accounting cases

Smith Publishers, Inc. produces various manuals ranging from computer software instructional booklets to manuals explaining the installation and use of large pieces of industrial equipment. At the end of 2016, the company's balance sheet reported total assets of $62 million and total liabilities of $40 million. The income statement for 2016 reported net income of $1.1 million, which represents an approximate 3% increase from the prior year. The company's effective income tax rate is 30%.

Near the end of 2016, a variety of expenditures were made to overhaul the company's manufacturing equipment. None of these expenditures exceeded $750, the materiality threshold the company has set for the capitalization of any such expenditure. Even though the overhauls extended the service life of the equipment, the expenditures were expensed, not capitalized.

John Henderson, the company's controller, is worried about the treatment of the overhaul expenditures. Even though no individual expenditure exceeded the $750 materiality threshold, total expenditures were $70,000.

Required:

Should the overhaul expenditures be capitalized or expensed? Give your rationale to justify your position.

Case #2 3

At the beginning of 2014, the HL 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 2014 and 2015.

Late in 2016, 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 (2017 and 2018) and then discontinue the line. At that time, the equipment will be sold for minimal scrap values.

The controller, Stephanie Taylor, was asked by Steve Dent, the company's chief executive officer (CEO), to determine the appropriate treatment of the change in service life of the equipment. Stephanie 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 Stephanie’s conclusion because of the effect it would have on 2016 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, Stephanie.”

Required:

1. What is the difference in before-tax income between the CEO's and Stephanie’s treatment of the situation?

2. Discuss Stephanie’s ethical dilemma and give her advice on how to handle this situation.

Case #3

Companies often are under pressure to meet or beat Wall Street earnings projections in order to increase stock prices and also to increase the value of stock options. Some resort to earnings management practices to artificially create desired results.

Required:

1. How can a company manage earnings by changing its depreciation method? Is this an effective technique to manage earnings?

2. How can a company manage earnings by changing the estimated useful lives of depreciable assets? Is this an effective technique to manage earnings?

3. Using a fictitious example and numbers you make up, describe in your own words how asset impairment losses could be used to manage earnings. How might that benefit the company?