For Accounting only

Ethics Case 11–10

Asset impairment

• LO11–8

At the beginning of 2011, the Healthy Life Food Company purchased equipment

for $42 million to be used in the manufacture of a new line of gourmet frozen

foods. The equipment was estimated to have a 10-year service life and no

residual value. The straight-line depreciation method was used to measure

depreciation for 2011 and 2012.

Late in 2013, it became apparent that sales of the new frozen food line were

significantly below expectations. The company decided to continue production

for two more years (2014 and 2015) and then discontinue the line. At that time,

the equipment will be sold for minimal scrap values.

The controller, Heather Meyer, was asked by Harvey Dent, the company's chief

executive officer (CEO), to determine the appropriate treatment of the change in

service life of the equipment. Heather determined that there has been an

impairment of value requiring an immediate write-down of the equipment of

$12,900,000. The remaining book value would then be depreciated over the

equipment's revised service life.

The CEO does not like Heather's conclusion because of the effect it would have

on 2013 income. “Looks like a simple revision in service life from 10 years to 5

years to me,” Dent concluded. “Let's go with it that way, Heather.”

Required:

1. What is the difference in before-tax income between the CEO's

and Heather's treatment of the situation?

2. Discuss Heather Meyer's ethical dilemma.

Ethics Case 11–10 Requirement 1

2013 expense using CEO's approach:

$42,000,000 Cost

$4,200,000 Previous annual depreciation ($42,000,000 ÷ 10 years)

x 2 years 8,400,000 Depreciation to date (2011–2012)

33,600,000 Book value

÷ 3 Estimated remaining life (2013–2015)

$11,200,000 New annual depreciation

2013 income would include only depreciation expense of $11,200,000.

2013 expense using Heather's approach:

$42,000,000 Cost

$4,200,000 Previous annual depreciation ($42,000,000 ÷ 10 years)

x 2 years 8,400,000 Depreciation to date (2011–2012)

33,600,000 Book value

12,900,000 Write-down

20,700,000 New depreciable base

÷ 3 Estimated remaining life (2013–2015)

$ 6,900,000 New annual depreciation

2013 income would include depreciation expense of $6,900,000 and an asset

writedown

of $12,900,000 for a total income reduction of $19,800,000.

Using Heather's approach, 2013's before tax income would be lower by $8,600,000

($19,800,000 – 11,200,000).

Case 11–10 (concluded)

Requirement 2

Discussion should include these elements.

Facts:

GAAP provides guidance for recording impairment losses on partial write-downs

of property, plant, and equipment and intangible assets remaining in use. Assets

should be written down if there has been a significant impairment of value such as

in

decreased product demand and full recovery of book value through use or resale is

not

expected. Although the decision and computation to record an impairment loss

often

is very subjective and difficult to measure, Heather is able to estimate an

equipment

impairment of $12,900,000, presumably using the best information available. The

simple revision in service life approach is clearly an effort to enhance net income

on

the part of the CEO.

Ethical Dilemma:

Is Heather's obligation to challenge the questionable application of revision in

service life more important than her obligation to her boss and to the company's

effort

to reflect a favorable net income?

Who is affected?

Heather

CEO and other managers

Other employees

Shareholders

Potential shareholders

Creditors

Company auditors