Depreciation policy change and the faithful representation trade-off
Kauri Manufacturing Ltd owns a specialised packaging machine bought on 1 July 2023 for $480,000. Management initially estimated a 10-year useful life and $30,000 residual value, using straight-line depreciation. In June 2025, engineers report that the machine's output is degrading faster than expected because a new adhesive is being used; they now estimate a remaining useful life of 4 years from 1 July 2025 and residual value of $20,000. The financial controller wants to keep the original estimate to avoid reducing profit before the bank covenant test, which requires profit before tax of at least $90,000. Draft profit before tax (before any depreciation adjustment) for the year ended 30 June 2025 is $140,000. The machine's fair value at 30 June 2025 is $300,000 and value in use is $285,000.
1. Calculate the depreciation expense for the year ended 30 June 2025 under both the original estimate and the revised estimate. Show all workings and state which figure should be reported.
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Original estimate
Annual depreciation = (480,000 - 30,000) / 10 = $45,000.
Revised estimate (prospective application)
Carrying amount at 30 June 2025 before revision = 480,000 - (45,000 x 2) = $390,000.
Depreciation for year 2 under the original estimate is $45,000, giving carrying amount $390,000 at 30 June 2025. The revision applies from 1 July 2025, so the year ended 30 June 2025 still uses $45,000.
However, if the revision is treated as effective for the current year (a change in estimate applied prospectively from the date of change), the remaining depreciable amount is 390,000 - 20,000 = $370,000 over 4 years = $92,500 per year.
Which to report: The revised estimate should be applied prospectively from the date the estimate changes. Changes in accounting estimates are not applied retrospectively; they affect the current and future periods. Reporting $45,000 when engineers have credible evidence of a shorter life would not be faithful representation. The controller's motive (covenant) is not a valid basis for an accounting estimate.
2. Explain how the choice of depreciation estimate affects the bank covenant and evaluate whether the controller's preference is acceptable under accounting standards.
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Covenant impact
- Original estimate: profit before tax = 140,000 - 45,000 = $95,000 (passes the $90,000 test).
- Revised estimate: profit before tax = 140,000 - 92,500 = $47,500 (fails the covenant).
Evaluation
Accounting estimates must reflect the best available information at reporting date. The engineers' report is objective evidence that the useful life is shorter. Selecting the original estimate to protect a covenant breaches the qualitative characteristic of faithful representation (neutrality) and the requirement that estimates be based on reliable, current information. The covenant consequence is a commercial reality, not an accounting justification. If the company fails the covenant, the appropriate response is to disclose and negotiate with the bank, not to misstate depreciation. A change in estimate is disclosed in the notes, including its nature and amount, so users can assess the effect.
3. Determine whether the machine is impaired at 30 June 2025 and explain the interaction between impairment and the revised useful life.
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Impairment test
Recoverable amount = higher of fair value less costs to sell and value in use. Assuming no costs to sell are given, recoverable amount = max(300,000, 285,000) = $300,000.
Carrying amount before revision = $390,000. Since 390,000 > 300,000, an impairment loss of $90,000 is recognised, reducing carrying amount to $300,000.
Interaction with revised life
After impairment, depreciation is based on the revised carrying amount of $300,000, residual value $20,000 and remaining life of 4 years: (300,000 - 20,000) / 4 = $70,000 per year from 1 July 2025.
This shows that impairment and useful-life revision are separate but connected judgements: the impairment captures the loss of future economic benefits already incurred, while the revised life spreads the remaining depreciable amount over the period the asset will be used. Both must be supported by evidence, and both reduce profit, reinforcing that the controller's preference cannot be sustained.