Chapter 8, Problem 11E

Computing Depreciation and Book Value for Two Years Using Alternative Depreciation Methods and Interpreting the Impact on Cash Flows

Schrade Company bought a machine for $96,000 cash. The estimated useful life was four years and the estimated residual value was $6,000. Assume that the estimated useful life in productive units is 120,000. Units actually produced were 43,000 in Year 1 and 45,000 in Year 2.

Required:

1. 1. Determine the appropriate amounts to complete the following schedule. Show computations, and round to the nearest dollar.

	Depreciation Expense for		Net Book Value at the End of
Method of Depreciation	Year 1	Year 2	Year 1	Year 2
Straight-line
Units-of-production
Double-declining-balance

1. 2. Which method would result in the lowest EPS for Year 1? For Year 2?
2. 3. Which method would result in the highest amount of cash outflows in Year 1? Why?
3. 4. Indicate the effects of (a) acquiring the machine and (b) recording annual depreciation on the operating and investing activities sections of the statement of cash flows (indirect method) for Year 1 (assume the straight-line method).

To determine

Ascertain the appropriate amounts to complete the following schedule by showing computations.

Explanation of Solution

Depreciation expense:

Depreciation refers to allocation, of the cost of asset to expense over the useful life of the asset. Depreciation expense relating to the current accounting period should be accounted for, by an adjusting entry.

Following are the appropriate amounts determined to complete the following schedule.

Method of depreciation	Depreciation expense		Book value at the end of
	Year 1	Year 2	Year 1	Year 2
Straight-line	(2)$22,500	(3)$22,500	$73,500 (10)	$51,000 (11)
Units-of-production	(5)$32,250	(6)$33,750	$63,750 (12)	$30,000 (13)
Double-declining-balance	(8)$48,000	(9)$24,000	$48,000 (14)	$24,000 (15)

Table (1)

Working notes:

Calculate the cost of asset:

$\begin{array}{c}\text{Cost}\text{of}\text{asset}\text{=}\text{Cost}\text{of}\text{purchase}-\text{Residual}\text{value}\\ \text{=\$96,000}-\text{\$6,000}\\ \text{=\$90,000}\end{array}$ (1)

Depreciation expense under straight-line method:

Calculate the amount to be depreciated under straight-line method for year 1:

$\begin{array}{c}\begin{array}{l}\text{Amount}\text{to}\text{be}\text{depreciated}\text{under}\\ \text{straight-line}\text{method}\text{for}\text{year}\text{1}\end{array})\text{=}\frac{\text{Cost}\text{of}\text{asset}}{\text{Estimated}\text{useful}\text{life}}\\ \text{=}\frac{\text{\$90,000 (1)}}{\text{4}\text{years}}\\ \text{=}\text{\$22,500}\end{array}$ (2)

Calculate the amount to be depreciated under straight-line method for year 2:

$\begin{array}{c}\begin{array}{l}\text{Amount}\text{to}\text{be}\text{depreciated under}\\ \text{straight-line}\text{method}\text{for}\text{year}\text{2}\end{array})\text{=}\frac{\text{Cost}\text{of}\text{asset}}{\text{Estimated}\text{useful}\text{life}}\\ \text{=}\frac{\text{\$90,000 (1)}}{\text{4}\text{years}}\\ \text{=}\text{\$22,500}\end{array}$ (3)

Depreciation expense under Units-of-production method:

Calculate the units-of-production:

$\begin{array}{c}\text{Units}\text{of}\text{production}\text{=}\frac{\text{Cost}\text{of}\text{asset}}{\text{Productive}\text{units}\text{in}\text{estimated}\text{useful}\text{life}\text{of}\text{the}\text{asset}}\\ \text{=}\frac{\text{\$90,000 (1)}}{\text{120,000}\text{units}}\\ \text{=\$0}\text{.75}\text{units}\end{array}$ (4)

Calculate the amount of depreciation for year 1 (Units-of-production method):

$\begin{array}{c}\text{Amount}\text{of}\text{depreciation}\text{for}\text{year}\text{1=}\text{Units}\text{produced×Per}\text{rate}\text{of}\text{unit}\\ \text{=}\text{43,000}\text{units×\$0}\text{.75 (4)}\text{per}\text{unit}\\ \text{=}\text{\$32,250}\end{array}$ (5)

Calculate the amount of depreciation for year 2 (Units-of-production method):

$\begin{array}{c}\text{Amount}\text{of}\text{depreciation}\text{for}\text{year}2\text{=}\text{Units}\text{produced×Per}\text{rate}\text{of}\text{unit}\\ \text{=}\text{45,000}\text{units×\$0}\text{.75}(4)\text{per}\text{unit}\\ \text{=}\text{\$33,750}\end{array}$ (6)

Depreciation expense under Double-declining-balance method:

Calculate the rate of Double-declining-balance:

$\begin{array}{c}\text{Double-Declining-Depreciation}\text{rate}\text{=}\text{Straight}\text{line}\text{depreciation}\text{rate×200\%}\\ \text{=}\text{25\%×200\%}\\ \text{=}25\%\times 2\\ =50\%\end{array}$ (7)

Note: Straight line depreciation rate = $\frac{1}{4}$ = $25\%$ per year

Calculate the amount of depreciation for year 1 (Double-declining-balance method):

$\begin{array}{c}\text{Amount}\text{depreciation}\text{for}\text{year}\text{1=}\text{Cost}\text{of}\text{purchase×Double-declining-balance}\text{rate}\\ \text{= \$96,000×50\% (7)}\\ \text{=}\text{\$48,000}\end{array}$ (8)

Calculate the amount of depreciation for year 2 (Double-declining-balance method):

$\begin{array}{c}\text{Amount}\text{depreciation}\text{for}\text{year}2\text{=}\text{Cost}\text{of}\text{purchase×Double-declining-balance}\text{rate}\\ \text{= \$48,000×50\% (7)}\\ \text{=}\text{\$24,000}\end{array}$ (9)

Calculate the book value of asset under straight-line method for year 1:

$\begin{array}{c}\text{Book}\text{value}\text{at}\text{end}\text{of}\text{year}\text{1=}\text{Cost}\text{of}\text{purchase}-\text{Depeciation}\text{expense}\text{for}\text{year}\text{1}\\ \text{=}\text{\$96,000}-\text{\$22,500 (2)}\\ \text{=}\text{\$73,500}\end{array}$ (10)

Calculate the book value of asset under straight-line method for year 2:

$\begin{array}{c}\text{Book}\text{value}\text{at}\text{end}\text{of}\text{year}2\text{=}\text{Cost}\text{of}\text{purchase}-\text{Depeciation}\text{expense}\text{for}\text{year}2\\ \text{=}\text{\$73,500 (10)}-\text{\$22,500 (3)}\\ \text{=}\text{\$51,000}\end{array}$ (11)

Calculate the book value of asset under units-of-production method for year 1:

$\begin{array}{c}\text{Book}\text{value}\text{at}\text{end}\text{of}\text{year}1\text{=}\text{Cost}\text{of}\text{purchase}-\text{Depeciation}\text{expense}\text{for}\text{year}1\\ \text{=}\text{\$96,000}-\text{\$32,250 (5)}\\ \text{=}\text{\$63,750}\end{array}$ (12)

Calculate the book value of asset under units-of-production method for year 2:

$\begin{array}{c}\text{Book}\text{value}\text{at}\text{end}\text{of}\text{year}2\text{=}\text{Cost}\text{of}\text{purchase}-\text{Depeciation}\text{expense}\text{for}\text{year}2\\ \text{=}\text{\$63,750 (12)}-\text{\$33,750 (6)}\\ \text{=}\text{\$30,000}\end{array}$ (13)

Calculate the book value of asset under double-declining-balance method for year 1:

$\begin{array}{c}\text{Book}\text{value}\text{at}\text{end}\text{of}\text{year}1\text{=}\text{Cost}\text{of}\text{purchase}-\text{Depeciation}\text{expense}\text{for}\text{year}\\ \text{=}\text{\$96,000}-\text{\$48,000 (8)}\\ \text{=}\text{\$48,000}\end{array}$ (14)

Calculate the book value of asset under double-declining-balance method for year 2:

$\begin{array}{c}\text{Book}\text{value}\text{at}\text{end}\text{of}\text{year}2\text{=}\text{Cost}\text{of}\text{purchase}-\text{Depeciation}\text{expense}\text{for}\text{year}\\ \text{=}\text{\$48,000 (14)}-\text{\$24,000 (9)}\\ \text{=}\text{\$24,000}\end{array}$ (15)

To determine

Ascertain the method that would result in the lowest earnings per share for year 1 and year 2

Explanation of Solution

Earnings per Share:

Earnings per share help to measure the profitability of a company. Earnings per share are the amount of profit that is allocated to each share of outstanding stock.

• The method that would result in the lowest earnings per share during the year 1 is the double-declining-balance method. Thus, the highest depreciation expense was produced in this method which resulted in the lowest income (from requirement 1).
• During the year 2 the units-of-production method results in the lowest earnings per share. Thus, the highest depreciation expense was produced in this method which resulted in the lowest income.

To determine

Ascertain the method that would result in the highest amount of cash outflows in year 1 and to explain the reason for it.

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.

• While recognising the depreciation there is no payment of cash involved therefore, it is a noncash expense. All methods have the same impact on cash flows during the year 1 since it ignored implications of income tax. The straight-line method results in the highest net income, lowest expense and highest tax liability, when a method is assumed to be applied for tax determination.
• Thus the highest amount of cash outflows is resulted from the straight-line depreciation method. The Methods are selected by the companies for tax purposes in order to reduce the tax obligations.

To determine

Indicate the effects of (a) acquiring the machine and (b) recording annual depreciation on the operating and investing activities sections of the statement of cash flows (indirect method) for Year 1(Assume the straight-line method).

Explanation of Solution

Statement of cash flows:

It is one of the financial statement that shows the cash and cash equivalents of a company for a particular period. It determines the net changes in cash through reporting the sources and uses of cash due to the operating, investing, and financing activities of a company.

Operating activities:

Operating activities refer to the normal activities of a company to carry out the business. The examples for operating activities are purchase of inventory, payment of salary, sales, and others.

Investing activities:

Investing activities refer to the activities carried out by a company for acquisition of long term assets. The examples for investing activities are purchase of equipment, long term investment, sale of land, and others.

Following are the effects of (a) acquiring the machine and (b) recording annual depreciation on the operating and investing activities sections of the statement of cash flows (indirect method) for Year 1(Assume the straight-line method).

(a) Acquiring the machine:

The acquisition of machine decrease the cash provided by investing activities due to the purchase cost of $96,000.

(b) Recording annual depreciation on the operating and investing activities sections of the statement of cash flows (indirect method) for Year 1(Assume the straight-line method):

There is no effect on the cash provided by operating activities since depreciation is a noncash expense. The depreciation expense of $22,500 is added back to net income in the operating activities of cash flow statement because the depreciation must be originally subtracted in order to get the net income, and adjustments have to be made for reversing this cash flow effect.