(Depreciation Basic Concepts) Burnitz Manufacturing Company was organized January 1, 2012. During 2012, it has used in its reports to management the straight-line method of depreciating its plant assets. On November 8, you are having a conference with Burnitz’s officers to discuss the depreciation method to be used for income tax and stockholder reporting. James Bryant, president of Burnitz, 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. Following is an example in which the proposed method is applied to a fixed asset with an original cost of $248,000, an estimated useful life of 5 years, and a salvage value of approximately $8,000.
|
Year
|
Years of
Life
Used
|
Fraction
Rate
|
Depreciation
Expense
|
Accumulated
Depreciation
at End
of Year
|
Book Value
at End
of Year
|
|
1
|
1
|
1/15
|
$16,000
|
$ 16,000
|
$232,000
|
|
2
|
2
|
2/15
|
32,000
|
48,000
|
200,000
|
|
3
|
3
|
3/15
|
48,000
|
96,000
|
152,000
|
|
4
|
4
|
4/15
|
64,000
|
160,000
|
88,000
|
|
5
|
5
|
5/15
|
80,000
|
240,000
|
8,000
|
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 assets’ useful lives when maintenance and replacement disbursements are high.
2. It will result in increased write-offs in later years and thereby will reduce taxes.
Instructions
(a) What is the purpose of accounting for depreciation?
(b) Is the president’s proposal within the scope of generally accepted accounting principles? In making your decision discuss the circumstances, if any, under which use of the method would be reasonable and those, if any, under which it would not be reasonable.
(c) The president wants your advice on the following issues.
(1) Do depreciation charges recover or create funds? Explain.
(2) Assume that the Internal Revenue Service accepts the proposed depreciation method in this case. If the proposed method were used for stockholder and tax reporting purposes, how would it affect the availability of cash flows generated by operations?