Depreciation policy change and profit quality
Kestrel Traders owns a delivery van bought on 1 July 2024 for $48,000 cash. The accountant recorded straight-line depreciation over 6 years with a $6,000 residual, so 2024-25 depreciation was $7,000. In June 2025 the owner, Priya, learns that competitors use reducing balance at 25%. She asks for the method to be changed retrospectively so 2024-25 profit 'looks fair'. Under reducing balance, 2024-25 depreciation would be $12,000. Reported profit before depreciation was $30,000. The van will be sold in 2029 for an estimated $9,000. Priya also wants the $5,000 extra depreciation charged against retained earnings rather than profit.
1. Distinguish a change in accounting estimate from a change in accounting policy. Which category does this change fall into, and how should it be treated in the 2024-25 and 2025-26 reports?
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A change in accounting policy means adopting a different measurement or recognition basis (for example, moving from cost to fair value). A change in estimate means revising an input whose outcome was uncertain, such as useful life, residual value, or the pattern of consumption.
Switching from straight-line to reducing balance is a change in the estimation of the pattern in which the asset's benefits are consumed. It is treated as a change in estimate, applied prospectively from the date of change. No prior-period figures are restated and no adjustment goes to retained earnings.
- 2024-25: depreciation stays at $7,000; profit before depreciation $30,000 less $7,000 = $23,000.
- 2025-26: carrying amount at 1 July 2025 = $48,000 − $7,000 = $41,000. Depreciation = 25% × $41,000 = $10,250.
Priya's request to charge $5,000 to retained earnings is rejected: retrospective restatement is only for genuine policy changes, and even then it is a prior-period adjustment, not a discretionary charge. Charging it against retained earnings would understate 2024-25 profit and mislead users about the year's performance. The disclosure note should explain the new method and its effect on future depreciation.
2. Evaluate whether the new method better matches the van's consumption of benefits, using the expected sale proceeds. Show calculations.
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Under straight-line, total depreciation over 6 years = 6 × $7,000 = $42,000, leaving carrying amount $6,000 against an expected $9,000 - a $3,000 gain on sale, suggesting the asset was under-depreciated relative to its actual loss of value.
Under reducing balance at 25%:
- 2024-25: $12,000 → carrying $36,000
- 2025-26: $9,000 → $27,000
- 2026-27: $6,750 → $20,250
- 2027-28: $5,062.50 → $15,187.50
- 2028-29: $3,796.88 → $11,390.62
Depreciation over five years ≈ $36,609, leaving carrying amount ≈ $11,391 against expected proceeds of $9,000 - a $2,391 loss. Neither method lands exactly on $9,000, but reducing balance front-loads depreciation, which better reflects a delivery van that loses value fastest in its early years (high kilometres, warranty expiry, technology change).
The stronger argument for the change is pattern of benefits, not the sale figure. Priya should also consider that reducing balance never reaches the $6,000 residual automatically, so a residual check is needed late in the life. The decision should be documented with the reasoning, not justified solely by competitor practice.