Question

(Depreciation Basic Concepts) Burnitz Manufacturing Company was organized on January 1, 2017. In 2017, it has used in its reports to management the straight-line method of depreciating its plant assets.

On November 8, you are having a conference with Burnitz’s officers to discuss the depreciation method to be used for income tax and stockholder reporting. James Bryant, president of Burnitz, has suggested the use of a new method, which he feels is more suitable than the straight-line method for the needs of the company during the period of rapid expansion of production and capacity that he foresees. Following is an example in which the proposed method is applied to a fixed asset with an original cost of \(248,000, an estimated useful life of 5 years, and a salvage value of approximately \)8,000.

Year	Year of life used	Fraction rate	Depreciation expense	Accumulated depreciation at the end of year	Book value at the end of Year
1	1	1/15	\(16,000	\) 16,000	$232,000
2	2	2/15	32,000	48,000	200,000
3	3	3/15	48,000	96,000	152,000
4	4	4/15	64,000	160,000	88,000
5	5	5/15	80,000	240,000	8,000

The president favors the new method because he has heard that:

1. It will increase the funds recovered during the years near the end of the assets’ useful lives when maintenance and replacement disbursements are high.
2. It will result in increased write-offs in later years and thereby will reduce taxes.

Instructions

1. What is the purpose of accounting for depreciation?
2. Is the president’s proposal within the scope of generally accepted accounting principles? In making your decision, discuss the circumstances, if any, under which use of the method would be reasonable and those, if any, under which it would not be reasonable.
3. The president wants your advice on the following issues.
   1. Do depreciation charges recover or create funds? Explain.

(2) Assume that the Internal Revenue Service accepts the proposed depreciation method in this case. If the proposed method were used for stockholder and tax reporting purposes, how would it affect the availability of cash flows generated by operations?

Short answer

Answer

The purpose of depreciation is to distribute the cost. The proposed method of depreciation is systematic. Depreciation charges neither recover nor create funds.

Step-by-step solution

Step-by-Step SolutionStep 1: Meaning of Depreciation

Depreciation is an accounting procedure that is used to know the exact value of the asset as the time passes and when the asset becomes absolute. A company has different options for analyzing depreciation, with the straight-line method being the most common one.

(a) Explaining the purpose of accounting for depreciation

Depreciation expense is incurred on a tangible asset due to obsolescence or the passage of time on that asset, and the purpose of depreciation is to distribute the cost.

Depreciation accounting is a process of allocation, not valuation, in which productive effort (cost) in line with the usage of the asset (expense recognition principle) is matched with productive achievement (revenue) for the period, according to generally accepted accounting standards. As a result, depreciation accounting is concerned with when the cost of physical plant assets will expire.

(b) Discussing the circumstances

Of course, the recommended method of depreciation is methodical. It depends on the details of the situation whether it is sensible in terms of cost allocation. It results in a growing depreciation charge, which is usually unjustifiable in terms of the gain from asset utilization. Firms want to employ new equipment as feasible and old equipment just as needed to satisfy output quotas during peak demand periods. As a general rule, then, the benefit declines with age.

Assuming that each year's actual activities (including equipment usage) are comparable, maintenance and repair expenses will likely be greater in later use than in early years. As a result, the suggested technique would combine modest depreciation and repair expenditures in the early years. During times of similar operation, reported net income in the early years would be significantly greater than reported net income in the later years of asset life, an illogical and undesired fluctuation.

If, on the other hand, the expected level of operations (including equipment usage) in the early years of asset life is expected to be lower than in later years due to slack demand or production policies, the proposed method's pattern of depreciation charges roughly parallels expected benefits (and revenues) and is thus reasonable. Although the units-of-production depreciation technique is the most common choice for this situation, the proposed method still adheres to widely recognized accounting standards if an adequate rationale is supplied.

(c1) Explaining whether depreciation charges recover or create funds

Depreciation costs do not create or recover funds. Revenue-producing activities are the sources of funds from operations: if revenues exceed out-of-pocket costs during a fiscal period, funds are available to cover other than out-of-pocket costs; if revenues do not exceed out-of-pocket costs during a fiscal period, no funds are available regardless of how much, or how little, depreciation is charged.

(c2) Explaining the effect of availability of cash flows generated by operations.

Depreciation can have two effects on finances. First, depreciation costs impact reported income, which can influence managerial choices like pricing, product selection, and dividends. For example, because the suggested technique produces larger reported income at first than the straight-line method, investors may demand bigger dividends in the early years than they would otherwise anticipate.

Compared to the suggested technique, the straight-line method may stimulate earlier reinvestment in other profit-earning assets to satisfy expanding demand by causing lower reported income during the early years of asset life and limiting the number of future dividends in the early years.

Second, depreciation compact on reported taxable income, which directly impacts the amount of income taxes due in the year of deduction.

Using the suggested technique for tax purposes would lower the overall tax cost throughout the life of the assets

1. if tax rates were to rise in future years, or
2. if the firm was now performing poorly but was expected to perform much better in the future. The first criterion is political and hypothetical, but the second condition may be relevant given Burnitz Manufacturing Company's early beginnings and ambitious development program. As a result, if one of the assumptions above holds, more cash may be available for reinvestment in plant assets in years with substantial deductions.

Burnitz should explore an escalating charge technique for tax purposes, such as the one recommended if it is not profitable presently and would not benefit from higher deductions. If Burnitz is now profitable, the president should reconsider his plan because it would postpone the availability of the depreciation tax break. This choice, however, should have no bearing on the decision to utilize a depreciation method for shareholders' reporting that is methodical and logical in terms of cost allocation under currently accepted accounting rules.