Question

(Book vs. Tax (MACRS) Depreciation) Shimei Inc. purchased computer equipment on March 1, 2017, for \(31,000. The computer equipment has a useful life of 10 years and a salvage value of \)1,000. For tax purposes, the MACRS class life is 5 years.

Instructions

a. Assuming that the company uses the straight-line method for book and tax purposes, what is the depreciation expense reported in

1. the financial statements for 2017 and
2. the tax return for 2017?
   

b. Assuming that the company uses the double-declining-balance method for both book and tax purposes, what is the depreciation expense reported in

1. the financial statements for 2017 and
2. the tax return for 2017?

c. Why is depreciation for tax purposes different from depreciation for book purposes even if the company uses the same depreciation method to compute them both?

Short answer

Answer

a. Depreciation expense is (1) $2,500 and (2) $3,100

b. Depreciation expense is (1) $5,167 and (2) $6,200.

c. The tax life of an asset and the useful life of the asset are different

Step-by-step solution

Meaning of Depreciation

Depreciation is considered an expense in the book of account for the decrease in the asset’s value due to the wear and tear of the asset. Depreciation can be computed using a different method, but most companies follow straight-line depreciation.

(a 1) Calculating depreciation expenses reported in the financial statements for 2017

Depreciation expense = $2,500

Working Notes:

Calculating depreciation expense

$\begin{array}{rcl}\text{Depreciation}\text{expense}& =& \left(\text{Cost} \text{of}\text{computer}-\text{Salvage}\text{value}\right)\times \frac{\text{Number} \text{of}\text{year}}{\text{Useful}\text{life}}\times \frac{\text{Number}\text{of}\text{month}}{\text{Total}\text{month}\text{in}\text{year}}\\ & =& \left(\$31,000-\$1,000\right)\times \frac{1}{10}\times \frac{10}{12}\\ & =& \$30,000\times \frac{1}{10}\times \frac{10}{12}\\ & =& \$2,500\end{array}$

(a 2) Calculating depreciation expenses that should be reported in the tax return for 2017

Depreciation expense = $3,100

Working notes:

Calculating depreciation expense

$\begin{array}{rcl}\text{Depreciation} \text{expense}& =& \text{Cost}\text{of}\text{computer}\times \frac{\text{Number} \text{of}\text{year}}{\text{Useful}\text{life}}\times \frac{\text{Number}\text{of}\text{month}}{\text{Total}\text{month}\text{in}\text{a}\text{year}}\\ & =& \$31,000\times \frac{1}{5}\times \frac{6}{12}\\ & =& \$3,100\\ & & \end{array}$

(b 1) Calculating depreciation expense reported in the financial statement for 2017

Depreciation expense = $5,167

Working notes:

Calculating depreciation expense

$\begin{array}{rcl}\text{Depreciation}\text{expense}& =& \text{Cost}\text{of}\text{computer}\times \left(\frac{\text{Number}\text{of}\text{year}}{\text{Useful}\text{life}}\times 2\times 100\right)\times \frac{\text{Number} \text{of}\text{month}}{\text{Total}\text{month}\text{in}\text{a}\text{year}}\\ & =& \$31,000\times \left(\frac{1}{10}\times 2\times 100\right)\times \frac{10}{12}\\ & =& \$31,000\times 20\%\times \frac{10}{12}\\ & =& \$5,167\end{array}$

(b 2) calculating the depreciation expense that should be reported in the tax return for 2017

Depreciation expense = $6,200

Working notes:

Calculating depreciation expense

$\begin{array}{rcl}\text{Depreciation}\text{expense}& =& \text{Cost}\text{of}\text{computer}\times \left(\frac{\text{Number}\text{of}\text{year}}{\text{Useful}\text{life}}\times 2\times 100\right)\times \frac{\text{Number} \text{of}\text{month}}{\text{Total}\text{month}\text{in}\text{a}\text{year}}\\ & =& \$31,000\times \left(\frac{1}{5}\times 2\times 100\right)\times \frac{1}{12}\\ & =& \$31,000\times 40\%\times \frac{1}{12}\\ & =& \$6,200\end{array}$

(c) Explaining the difference

There will be differences due to the following factors:

1. For tax purposes, a half-year convention is used.
2. There is no correlation between anticipated use life and tax life.
3. The tax system ignores salvage value.