

 $       853,731

 $         346,269

   

2020

 $        246,269

 $   1,100,000

 $         100,000

Advantages and Disadvantages of Each Depreciation Method 

Straight Line – This method is very easy to calculate and solve and is less time consuming. The main disadvantage is that it may not reflect the fair view of the performance of the assets (Arora, 2015).

Diminishing Balance – It is useful where the importance and the usage of the asset decline over the useful life. The disadvantage is that the rate of depreciation is subject to the personal bias.

Sum of Years Digit Method – It is very easier to grasp and on the other hand is very cumbersome to calculate.

Units of Production Method – It reflects the fair view of the performance of the assets. But it is very difficult to identify and difficult to measure the sense of reliability.

It is recommended to adopt straight line method as it is permissible by the Australian Accounting Standards. 

Buy Or Lease 

OPTION 1 – BUY

             

Calculation of IRR

             
   

YEAR 0

YEAR 1

YEAR 2

YEAR 3

YEAR 4

YEAR 5

NPV @ 20%

             

Present Value

 

(1200000)

350000

340000

355000

360000

380000

PVF (20%,n)

 

1.00

0.83

0.69

0.58

0.48

0.40

Present Value

 

(1200000)

291667

236111

205440

173611

152713

Net Present Value

 

(140458)

         

NPV @ 10%

             

Present Value

 

(1200000)

350000

340000

355000

360000

380000

PVF (10%,n)

 

1.00

0.91

0.83

0.75

0.68

0.62

Present Value

 

(1200000)

318182

280992

266717

245885

235950

Net Present Value

 

147725

         

IRR  (In Percentage)

=

Low Rate + (NPV at lower rate / (NPV at lower rate - NPV at higher rate))*(Difference in rates)

 

=

10+(147725 / (147725-(-140458))*(20-10)

   
 

=

15

         

   

OPTION 2 – LEASE

             

Calculation of IRR

 

YEAR 0

YEAR 1

YEAR 2

YEAR 3

YEAR 4

YEAR 5

NPV @ 70%

             

Present Value

 

(250000)

170000

150000

195000

205000

480000

PVF (70%,n)

 

1.00

0.59

0.35

0.20

0.12

0.07

Present Value

 

(250000)

100000

51903

39691

24545

33806

Net Present Value

 

(55)

         

NPV @ 60%

             

Present Value

 

(250000)

170000

150000

195000

205000

480000

PVF (60%,n)

 

1.00

0.63

0.39

0.24

0.15

0.10

Present Value

 

(250000)

106250

58594

47607

31281

45776

Net Present Value

 

39508

         

IRR  (In Percentage)

=

Low Rate + (NPV at lower rate / (NPV at lower rate - NPV at higher rate))*(Difference in rates)

 

=

60+(39508/ (39508-(-55))*(70-60)

     
 

=

70

         

As the Internal Rate of Return is higher in case of Leasing decision, the company shall adopt to have Machinery on Lease.

Analysis - Wefarmers 

Reporting of Property Plant and Equipment

The property plant and equipment has been reported at the cost less depreciation and impairment loss if any. The total carrying amount of Property plant and equipment for the year ending 30th June 2016 is $9612 Million.

Composition of Property Plant and Equipment

Property Plant and Equipment is composed of Freehold Land, Building, Leasehold Improvements, Plant, Vehicles and Equipment and Mineral Lease and Development (Wesfarmers Official Website, 2016). 

Methods of Depreciation Used

The depreciation has been calculated using straight line method in which cost has been depreciated over the useful life of an asset.

Rates of Depreciation or Useful Life of an Asset

Yes the group has disclosed the useful life of an asset. These are mentioned below:

  • Buildings 20 to 40 years
  • Plant and Equipments Between 3 and 40 years
  • Leasehold Improvements Leasehold period

Amount of Depreciation for Current and Previous Year

The amount of Depreciation charged in the current year is $1162 million and in the previous year $1101 million.

Purchases and Treatment of Borrowing Costs

Yes, asset of $1738 million has been purchased during the year. Yes assets of $984 million are under construction. Borrowing costs have been capitalized by the company in the assets. No the company does not have any commitments for future expansions.

Conclusion 

Depreciation has been the major part of the financial statements as it is directly related to the assets of the company which is counted as the Net Worth of the company. Every company is required to follow the guidelines of the accounting standards of the respective countries and also the International Accounting Standards.

To conclude, every company shall follow the correct depreciation method and shall not in any manner manipulate the financial statements of the company.

 

References 

AASB, (2011), “Depreciation” available on                                                                                                   https://www.aasb.gov.au/admin/file/content102/c3/AAS04_8-11.pdf  accessed on 31/08/2017

AASB, (2014), “Complied AASB Standard – Property, Plant and Equipment” available at https://www.aasb.gov.au/admin/file/content105/c9/AASB116_07-04_COMPjun14_07       -14.pdf            accessed on 31/08/2017

Andrews K., (2011), “Ethics in Practice : Managing the Moral Corporation”, Harward Business Review – School Press.

Arjoon S. , J. Gopal, (2003), “Ethical Orientation for Future Managers : The Case of Trinidad”, Social and Economic Studies, pages 98-114.

Arora D. (2015), “Different Methods of Depreciation calculation” available on https://scn.sap.com/docs/DOC-46210   accessed on 31/08/2017

Australian government official website, (2014), “Amendments to Australian Accounting Standards – Clarification of Acceptable Methods of Depreciation and Amortization”, available on https://www.legislation.gov.au/Details/F2014L01174  accessed on 31/08/2017

Badaracco T, (2005), “Business Ethics : A view from the Trenches”, California Management Review, Pages 8-28.

Fontaine C, Haarman A. and Schmid S, (2016), “The Stakeholder Theory” available on                             https://www.martonomily.com/sites/default/files/attach/Stakeholders%20theory.pdf                         accessed on 31/08/2017

EC Europa, (2009),”International Accounting Standard 16- Property, Plant and Equipment”available at https://ec.europa.eu/internal_market/accounting/docs/consolidated/ias16_en.pdf   accessed on 31/08/2017.

Harsen (2004), “Business Ethics Platitude or Commitment ?” Centre for Business Ethics,  Bentley MA

IFRS Official Website, (2012), “IAS 16 Property, Plant and Equipment” available at  https://www.ifrs.org/Documents/IAS16.pdf  accessed on 31/08/2017

Longstaff S., (2008) “The ethical dimension of Corporate Governance” available at https://www.ethics.org.au/on-ethics/blog/december-2008/the-ethical-dimension-of  -corporate-governance     accessed on 31/08/2017

Wesfarmers Official Website, (2016), “Annual Report 2016), available on   www.wesfarmers.com.au  accessed on 31/08/2017.

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