Question 1
Depreciation is the systematic allocation of the cost of an asset over its estimated economic life. Generally, depreciation is an expense reported on the income statement. Why is it only generally an expense item reported on the income statement? Consider this question before responding: What must taxpayers do if depreciable equipment is used in the construction of capital improvements? What impact will it have on the depreciation of the equipment?
Separately, discuss whether it is possible to exclude property from the MACRS system (assume the property was placed in service after December 31, 1986). Provide an example specifying the nature of the business, type of property and the method that would be used.
Use the Internal Revenue Service's website at https://www.IRS.gov and its search feature to obtain additional information on depreciation.
Respond to this... Depreciation by definition is simply the amount a capital asset was worth when purchased then "depreciated" or deducted numerically from the historical purchase price through a series of deprecation formulas. For example if a company truck was purchased for 50k and had a useful life of 10 years it would be annually depreciated every year for a specific amount. Additionally the depreciation amount is shown as a liability expense shown on the income statement and its contra account is the accumulated depreciation account which is seen on the balance sheet. This at first was confusing to me however it does make sense since assets lose value as they are used and their "value loss" is accounted for as an expense. Also the accumulated depreciation is shown as a credit account on the balance sheet further showing how depreciation lowers the value of the company's assets.
The IRS states the following related to depreciation when filing taxes and utilizes MACRS.
"In order for a taxpayer to be allowed a depreciation deduction for a property, the property must meet all the following requirements:
• The taxpayer must own the property.Taxpayers may also depreciate any capital improvements for property the taxpayer leases.
• A taxpayer must use the property in business or in an income-producing activity. If a taxpayer uses a property for business and for personal purposes, the taxpayer can only deduct depreciation based only on the business use of that property.
• The property must have a determinable useful life of more than one year." (IRS, 2016)
Additionally there is a way to exclude depreciation by way of MACRS if the asset can be depreciated without using annual or yearly methods such as the unit ofproduction method.
"If you can properly depreciate any property under a method not based on aterm of years, such as the unit-of-production method, you can elect to exclude that property from MACRS. You make the election by reporting your depreciation for the property on line 15 in Part II of Form 4562 and attaching a statement as described in the Instructions for Form 4562" (Taxmap, 2016)
References
https://taxmap.ntis.gov/taxmap/pubs/p946-004.htm#TXMP718c8f20
Question 2
As we are bringing to a close everything we have learned over the past several modules, share with the class at least one important hint or tip that has helped you with a difficult concept. Also, if you could take any one piece of important information with you as you leave this class, what would it be? Why?
Respond to this... This course has taught me a lot of financial reporting aspects. Between income statements and balance sheets to inventory and receivables I have learned a lot of valuable information. I think the one thing I will think about often, is the percentage of collection over a period of time for receivables. I work with receivables everyday and it is important that I consider the percentage of what I may get back and what I need to count as a bad debt expense. It was good to know that the Generally Accepted Accounting Principles are changing to International Financial Reporting Standards, and that only one way of counting for inventory is acceptable while using IFRS. I am excited to carry forward the information I have learned in this course and be able to use it with my ongoing career in accounting.
Question 3
Explain how "relative valuation" works. What are the primary steps involved in conducting comparable valuations? Give some examples of common valuation "multiples" used.
Respond to this... Relative valuation measures the value of assets in comparison with current market priced assets. In order to make the comparison, assets must first be standardized and you must compare across similar companies. There are different methods for standardization. One way is to look at an asset value as a multiple of the earnings per share generated by the company. This is the price/earnings ratio. Another method is to look at market value of equity and the book value of equity. This is the price/book ratio. The price/sales ratio looks at the value of an asset to the revenues it generates. Valuation multiples are commonly used because they require fewer assumptions than discounted cash flow valuation.
Investors benefit from relative valuation because they can compare ratios instead of just observing the ratio value itself. However, relative valuation has its limitations since it is assumed that the market has valued assets correctly. Also, valuation metrics are based on past performance and there is no guarantee that a "cheaper" company will outperform another.
References
Damodaran, A. (2015). Applied Corporate Finance (4th ed.). Hoboken: John Wiley & Sons, Inc.
https://www.investopedia.com/articles/stocks/11/relative-valuation-stocks-valuing-stocks.asp