Flo Choi owns a small business and manages its accounting. Her company just finished a year in which a large number of borrowed funds were invested in a new building addition, as well as in equipment and fixture additions. Choi’s banker requires her to submit semiannual financial statements so he can monitor the financial health of her business. He has warned her that as profit margins erode, this might raise the interest rate on borrowed funds to reflect the increased loan risk from the bank’s point of view. Choi knows that profit margins are likely to decline this year. As she prepares year-end adjusting entries, she decides to apply the following depreciation rule: all asset additions are considered to be in use on the first day of the month following the purchase date. (The previous rules assume that assets are in use on the first day of the month nearest to the purchase dates.)
In your response, address the following:
- Identify decisions that managers like Choi must make in applying depreciation methods.
- Is Choi’s rule an ethical violation, or is it a legitimate choice for computing depreciation?
- How will Choi’s new depreciation rule affect the profit margin of her business?