Great Basin Enterprises, a large holding company, acquired North Spruce Manufacturing, a medium-sized manufacturing business, from its founder, who wishes to retire.
Despite great potential for development, North Spruce’s income has been dropping in recent years. Great Basin installs a new management group (including a new controller) at North Spruce and gives the group six years to expand and revitalize the operations; management compensation includes a bonus based on net income generated by the North Spruce operations. If North Spruce does not show considerable improvement by the end of the sixth year, Great Basin will consider selling it. The new management immediately makes significant investments in new equipment but finds that new revenues develop slowly. Most of the new equipment will be replaced in 8 to 10 years. To defer income taxes to the maximum extent, the controller uses accelerated depreciation methods and the minimum allowable “expected lives” for the new equipment, which average 5 years. In preparing financial statements, the controller uses the straight-line depreciation method and expected lives that average 12 years for the new equipment.
1. Why did the controller compute depreciation expense on the financial statements as he or she did?
2. What are the possible consequences of the controller’s decision on the amount of depreciation expense shown on the financial statements if this decision goes unchallenged?