CP 10-3 Effect of depreciation on net income
Atlas Construction Co. specializes in building replicas of historic houses. Paul Raines, president of Atlas Construction, is considering the purchase of various items of equipment on July 1, 2010, for $500,000. 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, Paul 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 (2010, 2011, 2012, 2013, 2014, and 2015) 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 2010 and 2015. Use the MACRS rates presented on page 457.
2. Assuming that income before depreciation and income tax is estimated to be $900,000 uniformly per year and that the income tax rate is 40%, compute the net income for each of the years 2010, 2011, 2012, 2013, 2014, and 2015 if (a) the straight-line method is used and (b) MACRS is used. 3. What factors would you present for Paul’s consideration in the selection of a depreciation method?
Answer:
1.
a. Straight-line method:
2010: ($500,000/5) × 1/2....................................................................... $ 50,000
2011: ($500,000/5)................................................................................ 100,000
2012: ($500,000/5)................................................................................ 100,000
2013: ($500,000/5)................................................................................ 100,000
2014: ($500,000/5)................................................................................ 100,000 2015: ($500,000/5) × 1/2....................................................................... 50,000
b. MACRS:
2010: ($500,000 × 20%)........................................................ $100,000
2011: ($500,000 × 32%)......................................................... 160,000
2012: ($500,000 × 19.2%)........................................................ 96,000
2013: ($500,000 × 11.5%)........................................................ 57,500
2014: ($500,000 × 11.5%)........................................................ 57,500
2015: ($500,000 × 5.8%)......................................................... 29,000
2.
a. Straight-line method: Year 2010 2011 2012 2013 2014 2015 Income before depreciation.......... $900,000 $900,000 $900,000 $900,000 $900,000 $900,000 Depreciation expense................... 50,000 100,000 100,000 100,000 100,000 50,000 Income before income tax............ $850,000 $800,000 $800,000 $800,000 $800,000 $850,000 Income tax...................................... 340,000 320,000 320,000 320,000 320,000 340,000 Net income..................................... $510,000 $480,000 $480,000 $480,000 $480,000 $510,000
b. MACRS: Year 2010 2011 2012 2013 2014 2015 Income before depreciation.......... $900,000 $900,000 $900,000 $900,000 $900,000 $900,000 Depreciation expense................... 100,000 160,000 96,000 57,500 57,500 29,000 Income before income tax............ $800,000 $740,000 $804,000 $842,500 $842,500 $871,000 Income tax...................................... 320,000 296,000 321,600 337,000 337,000 348,400 Net income..................................... $480,000 $444,000 $482,400 $505,500 $505,500 $522,600
3. For financial reporting purposes, Paul should select the method that provides the net income figure that best represents the results of operations. (Note to Instructors: The concept of matching revenues and expenses is discussed in Chapter 3.) However, for income tax purposes, Paul should consider selecting the method that will minimize taxes. Based on the analyses in (2), both methods of depreciation will yield the same total amount of taxes over the useful life of the equipment. MACRS results in fewer taxes paid in the early years of useful life and more in the later years. For example, in 2010 the income tax expense using MACRS is $320,000, which is $20,000 ($340,000 – $320,000) less than the income tax expense using the straight-line depreciation of $340,000. Atlas Construction Co. can invest such differences in the early years and earn income.
In some situations, it may be more beneficial for a taxpayer not to choose MACRS. These situations usually occur when a taxpayer is expected to be subject to a low tax rate in the early years of use of an asset and a higher tax rate in the later years of the asset’s useful life. In this case, the taxpayer may be better off to defer the larger deductions to offset the higher tax rate.
1. Compute depreciation for each of the years (2010, 2011, 2012, 2013, 2014, and 2015) 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 2010 and 2015. Use the MACRS rates presented on page 457.
2. Assuming that income before depreciation and income tax is estimated to be $900,000 uniformly per year and that the income tax rate is 40%, compute the net income for each of the years 2010, 2011, 2012, 2013, 2014, and 2015 if (a) the straight-line method is used and (b) MACRS is used. 3. What factors would you present for Paul’s consideration in the selection of a depreciation method?
Answer:
1.
a. Straight-line method:
2010: ($500,000/5) × 1/2....................................................................... $ 50,000
2011: ($500,000/5)................................................................................ 100,000
2012: ($500,000/5)................................................................................ 100,000
2013: ($500,000/5)................................................................................ 100,000
2014: ($500,000/5)................................................................................ 100,000 2015: ($500,000/5) × 1/2....................................................................... 50,000
b. MACRS:
2010: ($500,000 × 20%)........................................................ $100,000
2011: ($500,000 × 32%)......................................................... 160,000
2012: ($500,000 × 19.2%)........................................................ 96,000
2013: ($500,000 × 11.5%)........................................................ 57,500
2014: ($500,000 × 11.5%)........................................................ 57,500
2015: ($500,000 × 5.8%)......................................................... 29,000
2.
a. Straight-line method: Year 2010 2011 2012 2013 2014 2015 Income before depreciation.......... $900,000 $900,000 $900,000 $900,000 $900,000 $900,000 Depreciation expense................... 50,000 100,000 100,000 100,000 100,000 50,000 Income before income tax............ $850,000 $800,000 $800,000 $800,000 $800,000 $850,000 Income tax...................................... 340,000 320,000 320,000 320,000 320,000 340,000 Net income..................................... $510,000 $480,000 $480,000 $480,000 $480,000 $510,000
b. MACRS: Year 2010 2011 2012 2013 2014 2015 Income before depreciation.......... $900,000 $900,000 $900,000 $900,000 $900,000 $900,000 Depreciation expense................... 100,000 160,000 96,000 57,500 57,500 29,000 Income before income tax............ $800,000 $740,000 $804,000 $842,500 $842,500 $871,000 Income tax...................................... 320,000 296,000 321,600 337,000 337,000 348,400 Net income..................................... $480,000 $444,000 $482,400 $505,500 $505,500 $522,600
3. For financial reporting purposes, Paul should select the method that provides the net income figure that best represents the results of operations. (Note to Instructors: The concept of matching revenues and expenses is discussed in Chapter 3.) However, for income tax purposes, Paul should consider selecting the method that will minimize taxes. Based on the analyses in (2), both methods of depreciation will yield the same total amount of taxes over the useful life of the equipment. MACRS results in fewer taxes paid in the early years of useful life and more in the later years. For example, in 2010 the income tax expense using MACRS is $320,000, which is $20,000 ($340,000 – $320,000) less than the income tax expense using the straight-line depreciation of $340,000. Atlas Construction Co. can invest such differences in the early years and earn income.
In some situations, it may be more beneficial for a taxpayer not to choose MACRS. These situations usually occur when a taxpayer is expected to be subject to a low tax rate in the early years of use of an asset and a higher tax rate in the later years of the asset’s useful life. In this case, the taxpayer may be better off to defer the larger deductions to offset the higher tax rate.
