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Financial Accouting
Executive summary
Sunshine Limited been large Departmental Store has managed accounting system, currently the profit of the firm has exceptionally increased and as per the expectation of the management the increase in profit is likely to continue for the next 2 year that is 2016 and 2017.
Economist worldwide have predicted that here 2018 and 2019 would experience a slowdown in the entire economy as the business of sunshine Limited is dependent on the disposable income of people their business is also expected to have negative impact of economic slowdown. Thus the management of sunshine Limited feels that the profit of the firm is likely to decline in 2018 and 2019.
In order to maintain consistency in reporting profit the management of the firm has decided to suddenly change the depreciation method by which company is depreciating its asset. Company has decided to change its depreciation method from straight line to sum of years digits method. This change would incur more depreciation expense in the initial years of asset acquisition and subsequently the depreciation in the latter year of asset acquisition would be lower in comparison to the straight-line depreciation method.
This change of depreciation method by the accounting department of sunshine Limited would initially decrease the profit due to increase in expense which would be compensated against the higher profit and lower expense in the future years. Christie, A.A. and Zimmerman, J.L., 1994
Economist worldwide have predicted that here 2018 and 2019 would experience a slowdown in the entire economy as the business of sunshine Limited is dependent on the disposable income of people their business is also expected to have negative impact of economic slowdown. Thus the management of sunshine Limited feels that the profit of the firm is likely to decline in 2018 and 2019.
In order to maintain consistency in reporting profit the management of the firm has decided to suddenly change the depreciation method by which company is depreciating its asset. Company has decided to change its depreciation method from straight line to sum of years digits method. This change would incur more depreciation expense in the initial years of asset acquisition and subsequently the depreciation in the latter year of asset acquisition would be lower in comparison to the straight-line depreciation method.
This change of depreciation method by the accounting department of sunshine Limited would initially decrease the profit due to increase in expense which would be compensated against the higher profit and lower expense in the future years. Christie, A.A. and Zimmerman, J.L., 1994
Accounting department of sunshine limited has not disclosed the change of depreciation method in their notes to the financial statements does all the shareholders which are assessing the performance of the company are unaware of the given change. In this paper we will discuss the impact of adopting search policies and weather such policies can be characterized as financial fraud and whether such manipulation in income statement is legal or unethical.
Impact of change in depreciation method
A company can change its depreciation method under genuine circumstances If a company feels that there are substantial assets in the company which are depreciated in larger amount during initial years of asset acquisition than the letter years of asset acquisition. in such cases company can change its depreciation method. The change in depreciation method always signals change in accounting policy of the company and since the change of accounting estimate has increased the amount of expense it would significantly affect the net earnings of the company. since there is effect on net earning due to change in accounting policy, it is the duty of the company to follow certain reporting procedures and they should report this change in there filings as well as in their annual reports.
In order to change the depreciation method accompany will have to file IRS form 3115 which is basically an application which is required for change in accounting method. While filing an application for change in accounting method a company should give a proper justification with all the supporting documents and evidences which would prove that the significant amount of their assets are going to depreciate heavily in the initial years of asset acquisition. Christie, A.A. and Zimmerman, J.L., 1994
A company can also the multiple assets in their filing of form 3115. Once the application is filed by the company for change in depreciation method it is up to the IRS to accept or reject the application of the company, once the application for the change in depreciation method is accepted by IRS the company can change its depreciation method but why changing a depreciation method a company is required to mention a footnote in their annual report which would announce the change in depreciation method and will also give proper reasoning for making that change in the depreciation method. Soderstrom, N. S., & Sun, K. J. (2007)
In order to change the depreciation method accompany will have to file IRS form 3115 which is basically an application which is required for change in accounting method. While filing an application for change in accounting method a company should give a proper justification with all the supporting documents and evidences which would prove that the significant amount of their assets are going to depreciate heavily in the initial years of asset acquisition. Christie, A.A. and Zimmerman, J.L., 1994
A company can also the multiple assets in their filing of form 3115. Once the application is filed by the company for change in depreciation method it is up to the IRS to accept or reject the application of the company, once the application for the change in depreciation method is accepted by IRS the company can change its depreciation method but why changing a depreciation method a company is required to mention a footnote in their annual report which would announce the change in depreciation method and will also give proper reasoning for making that change in the depreciation method. Soderstrom, N. S., & Sun, K. J. (2007)
Consistency Consideration
Consistency consideration is one of the important theories of accounting which is followed as accounting standard throughout the world. This theory tells us that when an economic event transaction occurs at repeated time intervals then representation of accounting those transactions should be seen in all given times. However there are certain exceptions to this consistency consideration that it does not include the mistakes which are rectified by the accounting department or considering the transactions which were not earlier included these exceptions are allowed because rectifying the past mistakes helps in vector illustration of economic and business reality of the company. Consistency consideration also clearly states that any change in depreciation specifically the methods related to the accounting of depreciation should clearly illustrate of change in depreciation policies. This principle of consistency consideration helps in creating compatibility and uniformity of financial reporting in several accounting. Clikeman, P.M., 2003.
Laws and regulation regarding change in accounting principle
IRS has recently issued a proposed temporary and final regulations for acknowledging and mentioning the changes in amortization and depreciation method which are considered as accounting changes under their section 446 these rules of changes in depreciation or attempt to provide a consistent treatment to the financial statements and give increased certainty to the shareholders and the taxpayers regarding the reporting of depreciation or amortization. As the rules are clearly specified the main motive of iris is to reduce the controversies around the automatic change in accounting methods as these rules are going to extend and improve their ability to capture the results of cost segregation as per the convenient accounting method change request stop the rules specified by IRS make sure that the companies will not take undue advantage by automatic change in accounting methods. As per the registered section 1.446 there are the rules which provide temporary regulations and guidance for changes in depreciation and changes in accounting of depreciation. These encompasses change in recognition of asset from non-amortized able or non-depreciable to ammeter is able on depreciable or vice a versa. In order to do this a correction is required for the depreciation in order to compensate deduction of cost depreciable asset which was consistently treated as expense from the year of purchase. As there is a significant use of this rule which will result in issuance of new rules on fixed assets and their spare parts. An important thing to note here is that changes in depreciation method is only considered as an accounting change when the entire method of calculating depreciation is varied. Changes in depreciation due to previous mathematical errors or due to certain changes in underlying facts are not considered as accounting changes of depreciation. Soderstrom, N. S., & Sun, K. J. (2007)
There are several changes in depreciation which are considered as not accounting method changes as per the RTGS section 1.4 46 we have certain rules which provide temporary regulation that considers accounting method change will not be a part of and significant adjustment for the useful life of a asset which is being depreciated or amortizedfor which the depreciation will be determined. The second rule states that when there is a certain adjustment in a usable life of an asset and where change of accounting method is not applied to rules of change in accounting will apply regardless of the situation in which the adjustment will be initiated by IRS or the company. This will only result in adjustment in the useful life of an asset which cannot be considered as a accounting method change. Thrd revocation of depreciation which is timely valid or the election of depreciation is not considered as change in accounting method. However from the beginning of 2002 and 2010 tax payer required to file an amended return stop v is the rule which states that if there is a change in service state of a sizable on depreciable asset that changed in the server state is not considered as an change of accounting method also the change in convention of ammeter is able or depreciable asset is also not considered as change of accounting method because the final regulations define the example for the change in service date the change in service date is not accounting change and it is important to note that adjustment in this case is neither required and non it is permitted by the rules. Jackson, S.B., Liu, X.K. and Cecchini, M., 2009
The IRS has issued an order to obtain an automatic permission to change the accounting method in order to change their depreciation or amortisation methods. If there is a certain case where a company might be using impermissible accounting method in order to calculate depreciation on certain asset class and if company now wants to switch on from in permissible depreciation calculation method to the permissible calculation method of depreciation they could change the method of theirs depreciation calculation bye obtaining and automatic consent for the change in accounting method. Clikeman, P.M., 2003
If certain property which is going to be depreciated is being transformed in a certain transaction and in such transaction Trance 3 is being treated as a transfer for the suitability in computation of assets depreciation allowance with respect to so much of the bases in the transfer is hands I will not be larger than adjusted basis of depreciation in transfers hand, then the transferee come under such circumstances good file for the change in automatic accounting method. Jackson, S.B., Liu, X.K. and Cecchini, M., 2009.
There are several changes in depreciation which are considered as not accounting method changes as per the RTGS section 1.4 46 we have certain rules which provide temporary regulation that considers accounting method change will not be a part of and significant adjustment for the useful life of a asset which is being depreciated or amortizedfor which the depreciation will be determined. The second rule states that when there is a certain adjustment in a usable life of an asset and where change of accounting method is not applied to rules of change in accounting will apply regardless of the situation in which the adjustment will be initiated by IRS or the company. This will only result in adjustment in the useful life of an asset which cannot be considered as a accounting method change. Thrd revocation of depreciation which is timely valid or the election of depreciation is not considered as change in accounting method. However from the beginning of 2002 and 2010 tax payer required to file an amended return stop v is the rule which states that if there is a change in service state of a sizable on depreciable asset that changed in the server state is not considered as an change of accounting method also the change in convention of ammeter is able or depreciable asset is also not considered as change of accounting method because the final regulations define the example for the change in service date the change in service date is not accounting change and it is important to note that adjustment in this case is neither required and non it is permitted by the rules. Jackson, S.B., Liu, X.K. and Cecchini, M., 2009
The IRS has issued an order to obtain an automatic permission to change the accounting method in order to change their depreciation or amortisation methods. If there is a certain case where a company might be using impermissible accounting method in order to calculate depreciation on certain asset class and if company now wants to switch on from in permissible depreciation calculation method to the permissible calculation method of depreciation they could change the method of theirs depreciation calculation bye obtaining and automatic consent for the change in accounting method. Clikeman, P.M., 2003
If certain property which is going to be depreciated is being transformed in a certain transaction and in such transaction Trance 3 is being treated as a transfer for the suitability in computation of assets depreciation allowance with respect to so much of the bases in the transfer is hands I will not be larger than adjusted basis of depreciation in transfers hand, then the transferee come under such circumstances good file for the change in automatic accounting method. Jackson, S.B., Liu, X.K. and Cecchini, M., 2009.
Conclusion
After careful evaluation of all accounting policies and accounting theories we can conclude that the action taken by Sunshine Limited in order to reduce its earning in next 2 years and then further increase the earnings in the further 2 years cannot be considered right from the legal point of view because the rules of change in accounting method of depreciation are clearly defined and those rule indicate that Sunshine should clearly mention the change of depreciation policies in the footnotes to the financial statements but since sunshine has decided not to provide the change of depreciation method in the footnotes of their annual report this action of sunshine would be considered as a financial fraud. Jackson, S.B., Liu, X.K. and Cecchini, M., 2009
This financial fraud could have significant impact on the future sustainability of the company because this financial fraud can be easily detected by the auditors while analysing the financial statements. Auditor can identify this fraud by doing the careful analysis of each and every expense present in the financial statement. Herrmann, D., & Inoue, T. (1996).
Once the auditor is analysing each and every line item of profit and loss statement given by the sunshine Limited he would be able to identify that there is substantial reduction in depreciation assets without Bing a significant reduction in the fixed asset of the company.
Auditor can easily calculate that a company has applied a fixed line depreciation method in the previous year and now they have decided to change the depreciation method without informing the shareholders. Once the auditor will make his report public Sunshine Limited and its management could face severe embarrassment along with Unity legal action which will further destroy the value of the firm. Herrmann, D., & Inoue, T. (1996).
Sunshine Limited even decides to convince the auditor and they are able to make sure that the auditor's report is not made public but still non reporting of change in depreciation method will still be considered as financial fraud and since even the auditor is silent about it this would even be considered as a big offence. Christie, A.A. and Zimmerman, J.L., 1994
Several companies including the Giants like Enron has faced such scandals of the manipulation in the financial statements, these manipulations in the financial statements led to the downfall of gigantic companies and are never sustainable in the long run. Herrmann, D., & Inoue, T. (1996).
This financial fraud could have significant impact on the future sustainability of the company because this financial fraud can be easily detected by the auditors while analysing the financial statements. Auditor can identify this fraud by doing the careful analysis of each and every expense present in the financial statement. Herrmann, D., & Inoue, T. (1996).
Once the auditor is analysing each and every line item of profit and loss statement given by the sunshine Limited he would be able to identify that there is substantial reduction in depreciation assets without Bing a significant reduction in the fixed asset of the company.
Auditor can easily calculate that a company has applied a fixed line depreciation method in the previous year and now they have decided to change the depreciation method without informing the shareholders. Once the auditor will make his report public Sunshine Limited and its management could face severe embarrassment along with Unity legal action which will further destroy the value of the firm. Herrmann, D., & Inoue, T. (1996).
Sunshine Limited even decides to convince the auditor and they are able to make sure that the auditor's report is not made public but still non reporting of change in depreciation method will still be considered as financial fraud and since even the auditor is silent about it this would even be considered as a big offence. Christie, A.A. and Zimmerman, J.L., 1994
Several companies including the Giants like Enron has faced such scandals of the manipulation in the financial statements, these manipulations in the financial statements led to the downfall of gigantic companies and are never sustainable in the long run. Herrmann, D., & Inoue, T. (1996).
Recommendation
To recommend to the sunshine management that instead of changing depreciation method without informing their shareholders and without mentioning it in the annual report it is better for the management to convince the shareholders that the future decline in profit will with the combined effect of market and all other similar forms will also face similar slowdown in their revenues as well as their profits. Christie, A.A. and Zimmerman, J.L., 1994
Once the management of sunshine will prepare a proper report with the substantial backup of their study the shareholders will be able to understand that decline in the profits in the future years is due to no fault of the management and there will be no questions raised on the performance of the management. Clikeman, P.M., 2003
Management of sunshine should understand that the value of the firm is defined by all future cash flows to the form discounted at cost of capital and by doing a financial fraud they would be compromising with all the future cash flows of the firm which could significantly reduce the value of the firm. Clikeman, P.M., 2003
Once the management of sunshine will prepare a proper report with the substantial backup of their study the shareholders will be able to understand that decline in the profits in the future years is due to no fault of the management and there will be no questions raised on the performance of the management. Clikeman, P.M., 2003
Management of sunshine should understand that the value of the firm is defined by all future cash flows to the form discounted at cost of capital and by doing a financial fraud they would be compromising with all the future cash flows of the firm which could significantly reduce the value of the firm. Clikeman, P.M., 2003
References
Jackson, S.B., Liu, X.K. and Cecchini, M., 2009. Economic consequences of firms’ depreciation method choice: Evidence from capital investments. Journal of Accounting and Economics, 48(1), pp.54-68.
Keating, A. S., & Zimmerman, J. L. (1999). Depreciation-policy changes: tax, earnings management, and investment opportunity incentives. Journal of Accounting and Economics, 28(3), 359-389.
Herrmann, D., & Inoue, T. (1996). Income smoothing and incentives by operating condition: An empirical test using depreciation changes in Japan. Journal of International Accounting, Auditing and Taxation, 5(2), 161-177.
Clikeman, P. M., & LEMON, W. M. (2010). Called to account: Fourteen financial frauds that shaped the American accounting profession. The Accounting Review, 85(5), 1811-1814.
Soderstrom, N. S., & Sun, K. J. (2007). IFRS adoption and accounting quality: a review. European Accounting Review, 16(4), 675-702.
Benston, G.J., Bromwich, M. and Wagenhofer, A., 2006. Principles?versus rules?based accounting standards: the FASB's standard setting strategy. Abacus, 42(2), pp.165-188.
Christie, A.A. and Zimmerman, J.L., 1994. Efficient and opportunistic choices of accounting procedures: Corporate control contests. Accounting Review, pp.539-566.
Clikeman, P.M., 2003. Where auditors fear to tread: internal auditors should be proactive in educating companies on the perils of earnings management and in searching for signs of its use. Internal Auditor, 60(4), pp.75-80.
Keating, A. S., & Zimmerman, J. L. (1999). Depreciation-policy changes: tax, earnings management, and investment opportunity incentives. Journal of Accounting and Economics, 28(3), 359-389.
Herrmann, D., & Inoue, T. (1996). Income smoothing and incentives by operating condition: An empirical test using depreciation changes in Japan. Journal of International Accounting, Auditing and Taxation, 5(2), 161-177.
Clikeman, P. M., & LEMON, W. M. (2010). Called to account: Fourteen financial frauds that shaped the American accounting profession. The Accounting Review, 85(5), 1811-1814.
Soderstrom, N. S., & Sun, K. J. (2007). IFRS adoption and accounting quality: a review. European Accounting Review, 16(4), 675-702.
Benston, G.J., Bromwich, M. and Wagenhofer, A., 2006. Principles?versus rules?based accounting standards: the FASB's standard setting strategy. Abacus, 42(2), pp.165-188.
Christie, A.A. and Zimmerman, J.L., 1994. Efficient and opportunistic choices of accounting procedures: Corporate control contests. Accounting Review, pp.539-566.
Clikeman, P.M., 2003. Where auditors fear to tread: internal auditors should be proactive in educating companies on the perils of earnings management and in searching for signs of its use. Internal Auditor, 60(4), pp.75-80.
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