Depreciation Choice Under Pressure
A partnership operates a delivery service with two identical vans bought on the same day for $48,000 each, each with an estimated residual value of $6,000 and a useful life of six years. The partners are applying for a bank loan and the loan officer has asked for the current year's income statement. Partner A wants to switch from straight-line to reducing-balance depreciation for the vans this year because 'it will show we are being conservative'. Partner B wants to keep straight-line because 'the vans are used evenly'. One van was purchased in April and the other in October of the same reporting year; the reporting period ends 30 June. The partnership agreement is silent on depreciation policy.
1. Evaluate whether switching methods this year is acceptable, and identify the accounting principles in tension.
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Switching methods solely to influence a loan application is not acceptable: the choice must reflect the pattern of economic benefits consumed and must be applied consistently. Consistency supports comparability across periods; relevance and faithful representation require the method to reflect reality. If the vans are used evenly, straight-line is defensible. A change in method is only justified if the underlying consumption pattern has genuinely changed, and it must be disclosed with the reason and the financial effect. Conservatism does not mean deliberately lowering profit - it means exercising caution under uncertainty, not choosing a method to manage an impression. The partners should also note that the partnership agreement is silent, so the decision should be documented and agreed by both partners to avoid dispute.
2. Calculate depreciation for the year under straight-line for both vans, accounting for the different purchase dates, and comment on the effect on profit of the proposed switch.
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Annual straight-line depreciation per van = ($48,000 − $6,000) ÷ 6 = $7,000. The April van is held for the full year: $7,000. The October van is held for nine months (October to June): $7,000 × 9/12 = $5,250. Total depreciation expense = $12,250. Under reducing balance at, say, 30%, the first van would attract $48,000 × 30% = $14,400 and the second $48,000 × 30% × 9/12 = $10,800, a total of $25,200 - more than double. The switch would reduce reported profit by $12,950 this year, which is the opposite of what Partner A claims it achieves. The lesson: reducing balance front-loads expense, so it lowers early profit; the partners must decide on the merits of the consumption pattern, not the direction of the profit effect.