Use of Accelerated Depreciation Methods Allows Shifting of Income

Even though Mr. Fordham mentions that he in his “Statement of Cost of Goods Manufactured for Year Ended Dec. 31 1956” that he depreciated $24,000 of Plant and Equipment, I decided to change the depreciation schedule so that PP&E would be fully depreciated by the end of the 5 year period. Thus, I used a straight-line depreciation schedule that accumulated $40,000 worth of depreciation per year, which was spread evenly across the 12 months of this Balance Sheet (or $3,333.33 per month).

If the depreciation method changes from straight-line method to accelerated method then, depreciation expense would be increase and net income would decrease. The EPS ratio would represent a loss of $0.19 per share.

4. The depreciation accounting changes assume that Harnischfeger’s plant and machinery will last longer and will lose their value more slowly.  Given the business conditions Harnischfeger was facing in its primary industries in 1984, are these economic assumptions justified?

Depreciation is defined as “the loss in value, from all causes, of property having a limited economic life.” (Thimgan, p.257, 2010) The cause of depreciation could be wear and tear, decay, inadequacy, excessiveness, obsolescence, and negative externalities of factors external to the subject property. There are various forms depreciation recognized in the real estate appraisal. The following are commonly applied depreciation forms:

The value of fixed assets typically decreases over time. The amount of the decrease each year is accounted for and is called depreciation. Depreciation for the year is expensed on the income statement and added to the accumulated depreciation account on the balance sheet. So the value of the fixed assets on the balance sheet is reduced by the accumulated depreciation.

1. The first step to evaluating the cash flows is to conduct the depreciation tax flow analysis. Depreciation is not a cash flow, but the depreciation expense lows the taxes payable for the company. As a result, the tax effect of deprecation needs to be calculated as a cash flow. There are two depreciable items on the company's balance sheet the building and the equipment. The equipment is known to have a seven year depreciable life, which will be assumed to be straight line. The building is also assumed to be subject to straight line depreciation, this time of forty years. The tax saving reflects the depreciation expense multiplied by the tax rate, which in this case is assumed to be 28%. The following table illustrates the tax effect in future dollars of the depreciation expense:

Depreciation is inevitable once you purchase a fixed asset. Microsoft uses the straight-line method to calculate depreciation as most other companies do. The main point is that MS uses the straight-line method over the shorter of the estimated life

-The estimated depreciation lives on certain U.S. plants, machinery and equipment changed. The economic life of these assets was increased, so the depreciation expense was lowered.

A deferred tax liability is recognized for temporary differences that will result in taxable amounts in future years. In Packer, Inc’s case, depreciation has been recognized as deferred tax liabilities. Packer uses straight-line depreciation, for tax purposes, the cost of the depreciable recourses may have been deducted faster than that for financial reporting purposes.

Furthermore, by adopting a historical cost approach the assets will be depreciated over that useful life which has been estimated. With the useful life of an asset being so subjective it is hard to apportion a useful figure to depreciation. By increasing the useful life of an asset you are effectively spreading the depreciation expense over a longer period of time resulting in lower depreciation expenses and vice versa. In fact, Zheng et al. (2012) go one step further and consider depreciation to be a strategy for managers to manipulate profits.

Option II in which the new tax proposal is enacted. The new equipment is installed in December 1986. Paperco signs a binding contract soon enough to be “grandfathered”, this allows Paperco to receive the 8% tax credit and use ACRS depreciation. At the same time, their tax rate would fall to 34%. Paperco would benefit from this more favorable “grandfathered” tax approach. Option II has a positive NPV of $3,414,104.

It is critical to understand that the transaction events which give rise to timing differences are economic in nature and therefore have economic consequences. The question then becomes how to best reflect those economic consequences in the financial statements. Inter-period income tax allocation considers the tax consequences of transaction events such as revenue, expenses, gains, and losses and associates these items with the period in which these events are recognized. In other words, inter-period tax allocation is consistent with the basic tenets of accrual accounting. Underlying this method is the understanding that there is a direct economic relationship between identifiable transactions reflected in the financial statements and related income tax effects (Arthur et al., 1984). Therefore, each transaction has a tax effect.

In 1949 the introduction of Capital Cost Allowance (CCA) system was designed to be a simple method to depreciate capital property for tax purposes (Mida and Stewart, 1995). The CCA defined by Canada Revenue Agency (2014) as a tax deduction that Canadian tax laws allow a business to claim for the loss in value of capital assets due to wear and tear or obsolescence. Over time, the system whose aim was to ensure fair and equitable approach to asset depreciation for all taxpayers was significantly amended during tax reforms in 1972 and in 1987. Rock Lefebvre, Vice President of Research and Standards at CGA-Canada (CGA, 2013) argues that due to changes made to the system,

b. Increase. The more rapid that depreciation can occur, the larger the cash flows that stockholders can receive. This increased cash flow should lead to an increase in the payout ratios for the stockholders.

Depreciation expense is the way that the use of an asset is matched with the revenue that is generated from the asset on the income statement during the time period being reported. Each asset used in a business has a useful life as disclosed by the company’s depreciation policies for each category of asset. The other piece of calculating depreciation is the assumed salvage or “residual” value. There are several different methods of depreciating an asset: