Chapter 10, Problem 10.3CP

Effect of depreciation on net income

Tuttle Construction Co. specializes in building replicas of historic houses. Tim Newman, president of Tuttle Construction, is considering the purchase of various items of equipment on July 1, 2014, for $400,000. The equipment would have a useful life of five years and no residual value. In the past, all equipment has been leased. For tax purposes, Tim is considering depreciating the equipment by the straight-line method. He discussed the matter with his CPA and learned that, although the straight-line method could be elected, it was to his advantage to use the Modified Accelerated Cost Recovery System (MACRS) for tax purposes. He asked for your advice as to which method to use for tax purposes.

1. Compute depreciation for each of the years (2014, 2015, 2016, 2017, 2018, and 2019) of useful life by (a) the straight-line method and (b) MACRS. In using the straight-line method, one-half year’s depreciation should be computed for 2014 and 2019. Use the MACRS rates presented in Exhibit 9.

2. Assuming that income before depreciation and income tax is estimated to be $750,000 uniformly per year and that the income tax rate is 40%, compute the net income for each of the years 2014, 2015, 2016, 2017, 2018, and 2019 if (a) the straight-line method is used and (b) MACRS is used.

3. What factors would you present for Tim’s consideration in the selection of a depreciation method?