Account For An Increase In The Useful Life of a Fixed Asset.

Question: Discuss about Account For An Increase In The Useful Life of a Fixed Asset? Answer: If we see the graph of the effect of the change in the estimated life of an asset, we come to conclusion that if we increase the estimated life the earnings will increase but if we take shorter estimate of the life of the asset, the earnings will decrease. If we have to give effect to the above transactions then we have to pass the following journal entries: For increase in the estimated life of an asset: The company has to include is in the notes to account regarding the change in the estimated life of an asset. So, that the users of the financial statements come to know about the reason in the change in the value of the assets because when we change the estimated life of an asset it will definitely have affect value of the asset because change in the amount of depreciation has direct effect on the value of asset. b). If we change the estimated life of asset the we have to calculate the depreciation from the date of purchase of the asset as per revised estimate of life of asset and any difference DR or Cr has pass through profit Loss account. Journal Entry: Depreciation A/c___Dr To Profit Loss account A/c (If Less depreciation has come as per new estimate) Profit Loss account A/c ___Dr To Depreciation A/c (If more depreciation has come as per new estimate) C) (i) ii) Baasu and FASBs treatment are same as both have used the accounting principles to adapt the change which can be cleared by seeing that both have shown the effect of change in the estimated life of the asset in the profit of Loss account which is accepted as an accounting rule. So, the treatment of FASBs and Baasu is as per conservatism. Solution If the companys productive assets have a life longer than anticipated by the management (i.e., depreciation charges are overstated), I would, as an investor, view the investment favorably. Ceteris paribus, a longer asset life will make the investment more attractive because of higher profits in the future, on account of lower depreciation charges. In 2008 Delta Airlines increased the useful life of its flight equipment: depreciation expense decreased by approximately $127 million and net income increased by $69 million(How to account for an increase in the useful life of a fixed asset, 2016). The reverse will hold true if the asset life is shorter than anticipated, and would lead to lower profits due to an impairment loss written off immediately. This would lead to a downward pressure on the price of the investment. Since the immediate years profits will absorb all of the increase in depreciation because of the conservatism principle, the fall in price would be steeper than the rise in the case of good news (longer asset life). In a regression of annual earnings on returns, Basu finds that earnings respond more to negative returns (bad news) than positive returns (good news): earnings is about four and a half times as sensitive to negative returns as it is to positive returns. In the case of conditional conservatism, book values are written down under sufficiently adverse circumstances but not written up under favorable circumstances(William H Beaver, 2005). In case of a shorter asset life, the Basu treatment will entail writing off the shortfall in depreciation during one year itself, leading to a sharp drop in net income of that year. As Basus regression show, this is in line with how the stock market also treats bad news (discounts it in one year itself). On the contrary, the increase in asset life reflects in stock returns gradually. We suggest that since the purpose of depreciation is to set off an adequate reserve to replace the asset when it comes to the end of its useful life, a more regularly spread depreciation expense might also solve the purpose, without causing an unnecessary burden during any one year. The stock market, however, reacts differently. The more conservative treatment causes bias to seep in the representation of financial statements. Because of the principle of conservatism, net income for one year has to bear the entire impact of lower than anticipated asset life, while the future earnings remain unaffected. In the words of Basu, earnings reflect bad news more quickly than good news, hence a one-sided bias or asymmetric nature of loss recognition. The management can use its discretion and not impair assets if it feels that such a treatment will lead to assets being shown at less than fair value. For instance, the management might choose not to write off goodwill. Such treatment will practically undo the effects of conservative treatments on the books of accounts. However, the market is seen to act intelligently and assess the impact of the news independently. As (Roychowdhury, 2004) demonstrates, low market to book (MTB) firms that experience negative returns are more likely to record asset write-offs than high MTB firms. Managements ability to use discretion is both a good and a bad thing. It can be harmful to the interests of shareholders if the management is unscrupulous and uses its discretion to withhold negative information. In such cases, earnings will tend to be overstated in initial years as the management will have a tendency to push bad news later. For instance, management might be tempted to capitalize research development (RD) expenditure, even though there is no reliable measure of the future economic benefits of such costs. However, since SSAP13 requires that RD expenses be expenses rather than capitalized, this has arguably led to an under-investment in research because of markets fixation with earnings (J Peter Green, 1996). Thus, recent developments show that management has been given increased discretion (Sheldon Smith, 2013) in financial reporting, such as impairment of goodwill. Compared to the earlier method of amortizing goodwill compulsorily, the new method ensures that goodwill is shown at a fair and not unduly conservative value in the balance sheet. This reduces bias on the negative side arising due to conservatism. Bibliography How to account for an increase in the useful life of a fixed asset. (2016, March 5). Retrieved from Simple Studies: https://simplestudies.com/how-to-account-for-increase-in-useful-life-of-fixed-assets.html/page/2 J Peter Green, A. W. (1996). UK evidence on the market valuation of research and development expenditures. Journal of Business Finance and Accounting. Roychowdhury, S. (2004). Asymmetric timeliness of earnings, market-to-book and conservatism in financial reporting. Sheldon Smith, K. S. (2013, November). The end of conservatism in accounting. Retrieved from NZICA: https://www.nzica.com/News/Archive/2013/November/The-end-of-conservatism-in-accounting.aspx William H Beaver, S. G. (2005). Conditional and Unconditional Conservatism: Concepts and Modeling.