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Accounting

27th Edition
WARREN + 5 others
ISBN: 9781337272094

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BuyFindarrow_forward

Accounting

27th Edition
WARREN + 5 others
ISBN: 9781337272094
Textbook Problem

Financial versus tax depreciation

The following is an excerpt from a conversation between two employees of WXT Technologies, Nolan Sears and Stacy Mays. Nolan is the accounts payable clerk, and Stacy is the cashier.

Nolan: Stacy, could I get your opinion on something?

Stacy: Sure, Nolan.

Nolan: Do you know Rita, the fixed assets clerk?

Stacy: I know who she is, but I don’t know her real well. Why?

Nolan: Well, I was talking to her at lunch last Monday about how she liked her job. You know, the usual; and she mentioned something about having to keep two sets of books- one for taxes and one for the financial statements. That can’t be good accounting, can it? What do you think?

Stacy: Two sets of books? It doesn’t sound right.

Nolan: It doesn’t seem right to me either. I was always taught that you had to use generally accepted accounting principles. How can there be two sets of books? What can be the difference between the two?

How would you respond to Nolan and Stacy if you were Rita?

To determine

Methods of Depreciation: Depreciation refers to the reduction in the monetary value of a fixed asset due to its wear and tear, or obsolescence. It is a method of distributing the cost of the fixed assets over its estimated useful life.

The three methods of depreciation are:

  • Straight-line method: Under the straight-line method of depreciation, the same amount of depreciation is allocated every year over the estimated useful life of an asset.
  • Units-of-activity method: In this method of depreciation, the amount of depreciation is charged based on the unit of production each year.
  • Double-declining balance method (Accelerated method): In this method of depreciation, the diminishing value of the asset is taken into consideration for determining the depreciation for the succeeding years.

To Respond – Mr. N and Ms. S regarding the maintenance of two set of books, one for tax purposes and another for financial statement purposes.

Explanation

It is acceptable to maintain two set of books. Mostly, companies follow two different depreciation methods that is, straight-line method for financial reporting purposes and accelerated method for tax purposes. Hence, they maintain two set of books.

It motivates the companies for following different depreciation method for different purposes due to the following reasons:

  • Companies use “accelerated method” to reduce the income tax. This method increases the depreciation expense thereby reducing the net income for initial few years of the estimated useful life of the asset. The reduced net income reduces the taxable income. Hence, the income tax expense becomes less.
  • However, companies use “straight-line depreciation method” to record its assets at the right cost on the balance sheet...

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