A company lengthens the assumed depreciation lives of its equipment, with all else equal. Which way does reported profit move?
Show the answer and explanation
Answer: C. Up
Depreciation spreads an asset's cost over its useful life. Annual depreciation = Cost / Useful life. A longer life gives a smaller yearly charge, so reported profit rises. For example, equipment costing $100 million over 5 years gives 100 / 5 = $20 million a year. Over 10 years it gives 100 / 10 = $10 million, which lifts profit by $10 million. Nothing in the business has improved, so a lengthened life is a warning sign. US GAAP and IFRS both treat this as a change in estimate, applied from the date of the change.
Why the other options are wrong:
A. Down - Backwards. The same cost spread over more years is a smaller annual charge, which raises profit.
B. Unchanged - The total depreciation over the asset's life is the same, but each year's share of it falls, so profit in the year of the change is not unchanged.