Chapter 8, Problem 8.5P

Evaluating the Effect of Alternative Depreciation Methods on Key Ratios from an Analyst’s Perspective

LO8-1, 8-3 You are a financial analyst for Ford Motor Company and have been asked to determine the impact of alternative depreciation methods. For your analysis, you have been asked to compare methods based on a machine that cost $106,000. The estimated useful life is 13 years and the estimated residual value is $2,000. The machine has an estimated useful life in productive output of 200,000 units. Actual output was 20,000 in Year 1 and 16,000 in Year 2. (Round results to the nearest dollar.)

Required:

1. 1. For years 1 and 2 only, prepare separate depreciation schedules assuming:
   1. a. Straight-line method.
   2. b. Units-of-production method.
   3. c. Double-declining-balance method.

Method: _________
Year	Computation	Depreciation Expense	Accumulated Depreciation	Net Book Value
At acquisition
1
2

  2.    Evaluate each method in terms of its effect on cash flow, fixed asset turnover, and EPS. Assuming that Ford Motor Company is most interested in reducing taxes and maintaining a high EPS for Year 1, what would you recommend to management? Would your recommendation change for Year 2? Why or why not?

To determine

Prepare the depreciation expense schedule under straight-line method.

Explanation of Solution

Straight-line method:

The depreciation method which assumes that the consumption of economic benefits of long-term asset could be distributed equally throughout the useful life of the asset is referred to as straight-line method.

Formula for straight-line depreciation method:

$\begin{array}{c}\begin{array}{l}\text{Depreciation }\\ \text{expense}\end{array}\}=\text{Depreciable cost}\text{× Depreciation rate}\\ \text{= }\left(\text{Cost–Residual value}\right)\text{×}\frac{1}{\text{Useful life}}\end{array}$

Depreciation expense:

Depreciation expense is a non-cash expense, which is recorded on the income statement reflecting the consumption of economic benefits of long-term asset.

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:

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

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:

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

Depreciation schedule under straight-line method:

Year	Computation	Depreciation Expense	Accumulated Depreciation	Net Book Value
At Acquisition				$106,000
1	$\left(\$106,000-\$2,000\right)\times \frac{1}{13}$	$8,000	$8,000	98,000
2	$\left(\$106,000-\$2,000\right)\times \frac{1}{13}$	8,000	16,000	90,000

Table (1)

To determine

Prepare the depreciation expense schedule under units-of-production method.

Explanation of Solution

Units-of-production method:

The depreciation method which assumes that the consumption of economic benefits of long-term asset is based on the production capacity or output is referred to as units-of-production method.

Formula for units-of-production depreciation method:

$\begin{array}{c}\begin{array}{l}\text{Depreciation }\\ \text{expense}\end{array}\}=\text{Depreciable cost × Depreciation rate}\\ \text{= }\left(\text{Cost–Residual value}\right)\text{×}\frac{\text{Actual production}}{\text{Estimated total production}}\end{array}$

Depreciation schedule under units-of-production method:

Year	Computation	Depreciation Expense	Accumulated Depreciation	Net Book Value
At Acquisition				$106,000
1	$\left(\$106,000-\$2,000\right)\times \frac{20,000\text{ units}}{200,000\text{ units}}$	$10,400	$10,400	95,600
2	$\left(\$106,000-\$2,000\right)\times \frac{16,000\text{ units}}{200,000\text{ units}}$	8,320	18,720	87,280

Table (2)

To determine

Prepare the depreciation expense schedule under double-declining-balance method.

Explanation of Solution

Double-declining-balance method:

The depreciation method which assumes that the consumption of economic benefits of long-term asset is high in the early years but gradually declines towards the end of its useful life, is referred to as double-declining-balance method.

Formula for double-declining-balance depreciation method:

$\begin{array}{c}\begin{array}{l}\text{Depreciation }\\ \text{expense}\end{array}\}=\left(\begin{array}{l}\text{Book value at the }\\ \text{beginning of the period }\end{array}\right)\text{ ×Depreciation rate}\\ \text{= }\left(\text{Cost–Accumulated depreciation}\right)\text{×}\frac{\text{2}}{\text{Useful life}}\end{array}$

Depreciation schedule under double-declining-balance method:

Year	Computation	Depreciation Expense	Accumulated Depreciation	Net Book Value
At Acquisition				$106,000
1	$\left(\$106,000-\$0\right)\times \frac{2}{13}$	$16,308	$16,308	89,692
2	$\left(\$106,000-\$16,308\right)\times \frac{2}{13}$	13,799	30,107	75,893

Table (3)

To determine

Evaluate each method of depreciation in terms of its effect on cash flow, fixed asset turnover, and EPS.

Explanation of Solution

Fixed Asset turnover:

Fixed asset turnover is a ratio that measures the productive capacity of the fixed assets to generate the sales revenue for the company. Thus, it shows the relationship between the net sales and the average total fixed assets.

Earnings per Share (EPS):

The part of profit earned by each share of the Company is called as earning per share. It reveals the profitability of the company. To calculate earnings per share net income is divided by average number of outstanding shares.

Evaluate each method of depreciation in terms of its effect on cash flow, fixed asset turnover, and EPS.

Cash Flow:

The method which Company F would prefer to use for income tax purposes is Double-declining balance method. This is because of the fact that the depreciation expense is the highest for the first year under the double-declining balance method, when compared to the other methods of the depreciation. When the depreciation expense increases, the net income for the year will decrease. This method saves the cash by producing fastest tax deductions, and this cash can be reinvested in the business to generate more income. Cash flows are affected by the depreciation method chosen by the management only in case of the tax purposes. For financial reporting purposes, any depreciation method chosen by the management does not affect it. The management can also choose different methods for tax and financial reporting purposes.

Fixed Assets:

Fixed asset turnover is a ratio that measures the productive capacity of the fixed assets to generate the sales revenue for the company. Thus, it shows the relationship between the net sales and the average total fixed assets.

In this case, Company F should choose double-declining-balance method for most favorable fixed asset turnover. This is because of the fact that during the early years, there will be highest amount of depreciation expense, and lowest amount of net fixed assets under the double-declining-balance method. Hence, this method yields the highest fixed asset turnover. In the later years, there would be a reverse effect.

Earnings per share (EPS):

The part of profit earned by each share of the Company is called as earning per share. It reveals the profitability of the company. To calculate earnings per share net income is divided by average number of outstanding shares.

In this case, Company F should choose straight-line method for most favorable EPS. This is because of the fact that during the early years, there will be lowest amount of depreciation expense, and highest amount of net income under the straight-line method. Hence, this method yields the highest EPS. In the later years, there would be a reverse effect.

To determine

Discuss the recommendations that would be made to the management of Company F for Year 1, and also to discuss whether these recommendations may change for Year 2 and the reasons for that.

Explanation of Solution

• The management can choose different methods for tax and financial reporting purposes. In Year 1, it is recommended to choose double-declining balance method of depreciation for the purpose of tax reduction, and highest fixed asset turnover, and to choose straight-line depreciation method for the highest EPS.
• In Year 2, the recommendations may change because there would be a reverse effect among the different depreciation methods. However, accounting methods should be used consistently over the time by the management. A reasonable justification is required to be given, if the management wishes to change the depreciation method in the future.