Case #2

At the beginning of 2014, the Fancy Food Company purchased equipment for $42 million to be used in the manufacture of a new line of gourmet frozen foods. The equipment was estimated to have a 10-year service life and no residual value. The straight-line depreciation method was used to measure depreciation for 2014 and 2015. Late in 2016, it became apparent that sales of the new frozen food line were significantly below expectations. The company decided to continue production for two more years (2017 and 2018) and then discontinue the line. At that time, the equipment will be sold for minimal scrap values. The controller, Shannon Jones, was asked by Jerry Dent, the company's chief executive officer (CEO), to determine the appropriate treatment of the change in service life of the equipment. Shannon determined that there has been an impairment of value requiring an immediate write-down of the equipment of $12,900,000. The remaining book value would then be depreciated over the equipment's revised service life (3 years). The CEO does not like Shannons conclusion because of the effect it would have on 2016 income. Looks like a simple revision in service life from 10 years to 5 years to me, Dent concluded. Let's go with it that way, Shannon. Required: 1. What is the difference in before-tax income between the CEO's and Shannons treatment of the situation? (Hint: calculate before-tax income the way the CEO would like and compare to Shannons method). 2. Why would the CEO have an incentive to not record the impairment? 3. Discuss Shannons ethical dilemma and give her advice on how to handle this situation.