Question

(Book vs. Tax (MACRS) Depreciation) Futabatei Enterprises purchased a delivery truck on January 1, 2017, at a cost of \(27,000. The truck has a useful life of 7 years with an estimated salvage value of \)6,000. The straight-line method is used for book purposes. For tax purposes, the truck, having an MACRS class life of 7 years, is classified as 5-year property; the optional MACRS tax rate tables are used to compute depreciation. In addition, assume that for 2017 and 2018 the company has revenues of \(200,000 and operating expenses (excluding depreciation) of \)130,000.

Instructions

1. Prepare income statements for 2017 and 2018. (The final amount reported on the income statement should be income before income taxes.)
2. Compute taxable income for 2017 and 2018.
3. Determine the total depreciation to be taken over the useful life of the delivery truck for both book and tax purposes.
4. Explain why depreciation for book and tax purposes will generally be different over the useful life of a depreciable asset.

Short answer

Answer

1. Income before income and taxes is $67,000 for 2017 and 2018.
2. Taxable income for 2017 and 2018 is $64,000 and $61,360.
3. Book value is $21,000.
4. Salvage value is considered for depreciation.

Step-by-step solution

Meaning of Depreciation 

In an accounting term, depreciation can be referred to as an expense incurred on an intangible asset due to corrosion and abrasion. A firm may adopt various methods for computing depreciation to reflect the true and accurate value of the asset.

(a) Preparing income statements for 2017 and 2018. 

	2017	2018
Revenues	$200,000	$200,000
Operating expenses (excluding depreciation)	130,000	130,000
Depreciation	3,000	3,000
Income before income taxes	$ 67,000	$ 67,000

Working note:

Calculation of depreciation expenses

$\begin{array}{rcl}\mathrm{Depreciation}& =& \frac{\mathrm{Cost}\mathrm{of}\mathrm{truck}-\mathrm{Salvage}\mathrm{value}}{\mathrm{Usefule}\mathrm{life}}\\ & =& \frac{\$27,000-\$6,000}{7}\\ & =& \frac{\$21,000}{7}\\ & =& \$3,000\end{array}$

(b) Computing taxable income for 2017 and 2018

	2017	2018
Revenues	$200,000	$200,000
Operating expenses (excluding depreciation)	130,000	130,000
Depreciation	5,400	8,640
Taxable income	$ 64,600	$ 61,360

Working notes:

Calculating depreciation for 2017

$\begin{array}{rcl}\mathrm{Depreciation}& =& \mathrm{Cost}\mathrm{of}\mathrm{truck}\times \mathrm{Depreciation}\mathrm{rate}\\ & =& \$27,000\times 20\%\\ & =& \$5,400\end{array}$

Calculating depreciation for 2018

$\begin{array}{rcl}\mathrm{Depreciation}& =& \mathrm{Cost}\mathrm{of}\mathrm{truck}\times \mathrm{Depreciation}\mathrm{rate}\\ & =& \$27,000\times 30\%\\ & =& \$8,640\end{array}$

Note:The tax rate for the 1^st year is 20%, and the tax rate for the 2^nd year is 30%.

(c) Determining the depreciation 

Book purposes	$21,000
Tax purposes (entire cost of asset)	$27,000

Working notes:

Calculating the value of depreciation for book purposes

$\begin{array}{rcl}\mathrm{Book}\mathrm{value}& =& \mathrm{Cost}\mathrm{of}\mathrm{truck}-\mathrm{Salvage}\mathrm{valye}\\ & =& \$27,000-\$6,000\\ & =& \$21,000\end{array}$

(d) Explaining the reason behind depreciation which will typically vary over the useful life of the depreciable asset for book and tax purposes.

Differences will arise as a result of the following factors:

1. Several ways of depreciation.
2. For tax reasons, a half-year convention is utilized.
3. Anticipated usable life and tax life are not the same.
4. The tax system disregards salvage value.