Answer to Question #211423 in Economics of Enterprise for Huong Pham

Question

Case Study HP Company is suffering declining sales of its medical products. The president, Toshio Nakao, instructs his controller, Satoshi Kasai, to lengthen asset lives to reduce depreciation expense. A processing line of medical equipment, purchased for $4 million in January 2020, was originally estimated to have a useful life of 5 years and a salvage value of $200,000. Depreciation has been recorded for 2 years on that basis. Nakao wants the estimated life changed to 10 years total and the straight-line method continued. Kasai is hesitant to make the change, believing it is unethical to increase net income in this manner. Nakao says, “The life is only an estimate, and I've heard that our competition uses a 12year life on their medical equipment.”Instructions
(a) Who are the stakeholders in this situation?
(b) Is the proposed change in asset life unethical? Give your explanation.
(c) What is the effect of Nakao's proposed change on income before taxes in the year of change?

Answer 1

(a) Stakeholders are the persons who have a stake (interest) in the company

HP Company is dealing in medical products, hence, the stakeholders, in this case, will be the pharmaceutical industry, the government, the customers, the insurance company, and the employees of HP company.

(b) Yes, the proposed change in asset life is unethical. This is because, the asset value and its useful life cannot be adjusted as per the comfort of the company, in order to inflate or reduce the income. The revaluation of an asset and its useful life is done only after taking into consideration, the fair value (market value) of the asset and other external factors. It is important to consider the expert's advice before revaluation of the asset or changing the useful life. Also, the expert's opinion, along with the reason for such change should be documented before applying the same in the financial records.

Merely because the competitors use a 12-year life on their medical equipment, HP company cannot change the useful life. Also, the intention behind the change is to reduce depreciation expenses in order to increase the income. Hence, the proposed change is unethical.

(c) Such a change would result in depreciation being recorded at $285,000 per annum (calculated below) instead of the current depreciation of $760,000 per annum i.e. $(4,000,000- 200,000)/5. Hence, income before tax would increase by $475,000 i.e. $(760,000-285,000) in the year of change and thereafter.