Carol Keene, corporate controller for Dumaine Industries, is trying to decide ho
ID: 2507583 • Letter: C
Question
Carol Keene, corporate controller for Dumaine Industries, is trying to decide how to present "Property, plant, and equipment" in the balance sheet. She realizes that the statement of cash flows will show that the company made a significant investment in purchasing new equipment this year, but overall she knows the company's plant assets are rather old. She feels that she can disclose one figure titled "Property, plant, and equipment, net of depreciation," and the result will be a low figure. However, it will not disclose the age of the assets. If she chooses to show the cost less accumulated depreciation, the age of the assets will be apparent. She prepares the following.
Property, plant and equipment, net of depreciation $10,000,000
rather than
Property, plant, and equipment 50,000,000
Less: Accumulated depreciation (40,000,000)
Net book value $10,000,000
Answer the following questions:
1. What are the ethical issues involved?
2. What should Keene do?
Explanation / Answer
The "ethical" issue involved is a lack of transparency in financial reporting. By not reporting the accumulated depreciation she is not providing complete, accurate, and transparent financial info. She should show accumulated depreciation. On the other hand, an astute analyst would be able to calculate an average remaining life of the assets by dividing the net book by the depreciation expense from the income statement. Lets say that all but the new equipment are fully depreciated, that leaves $10m in new equipment. Say the other $40m was depreciated over 20 years straight-line and that the current year is the 20th year, giving a depreciation expense of $40m / 20 yrs = $2m. This would indicate that the remaining life of the assets is $10m / $2m = 5years - this would obviously be misleading and could, perhaps, actually be disadvantageous (punitive) to an analysis of the company's assets. Additionally, the Statement of Cash Flows would reflect both the purchase of the new equipment (CF Investing) and the depreciation (CF Ops - added back in the indirect method). She can't "hide" the numbers and trying to do so would just raise doubt in an analyst's mind about the quality of the financial statements and the quality of corporate governance.
Edit - re: Add'l Details
I used an ASSUMPTION that the "old" equipment was depreciated on a straight-line, 20 year basis because I do not have the figure for the ACTUAL depreciation expense. Needing to "create" a depreciation expense, I chose 20 years, giving $2m. The 20 year period is "generous" in the sense that it "produces" only a $2m annual depreciation expense. Using 20 years (on the $40m accumulated depreciation) makes the new ($10m) equipment have a remaining life of 5 years. This is "misleading" since the new equipment presumably would have the same depreciable "life" as the old equipment - 20 years, not 5 years. (It may actually only have a 5 yr life, but it would be odd to replace old equipment with 20 year lives, with new equipment that only had a 5 yr. life.) Here are some other numbers assuming different straight-line depreciation "lives":
10yrs: $40m/10 = $4m depr. expense = remaining life of $10m/$4m = 2.5 years (again, would be "odd" that the new equipment has a 2.5 yr life, when the old equipmt had a 10 year life)
Keep in mind that analysts use existing financial statements to project future performance. If an analyst saw only Net Assets and Depreciation Expense, they would project depreciation expense based off of current levels - i.e. the $2m. They would not know that $40m of equipment had already been fully depreciated and that next year's depreciation expense might actually only be $10m / 20 years = $0.5m. Hence the financial statements are "misleading"- an analyst would project $2m depr exp, when in actuality it may only be $0.5m. They are also misleading b/c it's not clear that the bulk of the company's equipment may soon need replacing - at a large capital expense - using either internally generated cash - i.e. from cash flow generated by operating income, or from new debt, either one of which would impact next years balance sheet and/or Cash Flows. This would impact next year's leverage ratios (in the case of new debt), and/or cash flows (in the case of using internally generated funds, or when payments on new debt affect (reduce) cash flows & profits). FYI-one other thing: a discussion of equipment depreciation rates (either specifically or in general) are usually found in the notes to the Financial Statements - Ms. Keene cannot hide from a good analyst!
(Add'l note: the ROA would change significantly. Example: say NI is $10m and the equipment is the co's only asset. This year ROA is $10m/$10m = 1 x 100% = 100%. Next year, same NI but all old equipment is replaced such that Net Assets = $50m...ROA is $10m/$50m = 0.2 x 100% = 20% - quite a difference!)