Question

Molly is an owner of a small business. His company has recently borrowed a large amount of funds to finance the construction of a large building addition, as well as, the purchase of equipment and machinery. Molly banker requires him to submit quarterly financial statements so that he can monitor the financial health of his business. The bank has warned that if profit margins decline, the interest rate on the loan may need to be increased in order to reflect additional risk. Molly knows that profit may decline this year. As he is preparing the year-end adjusting entries, Molly decides, for depreciation purposes, to treat all long-term asset purchases as though they occurr on the first day of the month following the month of purchase.

1. Is there an ethical issue with the implementation of this rule? If so, what is it?

2. When should depreciation first be recorded?

3. What impact will Molly approach to recording depreciation have on the financial statements?

Answer 1

Yes, this is an unethical behaviour on the part of Molly's.

The depreciation should be recorded at the end of every year, or else if the reports are prepared on quarterly basis, the depreciation should be calculated propertionately and allocated to all the quarters.

The effect will be, net income will get reduced in tbe quarter in which the assets are purchased and in the subsequent quarters the net income would increase. This might protect Molly from getting a interest rate hike from the banker.