Hard Bodies Co. is a fitness chain that has just completed its second year of operations. At the beginning of its first fiscal year, the company purchased fitness equipment at a cost of $600,000 and estimated that the equipment would have a useful life of five years and no residual value. The company uses the straight-line depreciation method. The company reported net income for the first two years of operations as follows:

YearNet Income (Loss)1$50,0002(2,000)

Mike Gambit, the company’s chief financial officer (CFO), has recently run financial models to predict future net income, and he expects net losses to continue at $(2,000) per year for the next three years. James Steed, the president of Hard Bodies, is concerned about these predictions, as he is under pressure from the company’s owner to return the company to Year 1 net income levels. If the company does not meet these goals, both he and Mike will likely be fired. Mike suggests that the company change the estimated useful life of the fitness equipment to 10 years and increase the equipment’s estimated residual value to $50,000. This will reduce depreciation expense and increase net income.

  1. Evaluate the decision to change the equipment’s estimated useful life and estimated residual value to improve earnings. How does this change impact the usefulness of the company’s net income for external decision makers?
  2. If Mike and James make the change, are they acting in an ethical manner? Explain.

Tonya Latirno is a staff accountant for Cannally and Kennedy, a local CPA firm. For the past 10 years, the firm has given employees a year-end bonus equal to two weeks’ salary. On November 15, the firm’s management team announced that there would be no annual bonus this year. Because of the firm’s long history of giving a year-end bonus, Tonya and her co-workers had come to expect the bonus and felt that Cannally and Kennedy had breached an implicit agreement by discontinuing the bonus. As a result, Tonya decided that she would make up for the lost bonus by working an extra six hours of overtime per week for the rest of the year. Cannally and Kennedy’s policy is to pay overtime at 150% of straight time.

Tonya’s supervisor was surprised to see overtime being reported, because there is generally very little additional or unusual client service demands at the end of the calendar year. However, the overtime was not questioned, because employees are on the “honor system” in reporting their work hours.

  1. Is Cannally and Kennedy acting in an ethical manner by eliminating the bonus?
  2. Is Tonya behaving ethically by making up the bonus with unnecessary overtime? Why?

CEG Capital Inc. is a large holding company that uses long-term debt extensively to fund its operations. At December 31, the company reported total assets of $100 million, total debt of $55 million, and total equity of $45 million. In January, the company issued $11 billion in long-term bonds to investors at par value. This was the largest debt issuance in the company’s history, and it significantly increased the company’s ratio of total debt to total equity. Five days after the debt issuance, CEG filed legal documents to prepare for an additional $50 billion long-term bond issue. As a result of this filing, the price of the $11 billion in bonds that the company issued earlier in the week dropped to 94 because of the increased risk associated with the company’s debt. The investors in the original $11 billion bond issuance were not informed of the company’s plans to issue additional debt so quickly after the initial bond issue.

  1. Did CEG Capital act unethically by not disclosing to initial bond investors its immediate plans to issue an additional $50 billion debt offering?