Analyse the case study on Sunshine Limited over the accounting issues related to the changing method of depreciation.
Depreciation is the systematic reduction in the cost of a fixed cost until the asset’s value becomes zero or near to zero. The reduction in the recorded value of the asset is done to give an impact of wear and tear nature of assets, asset obsolescence or depletion with the passage of time. Though, depreciation is charged to profit and loss account as an expense of the current financial year however it is not an expense in real sense. Rather, it a mere allocation of cost of the asset to its useful life (Tsamis & Liapis, 2014). There does not occur any cash outflow for depreciation. The prime purpose for which company charges depreciation on the assets is to prepare itself for the asset replacement one the useful life of asset already held by the entity. There are various methods of calculating of depreciation on any fixed assets such as straight-line method, written down method, sum of digits year method etc. (Tzovas, 2005).
Though, both the Generally Accepted Accounting Principles and International Financial Reporting Standards does not prescribe any particular method of depreciation to be mandatorily applied by the entities, but both emphasises on promoting the uniformity and consistency in the financial reporting practices (Gabriel, 2010). In the instant case, depreciation is charged by Sunshine Ltd. as per the straight line method. Under this method the useful life of the asset is determined firstly by making estimations. The expected salvage value of the asset is then deducted from the actual cost. The resulting amount is then equally distributed to the overall useful life of the asset.
The director of the Sunshine Ltd has instructed the accountant to change the method of deprecation from straight line to sum of years digits method to show the consistency of profits in all the years. The method of sum of years digit is emphasises on accelerating the process of depreciation. Under this method major portion of cost of asset is charged as depreciation in the initial years of useful life as it works on the assumption that assets are more productive in the initial years and thereafter their productivity of the asset decreases.
Change in the method of depreciation has direct influence on the amount of profits of the company in any financial year. The profitability of the company is the most important criteria which is used by the shareholders and other stakeholders to assess the financial health of the company. If the method of depreciation is changed merely for the purpose of misleading the shareholders by showing consistent profits, this practice will be opposed to the principles of corporate governance and also if the fact of change in method of depreciation is not disclosed in the notes to accounts of the financial statements then it would amount of violation of relevant accounting standards. Corporate governance is defined as the set of systems, procedures, principles, rules and regulations that provides directions to the managers to constantly control and monitor the business (Masulis, Wang & Xie, 2012). The main of corporate governance is to safeguard the interests of all the stakeholders of the company such as providers of finance, employees, investors or shareholders, regulatory bodies. If the company is not complying the corporate governance principles in undertaking its business, it might have to face various repercussions.
Business ethics is the most important part of corporate governance. In the conduct of business, the managers have to act in the ways that are morally correct. Business ethics are the moral principles which must be applied in undertaking all the significant aspects of the business. Business ethics helps the managers in maintaining the reputation of their business in the markets. The proper compliance with the code of ethics enhances the goodwill of the business which helps in retaining and attracting the potential investors as ethical practices generates confidence among the general public. Ethics are not only required to be applied in the business enterprises but also the professionals who are involved in providing various professional services are required to undertake only such practices that are ethically correct. In accounting profession, the accountants are generally responsible to the general public as they are expected to provide to the stakeholders, the necessary and appropriate financial information about the company’s state of affairs (AASB, 2004). In providing such information the accountants must act in the most professional and ethical manner so as to safeguard the stakeholder’s interest in the reporting entity. Ethical behaviour by the accountants can help them to prevent the fraudulent practices on part of management of the company in which they are functioning as the accountants (Ou, et al., 2014).
In this case, the accountant had to face the situation of ethical dilemma while providing the services of accounting profession to the employing entity. Ethical dilemma is the accounting profession is the situation where the management of the company instructs their accountants to record any event or transaction in a manner that is not in accordance with the generally accepted accounting principles and other rules framed by the regulatory bodies of accounting profession. The conflict of interests leads to the situation of ethical dilemma. From the given case, it can be seen that the accountant has to choose a particular course of action between accepting the instructions of manager of the company and functioning according to the requirements of accounting profession. If the accountant chooses to act in the best interest of his profession of accounting in accordance with the rules and policies framed by various regulators in the concerned area, his contract with the employing company will not be renewed which will affect the accountant’s personal interests. On the other hand, if the accountant chooses to act in the interest of his employing organisation, by changing the method of depreciation for the purpose of providing misleading financial results to the shareholders of the company, it would bring disrepute to the profession of accounting as it is not ethically correct on part of accountants to ignore the interests of the stakeholders of the company for their personal benefits and interests.
Maria Mars, the accountant of Sunshine Ltd. has to make a decision what would not only impede the trust of general public in the accounting profession but it would be detrimental to the interest of the shareholders of the company. The financial reports serves as the the only source of information available with the entity’s stakeholders regarding the financial performance of the company. These reports contains the information regarding the financial results of the reporting entity which helps the external parties i.e. the stakeholders to take sound and informed economic decisions. As shareholders are the parties who are not involved in the internal operations of the company, they require accountants of such company to provide them true and correct information regarding the company’s financial situation. If misleading or incorrect information about the entity’s state of affairs is provided by the accountants to the stakeholders, it could lead to incorrect decision making by such stakeholders. An incorrect decision can make the entity’s shareholders suffer heavy financial losses (Henderson, Pierson, Herbohn & Howieson, 2015). Therefore, the management accountant of the company must make adequate disclosures regarding the change in the method of depreciation along with the quantifications. Also, the reasons of such changes must also be mentioned by a way of notes to accounts so that users can understand the potential impact of such changes on the overall financial results of the reporting company.
The intention of the top level managers of the company behind changing the method of depreciation is not justified as the company is intending to mislead its shareholders by providing falsified information regarding the financial results of the company. The company is striving to manipulate the financial statements which is against the core business ethics and moral principles. The change in the method of depreciation is not a change in the accounting policy yet the method of depreciation cannot be changed until or unless there is a technical requirement to change it. Moreover, the change in the method of accounting can only be made if it is the requirement of new pronouncements, rules or policies by the regulatory bodies. Method of depreciation could also be made if it promotes better and appropriate presentation of financial information regarding the business transactions of the company as per the relevant accounting standards. However, in the instant case, the depreciation method is not changed for the above purposes. Rather, the change was intended to adjust the profits of the company in such a way that helps in depicting consistent profits over last few financial years which were actually not consistent in reality. Such change is aimed to make the shareholders of the company believe that the company is earning attractive profits since last few years and it has a sound financial track record.
The system of corporate governance is being questionable as the same is harming the shareholder’s interests in the company. The sound system of corporate governance requires proper communication between the company and its stakeholders regarding the financial results of the company so as to protect their interests. Managing the interests of stakeholders is the key function of system of corporate governance. It involves identifying their interests and powers in relation to the entity. Misrepresentation of financial statements for the purpose of creating misleading impression in the minds of its shareholders could never be a good element of corporate governance (Council, 2007). Further, if the adequate disclosure of the fact of change in the method of accounting is not made by the accountant of the reporting entity, it will adversely affect the level of desired communication as per the principles of corporate governance. The concealment of such a significant fact from the shareholders would amount to violation of such principles which can invite severe governmental interventions in the form of imposition of heavy penalties and fines or imprisonments (Irvine, Cooper & Moerman, 2011).
As per AASB 116 Property, plant and equipment, the method of depreciation once adopted by the entity must be applied consistently for all the years so as to promote the uniformity in the accounting treatment of assets on which depreciation is charged. However, such method of depreciation must be constantly reviewed at the end of every financial year by the management accountant of the company and it can be changed in the situation where there is any change in the pattern that was expected for the consumption of economic benefits to be incurred in future.
Conclusion:
In the current case, there does not exists any situation that demands the change in the method of depreciation hence the instructions given by the CEO of Sunshine Ltd. to the management accountant of the company to change the method of depreciation to satisfy its shareholders by showing fake consistency of profits, is not at all justified. The action of management to accept the instructions merely for the purpose of achieving the personal benefits of contract renewal between him and the concerned company is not ethically correct. Rather, the accountant shall act in the best interest of shareholders of the company to whom he is responsible to deliver true and correct financial information regarding entity. The accountant shall refuse the management of the company for adopting the changed method of depreciation and even if such change is made by the management, the accountant shall disclose it adequately by way of notes to accounts.
References:
AASB, A.S., 2004. Presentation of Financial Statements. Balance Sheet, 68, p.73.
Council, A.C.G., 2007. Corporate governance principles and recommendations.
Gabriel, S. J., 2010. Financial Accounting, Tata McGraw-Hill Education.
Henderson, S, Pierson, G, Herbohn, K & Howieson, B, 2015. Issues in Financial Accounting, Pearson Higher Education AU.
Irvine, H., Cooper, K. and Moerman, L., 2011. An epistemic community as influencer and implementer in local government accounting in Australia. Financial Accountability & Management, 27(3), pp.249-271.
Keating, A.S. and Zimmerman, J.L., 1999. Depreciation-policy changes: tax, earnings management, and investment opportunity incentives. Journal of Accounting and Economics, 28(3), pp.359-389.
Masulis, R.W., Wang, C. and Xie, F., 2012. Globalizing the boardroom—The effects of foreign directors on corporate governance and firm performance.Journal of Accounting and Economics, 53(3), pp.527-554.
Ou, A.Y., Tsui, A.S., Kinicki, A.J., Waldman, D.A., Xiao, Z. and Song, L.J., 2014. Humble chief executive officers’ connections to top management team integration and middle managers’ responses. Administrative Science Quarterly, p.0001839213520131.
Tsamis, A., & Liapis, K., 2014. Fair Value and Cost Accounting, Depreciation Methods, Recognition and Measurement for Fixed Assets. International Journal of Economics & Business Administration (IJEBA), 2(3), 115-133.
Tzovas, C., 2005. The Depreciation-policy Deci-sions of Industrial Firms: Tax Benefits Versus Non-tax Costs. Spoudal, 2, 48-77.
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