Question

A large body of scholarly literature exists relating to the subject of choices of accounting methods. The choice of depreciation methods is an example of these accounting choices. The choice of depreciation method affects several ratios.

Required:

1. Explain which financial statement ratios are affected by the choice of depreciation methods, with specific attention to the effects of straight-line vs. accelerated depreciation on the ratios.

2. Comment on the effects on financial statement users of the issues discussed in part 1.

Answer 1

Answer: The Choice of the Depreciation method effects the amount reported on the financial statements like operating and net income. It effects a lot of financial ratios like fixed asset turnover, total asset turnover, operating profit margin, operating return of assets and return on assets, return on equity.earning per share

In the straight line, we uniformly distribute the Depreciation where as in accelerated depreciation we take higher values in the starting years of the depreciation.

In accelerated depreciation we will have low Pre-tax income resulting in low taxes in the starting years where as in straight line depreciation it would be higher Pre-tax income resulting in higher taxes in the starting. This will impact the ratios like Operating profit margin, return on assets, return on equity etc. which in turn makes the life difficult for an financial analyst as he/she has to take in to consideration the impact of these changes.

Asset book value will also reduce at a greater rate in the starting years for the accelerated depreciation impacting ratios like asset turnover in comparison to straight line depreciation.

Answer 2: Financial statement users have to take in to consideration this impact of changing accounting methods as it can bring a huge difference in the judgement of the financial analyst regarding the company financial position even when comparing Companies with each other these things have to be kept in loop. That's why before comparing these things have to be normalized by bringing them on the same accounting level.