Identify the Depreciation Methods
On January 3, 2005, XYZ Distribution Co. paid $224,000 for a computer system. In addition to the basic purchase price, the company paid a setup fee of $6,200, $6,700 sales tax, and $3,100 for a special platform on which to place the computer. XYZ management estimates that the computer will remain in service 5 years and have a residual value of $20,000. The computer will process 50,000 documents the first year, with annual processing decreasing by 5,000 documents during each of the next 4 years (that is, 45,000 documents in 2006; 40,000 documents in 2007; and so on). In trying to decide which depreciation method to use, the company president has requested a depreciation schedule for each of three depreciation methods (straight-line, units-of- production, and double-declining-balance).
1. For each of the generally accepted depreciation methods, prepare a depreciation schedule showing asset cost, depreciation expense, accumulated depreciation, and asset book value.
2. XYZ reports to stockholders and creditors in the financial statements using the depreciation method that maximizes reported income in the early years of asset use. For income tax purposes, however, the company uses the depreciation method that minimizes income tax payments in those early years. Consider the first year XYZ uses the computer. Identify the depreciation methods that meet XYZs objectives, assuming the income tax authorities would permit the use of any of the methods.
3. Assume that income before tax is $200,000 for the computer's first year. The income tax rate is 35%. For the two depreciation methods identified in Requirement 2, compare the net income. Show which method gives the net-income advantage and which method gives the tax advantage.