How a company can manipulate its net income by estimating the longer estimated useful life and salvage value of the fixed assets?

Answer 1

Useful Life • Useful Life or Economic Life is the time period for machine is expected to operate efficiently. • It is the life for which a machine is estimated to provide more benefit than the cost to run it. Grouping of Fixed Assets Major groups of Fixed Assets: • Land • Building • Plant and Machinery • Furniture and Fixtures • Office Equipment • Vehicles No depreciation is charged for 'Land'. In case of 'Leased Asset/Lease Hold Land' the amount paid for it is charged over the life of the lease and is called Amortization. Methods of calculating Depreciation There are several methods for calculating depreciation. At this stage, we will discuss only two of them namely: • Straight line method or Original cost method or Fixed installment method • Reducing balance method or Diminishing balance method or written down method.Straight Line Method Under this method, a fixed amount is calculated by a formula. That fixed amount is charged every year irrespective of the written down value of the asset. The formula for calculating the depreciation is givenbelow: Depreciation = (cost - Residual value) / Expected useful life of the asset Residual value is the cost of the asset after the expiry of its useful life. Under this method, at the expiry of asset's useful life, its written down value will become zero. Consider the following example:• Cost of the Asset = Rs.100,000 • Life of the Asset = 5 years • Annual Depreciation = 20 % of cost or Rs.20,000Written down value method • Cost of the Asset = Rs. 100,000 • Annual Depreciation = 20% ? Year 1 Depreciation = 20 % of 100,000 = 20,000 ? Year 1 WDV = 100,000 - 20,000 = 80,000 ? Year 2 Depreciation = 20 % of 80,000 = 16,000 ? Year 2 WDV = 80,000 - 16,000 = 64,000 Illustration: Cost of an asset: Rs. 120,000 Residual value: Rs. 20,000 Expected life: Rs. 5 years Financial Statement Analysis-FIN621 VUCopyright© Virtual University of Pakistan 82 Calculate depreciation and the written down value of the asset for five years. Solution Straight line methodDepreciation = (120,000 - 20,000) / 5 = Rs. 20,000Particulars Depreciation (Rs) WrittenDown Value (Rs.) Depreciable costDep. Of the 1st year Dep. Of the 2nd year Dep. Of the 3rdyear Dep. Of the 4th year Dep. Of the 5th year (20,000) (20,000)(20,000) (20,000) (20,000) 100,00080,000 60,000 40,000 20,000 0Reducing Balance Method Under this method, depreciation is calculated on written down value. In the first year, depreciation is calculated on cost. Afterwards written down value is calculated by deducting accumulated depreciationfrom the cost of that asset(cost - accumulated depreciation) and depreciation is charged on that value. In this method, the value of asset never becomes zero. Consider the following example: Cost of an asset Rs. 100,000 Expected life Rs. 5 years Depreciation rate 20% SolutionParticulars Depreciation (Rs) AccumulatedDepreciation (Rs.) Written DownValue (Rs.) Depreciable cost Dep. Of the 1st year 100,000 x 20% Dep. Of the 2nd year 80,000 x 20% Dep. Of the 3rd year 64,000 x 20% Dep. Of the 4th year 51,200 x 20% Dep. Of the 5th year 40,960 x 20% 20,00016,000 12,800 10,240 8,19220,000 36,000 48,800 59,04067,232 100,000 80,000 64,00051,200 40,960 32,768 You see, at the end of five years, WDV of the asset is Rs. 32,768, not zero. But in case of straight line method, the WDV, after five years was zero. So, in the opinion of some people, reducing balance

Answer 2

By extending the estimated useful life and increasing the salvage value of fixed assets, a company can reduce depreciation expenses, which would raise net income. However, this can lead to inaccurate financial reporting and misrepresentation of the company's true financial performance. Eventually, it can affect investors' trust and the company's overall reputation.