Chapter 6, Problem 24P

Determining the effect of depreciation expense on financial statements

Three different companies each purchased trucks on January 1, 2018, for $50,000. Each truck was expected to last four years or 200,000 miles. Salvage value was estimated to be $5,000. All three trucks were driven 66,000 miles in 2018, 42,000 miles in 2019, 40,000 miles in 2020, and 60,000 miles in 2021. Each of the three companies earned $40,000 of cash revenue during each of the four years. Company A uses straight-line depreciation, company B uses double-declining-balance depreciation, and company C uses units-of-production depreciation.

Required

Answer each of the following questions. Ignore the effects of income taxes.

a. Which company will report the highest amount of net income for 2018?

b. Which company will report the lowest amount of net income for 2021?

c. Which company will report the highest book value on the December 31, 2020, balance sheet?

d. Which company will report the highest amount of retained earnings on the December 31, 2021, balance sheet?

e. Which company will report the lowest amount of cash flow from operating activities on the 2020 statement of cash flows?

To determine

Identify the company which will report the highest amount of net income for 2018.

Explanation of Solution

Net Income

Net income is the sum total of all the revenues generated in a particular accounting period after deducting cost of goods sold and expenses and losses, such as rent expense, depreciation of that particular accounting period.

Book value:

The amount of acquisition cost of less accumulated depreciation as on a particular date is referred to as book value.

Formula for book value:

$\text{Book value = }\left\{\begin{array}{l}\text{Acquisition cost–}\\ \text{Accumulated depreciation}\end{array}\right\}$

Accumulated depreciation:

The total amount of depreciation expense deducted, from the time asset acquired till date, as reported in the account as on a particular date, is referred to as accumulated depreciation.

Formula for accumulated depreciation:

$\text{Accumulated depreciation = }\left\{\begin{array}{l}\text{Depreciation expense in the previous years+}\\ \text{Depreciation in current year}\end{array}\right\}$

Identify the company which will report the highest amount of net income for 2018.

Net Income for 2018
	Company A (in $)	Company B (in $)	Company C (in $)
Revenue	40,000	40,000	40,000
Less: Depreciation expense	11,250 (W.N. 1)	25,000 (W.N. 2)	14,850 (W.N. 3)
Net Income	$28,750	$15,000	$25,150

Table (1)

Working Note 1:

Prepare depreciation schedule under straight-line method for Company A.

Date	Depreciable Cost (in $) (A)	Depreciation Rate (B)	Depreciation expense (in $)$\left(\left(\text{C}\right)=\left(\text{A}\right)\times \left(\text{B}\right)\right)$
2018	45,000	1/4	11,250
2019	45,000	1/4	11,250
2020	45,000	1/4	11,250
2021	45,000	1/4	11,250

Table (2)

Note:

1. 1. Calculate the depreciable cost.

$\begin{array}{c}\text{Depreciable cost=Cost of the asset}-\text{Residual value}\\ \text{=\$50,000}-\$5,000\\ =\$45,000\end{array}$

Working note 2:

Prepare depreciation schedule under double-declining-balance (DDB) method for Company B.

Date	Double-Declining-Balance Depreciation Rate (A)	Book Value (Refer note) (in $) (B)	Depreciation expense (in $)$\left(\left(\text{C}\right)=\left(\text{A}\right)\times \left(\text{B}\right)\right)$
2018	0.50	50,000	25,000
2019	0.50	25,000	12,500
2020	0.50	12,500	6,250
2021	0.50	6,250	1,250

Table (3)

Note:

1. 1. Determine the depreciation rate applied each year.

Useful life = 4 years

$\begin{array}{c}\text{Depreciation rate = }\frac{\text{100\%}}{\text{4 years}}\text{ × 2}\\ \text{= 50\%}\text{or }\text{.50}\end{array}$

1. 2. Compute depreciation expense on 2021.

$\begin{array}{c}\text{Depreciation on 2021}=\left(\begin{array}{l}\text{Asset cost–Residual value}-\\ \text{Accumulated depreciation in 2021}\end{array}\right)\\ =\text{\$50,000–\$5,000–}\left(\text{\$25,000+\$12,500+\$6,250}\right)\\ =\$45,000-\$43,750\\ =\$1,250\end{array}$

Working note 3:

Prepare depreciation schedule under units-of-production method for Company C.

Date	Depreciation per unit (A)	Number of miles (B)	Depreciation expense (in $)$\left(\left(\text{C}\right)=\left(\text{A}\right)\times \left(\text{B}\right)\right)$
2018	$0.225	66,000	14,850
2019	$0.225	42,000	9,450
2020	$0.225	40,000	9,000
2021	$0.225	60,000	11,700

Table (4)

Note:

1. 1. Compute depreciation per unit.

$\begin{array}{c}\text{Depreciation per unit =}\frac{\text{ Asset cost – Residual value}}{\text{Estimated units of total production}}\\ \text{=}\frac{\text{\$50,000–\$5,000}}{200,000\text{miles}}\\ \text{=}\frac{\text{\$45,000}}{200,000\text{miles}}\\ \text{= \$0}\text{.225}\end{array}$

1. 2. Compute depreciation expense on 2021.

$\begin{array}{c}\text{Depreciation on 2021}=\left(\begin{array}{l}\text{Asset cost–Residual value}-\\ \text{Accumulated depreciation in 2021}\end{array}\right)\\ =\text{\$50,000–\$5,000–}\left(\text{\$14,850+\$9,450+\$9,000}\right)\\ =\$45,000-\$33,300\\ =\$11,700\end{array}$

Conclusion

Hence, the company which will report the highest amount of net income for 2018 is Company A.

To determine

Identify the company which will report the lowest amount of net income for 2021.

Explanation of Solution

Identify the company which will report the lowest amount of net income for 2021.

Net Income for 2021
	Company A (in $)	Company B (in $)	Company C (in $)
Revenue	40,000	40,000	40,000
Less: Depreciation expense	11,250 (W.N. 4)	1,250 (W.N. 5)	11,700 (W.N. 6)
Net Income	$28,750	$38,750	$28,300

Table (5)

Working Note 4:

Prepare depreciation schedule under straight-line method for Company A.

Date	Depreciable Cost (in $) (A)	Depreciation Rate (B)	Depreciation expense (in $)$\left(\left(\text{C}\right)=\left(\text{A}\right)\times \left(\text{B}\right)\right)$
2018	45,000	1/4	11,250
2019	45,000	1/4	11,250
2020	45,000	1/4	11,250
2021	45,000	1/4	11,250

Table (6)

Note:

Calculate the depreciable cost.

$\begin{array}{c}\text{Depreciable cost=Cost of the asset}-\text{Residual value}\\ \text{=\$50,000}-\$5,000\\ =\$45,000\end{array}$

Working note 5:

Prepare depreciation schedule under double-declining-balance (DDB) method for Company B.

Date	Double-Declining-Balance Depreciation Rate (A)	Book Value (Refer note) (in $) (B)	Depreciation expense (in $)$\left(\left(\text{C}\right)=\left(\text{A}\right)\times \left(\text{B}\right)\right)$
2018	0.50	50,000	25,000
2019	0.50	25,000	12,500
2020	0.50	12,500	6,250
2021	0.50	6,250	1,250

Table (7)

Note:

1. 1. Determine the depreciation rate applied each year.

Useful life = 4 years

$\begin{array}{c}\text{Depreciation rate = }\frac{\text{100\%}}{\text{4 years}}\text{ × 2}\\ \text{= 50\%}\text{or }\text{.50}\end{array}$

1. 2. Compute depreciation expense on 2021.

$\begin{array}{c}\text{Depreciation on 2021}=\left(\begin{array}{l}\text{Asset cost–Residual value}-\\ \text{Accumulated depreciation in 2021}\end{array}\right)\\ =\text{\$50,000–\$5,000–}\left(\text{\$25,000+\$12,500+\$6,250}\right)\\ =\$45,000-\$43,750\\ =\$1,250\end{array}$

Working note 6:

Prepare depreciation schedule under units-of-production method for Company C.

Date	Depreciation per unit (A)	Number of miles (B)	Depreciation expense (in $)$\left(\left(\text{C}\right)=\left(\text{A}\right)\times \left(\text{B}\right)\right)$
2018	$0.225	66,000	14,850
2019	$0.225	42,000	9,450
2020	$0.225	40,000	9,000
2021	$0.225	60,000	11,700

Table (8)

Note:

1. 1. Compute depreciation per unit.

$\begin{array}{c}\text{Depreciation per unit =}\frac{\text{ Asset cost – Residual value}}{\text{Estimated units of total production}}\\ \text{=}\frac{\text{\$50,000–\$5,000}}{200,000\text{miles}}\\ \text{=}\frac{\text{\$45,000}}{200,000\text{miles}}\\ \text{= \$0}\text{.225}\end{array}$

1. 2. Compute depreciation expense on 2021.

$\begin{array}{c}\text{Depreciation on 2021}=\left(\begin{array}{l}\text{Asset cost–Residual value}-\\ \text{Accumulated depreciation in 2021}\end{array}\right)\\ =\text{\$50,000–\$5,000–}\left(\text{\$14,850+\$9,450+\$9,000}\right)\\ =\$45,000-\$33,300\\ =\$11,700\end{array}$

Conclusion

Hence, the company which will report the lowest amount of net income for 2021 is Company C.

To determine

Identify the company which will report the highest book value on the December 31, 2020, balance sheet.

Explanation of Solution

Book value:

The amount of acquisition cost of less accumulated depreciation as on a particular date is referred to as book value.

Formula for book value:

$\text{Book value = }\left\{\begin{array}{l}\text{Acquisition cost–}\\ \text{Accumulated depreciation}\end{array}\right\}$

Identify the company which will report the highest book value on the December 31, 2020, balance sheet.

Book value on December 31, 2020
	Company A (in $)	Company B (in $)	Company C (in $)
Cost	50,000	50,000	50,000
Less: Accumulated depreciation	33,750 (W.N. 7)	43,750 (W.N. 8)	33,300 (W.N. 9)
Book value	$16,250	$6,250	$16,700

Table (9)

Working note 7:

Prepare depreciation schedule under straight-line method for Company A.

Date	Depreciable Cost (in $) (A)	Depreciation Rate (B)	Depreciation expense (in $)$\left(\left(\text{C}\right)=\left(\text{A}\right)\times \left(\text{B}\right)\right)$	Accumulated Depreciation (in $)
2018	45,000	1/4	11,250	11,250
2019	45,000	1/4	11,250	22,500
2020	45,000	1/4	11,250	33,750

Table (10)

Note:

Calculate the depreciable cost.

$\begin{array}{c}\text{Depreciable cost=Cost of the asset}-\text{Residual value}\\ \text{=\$50,000}-\$5,000\\ =\$45,000\end{array}$

Working note 8:

Prepare depreciation schedule under double-declining-balance (DDB) method for Company B.

Date	Double-Declining-Balance Depreciation Rate (A)	Book Value (Refer note) (in $) (B)	Depreciation expense (in $)$\left(\left(\text{C}\right)=\left(\text{A}\right)\times \left(\text{B}\right)\right)$	Accumulated Depreciation (in $)
2018	0.50	50,000	25,000	25,000
2019	0.50	25,000	12,500	37,500
2020	0.50	12,500	6,250	43,750

Table (11)

Note:

Determine the depreciation rate applied each year.

Useful life = 4 years

$\begin{array}{c}\text{Depreciation rate = }\frac{\text{100\%}}{\text{4 years}}\text{ × 2}\\ \text{= 50\%}\text{or }\text{.50}\end{array}$

Working note 9:

Prepare depreciation schedule under units-of-production method for Company C.

Date	Depreciation per unit (A)	Number of miles (B)	Depreciation expense (in $)$\left(\left(\text{C}\right)=\left(\text{A}\right)\times \left(\text{B}\right)\right)$	Accumulated Depreciation (in $)
2018	$0.225	66,000	14,850	14,850
2019	$0.225	42,000	9,450	24,300
2020	$0.225	40,000	9,000	33,300

Table (12)

Note:

Compute depreciation per unit.

$\begin{array}{c}\text{Depreciation per unit =}\frac{\text{ Asset cost – Residual value}}{\text{Estimated units of total production}}\\ \text{=}\frac{\text{\$50,000–\$5,000}}{200,000\text{miles}}\\ \text{=}\frac{\text{\$45,000}}{200,000\text{miles}}\\ \text{= \$0}\text{.225}\end{array}$

Conclusion

Hence, the company which will report the highest book value on the December 31, 2020, balance sheet is Company C.

To determine

Identify the company which will report the highest amount of retained earnings on the December 31, 2021, balance sheet.

Explanation of Solution

Retained earnings:

The retained earnings statement is that financial statement which shows the amount of net income which is actually retained by the Company on a particular date. These earnings can be utilized by the Company for the reinvestment and to pay its debts.

Hence, the retained earnings for all the companies are the same on the December 31, 2021, balance sheet, as the total depreciation over the four year period is the same for all the three companies.

To determine

Identify the company which will report the lowest amount of cash flow from operating activities on the 2020 statement of cash flows.

Explanation of Solution

Statement of cash flows:

This statement reports all the cash transactions which are responsible for inflow and outflow of cash, and result of these transactions is reported as ending balance of cash at the end of reported period.

Cash flows from operating activities:

These refer to the cash received or cash paid in day-to-day operating activities of a company.  In this direct method, cash flow from operating activities is computed by using all cash receipts and cash payments during the year.

Depreciation expense is not a cash outflow item. If the income tax is not considered, all the three companies will report the same amount of cash flow from operating activities on the 2020 statement of cash flows.