Question

On January 1, 2016, Locke Company, a small machine-tool manufacturer, acquired for \(1,260,000 a piece of new industrial equipment. The new equipment had a useful life of 5 years, and the salvage value was estimated to be \)60,000. Locke estimates that the new equipment can produce 12,000 machine tools in its first year. It estimates that production will decline by 1,000 units per year over the remaining useful life of the equipment.

The following depreciation methods may be used:

1. straight-line,
2. double-declining-balance,
3. sum-of-the-years’-digits, and
4. units-of-output. For tax purposes, the class life is 7 years.

Use the MACRS tables for computing depreciation.

Instructions

1. Which depreciation method would maximize net income for financial statement reporting for the 3-year period ending December 31, 2018? Prepare a schedule showing the amount of accumulated depreciation at December 31, 2018, under the method selected. Ignore present value, income tax, and deferred income tax considerations.
2. Which depreciation method (MACRS or optional straight-line) would minimize net income for income tax reporting for the 3-year period ending December 31, 2018? Determine the amount of accumulated depreciation at December 31, 2018. Ignore present value considerations.

Short answer

Answer

The straight-line method would provide the highest total net income for financial reporting over the three years, as it reports the lowest total depreciation expense. The general MACRS method would minimize net income for income tax purposes for this period.

Step-by-step solution

Step-by-Step SolutionStep 1: Meaning of Straight-Line Depreciation

Straight-line depreciation is the simplest way to assess depreciation over time.By allocating identical amounts to the asset's accounting periods over its useful life, it makes the asset's expense predictable along with smoothing net income.

(a1) Calculating depreciation using the straight-line method

$\begin{array}{c}\text{Depreciation}=\frac{\text{Cost\hspace{0.17em}of\hspace{0.17em}asset}-\text{Salvage\hspace{0.17em}value}}{\text{Useful\hspace{0.17em}life}}\\ =\frac{\$1,260,000-\$60,000}{5}\\ =\$240,000\end{array}$

Year	Depreciation expense	Accumulated Depreciation
2016	$240,000	$240,000
2017	240,000	$480,000
2018	240,000	$720,000
	$720,000

(a2) Calculating depreciation using the double-declining-balance

Year	Depreciation Expense	Calculation of depreciation expense	Accumulated Depreciation
2016	$504,000		$504,000
2017	302,400		$806,400
2018	181,440		$987,840

(a3) Calculating depreciation using the Sum-of-the-years’-digits

Year	Depreciation Expense	Calculation of depreciation expense	Accumulated Depreciation
2016	$400,000		$400,000
2017	320,000		$720,000
2018	240,000		$960,000
	$960,000

(a4) Calculating depreciation using the Units-of-output

Year	Depreciation Expense	Calculation of depreciation expense	Accumulated Depreciation
2016	$288,000		$288,000
2017	264,000		$552,000
2018	240,000		$792,000
	$792,000

Working notes:

Calculating Unit per output value

$\begin{array}{c}\text{Unit\hspace{0.17em}per\hspace{0.17em}output}=\frac{\text{Cost\hspace{0.17em}ofasset}-\text{Salvage\hspace{0.17em}value}}{\text{Total\hspace{0.17em}units\hspace{0.17em}produce}}\\ =\frac{\$1,260,000-\$60,000}{50,000}\\ =\frac{\$1,200,000}{50,000}\\ =\$24\text{\hspace{0.17em}per\hspace{0.17em}unit}\end{array}$

(b) Calculation of General MARCS method

Date	Total Cost	MACRS Rates (%)	Annual Depreciation	Accumulated Depreciation
2016	$1,260,000	14.29	$180,054	$180,054
2017	1,260,000	24.49	308,574	$488,628
2018	1,260,000	17.49	220,374	$709,002
			$709,002

Note: Takes rates from the MACRS rates schedule

Optional straight-line method

For the three-year period ending December 31, 2018, the general MACRS approach would have a larger depreciation expenditure ($709,002) than the optional straight-line technique ($450,000). As a result, for this period, the general MACRS technique would minimize net income for tax purposes.