Question

P7-74B. (Learning Objectives 1, 2, 3: Computing depreciation by three methods; identifying the cash-flow advantage of accelerated depreciation for tax purposes) On January 6, 20X6, K. P. Scott Co. paid €265,000 for a computer system. In addition to the basic purchase price, the company paid a setup fee of €800, €6,400 sales tax, and €27,800 for a special platform on which to place the computer. K. P. Scott management estimates that the computer will remain in service for five years and have a residual value of €30,000. The computer will process 45,000 documents the first year, with annual processing decreasing by 2,500 documents during each of the next four years (that is, 42,500 documents in 20X7; 40,000 documents in 20X8; and so on). In trying to decide which depreciation method to use, the company president has requested a depreciation schedule for each of the three depreciation methods (straight-line, units-of-produc- tion, and double-declining-balance). Requirements 1. For each of the generally accepted depreciation methods, prepare a depreciation schedule showing asset cost, depreciation expense, accumulated depreciation, and asset book value. 2. K. P. Scott reports to shareholders and creditors in the financial statements using the depre- ciation method that maximizes reported income in the early years of asset use. For income tax purposes, the company uses the depreciation method that minimizes income tax pay- ments in those early years. Consider the first year K. P. Scott Co. uses the computer. Iden- tify the depreciation methods that meet Scott’s objectives, assuming the income tax authorities permit the use of any of the methods.

Answer 1

All financials below are in €

Capitalized cost, C0 = All the cost incurred to make the asset ready to perform = 265,000 + 800 + 6,400 + 27,800 =  300,000

Estimated salvage value, S = 30,000

Life, n = 5 years:

1) Straight line depreciation method:

Annual depreciation rate, d = 1/n = 1/5 = 20%

Annual depreciation value = (C0 - S) x d = (300,000 - 30,000) x 20% = 54,000

Hence, the entire schedule will be as shown below:

Year	Beginning book value	Depreciation for the year	Accumulated depereciaton	Ending book value
0				300,000
1	300,000	54,000	54,000	246,000
2	246,000	54,000	108,000	192,000
3	192,000	54,000	162,000	138,000
4	138,000	54,000	216,000	84,000
5	84,000	54,000	270,000	30,000

2. Double declining balance method:

Annual depreciation rate = 2 x striaght line dpereciaton rate = 2 x 20% = 40%

The depreciation rate will act on the beginning book value. In the year 5 depreciation has been adjusted in such a way that ending book value doesn't fall below the slavage value.

Year	Beginning book value	Depreciation for the year	Accumulated depereciaton	Ending book value
0				300,000
1	300,000	120,000	390,000	180,000
2	180,000	72,000	462,000	108,000
3	108,000	43,200	505,200	64,800
4	64,800	25,920	531,120	38,880
5	38,880	8,880	540,000	30,000

3. Units of production method:

Deprecition will be proportional to the units produced.

Depreciation rate for year 1 = Documents processed in year 1/ total number of documents processed over life and so on.

The depreciaton rate will act on the base (C0 - S) = (300,000 - 30,000) = 270,000

Year	Beginning book value	Documents processed	Depreciation rate	Depreciation for the year	Accumulated depereciaton	Ending book value
0						300,000
1	300,000	45,000	22.50%	60,750	585,000	239,250
2	239,250	42,500	21.25%	57,375	627,500	181,875
3	181,875	40,000	20.00%	54,000	667,500	127,875
4	127,875	37,500	18.75%	50,625	705,000	77,250
5	77,250	35,000	17.50%	47,250	740,000	30,000
	Total	200,000	100.00%

For the purpose of reporting to shareholders, use the method that has the least depreciaton in the first year: Straight line method.

For the purpose of Income tax: Use the method that has the maximum depreciation: Double declining balance method