Depreciation
Response to the following problem:
May Manufacturing Company was organized January 2, 2010. During 2010, it has used in its reports to management the straight-line method of depreciating its plant assets.
On November 9, you are having a conference with May's officers to discuss the depreciation method to be used for income tax and stockholder reporting. The president of May 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. The following is a schedule in which the proposed method is applied to a fixed asset with an original cost of $32,000, an estimated useful life of five years, and a scrap value of approximately $2,000.
| Year |
Years of Life Used |
Fraction Rate |
Depreciation Expense |
Accumulated Depreciation Year-End |
Book Value at Year- End |
|
1
|
1
|
1/15
|
$ 2,000
|
$ 2,000
|
$30,000
|
|
2
|
2
|
2/15
|
4,000
|
6,000
|
26,000
|
|
3
|
3
|
3/15
|
6,000
|
12,000
|
20,000
|
|
4
|
4
|
4/15
|
8,000
|
20,000
|
12,000
|
|
5
|
5 5/15
|
10,000
|
30,000
|
2,000
|
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 asset's useful life when maintenance and replacement disbursements are high.
2. It will result in increased write-offs in later years, thereby reducing taxes.
Required
1. Explain the purpose and, hence, the nature of accounting for depreciation.
2. Is the president's proposal within the scope of generally accepted accounting principles? In making your decision, explain the circumstances, if any, under which the method would be reasonable and those, if any, under which it would not be reasonable.
3. The president wants your advice.
a. Explain whether depreciation recovers or creates funds.
b. Assume that the Internal Revenue Service accepts the proposed depreciation method in this particular case. If the proposed method were used for stockholder and tax reporting purposes, explain how it would affect the availability of funds generated by operations