Prophet Manufacturing Company was organized January 1, 2008. During 2008 it has used in its reports to

Question:

Prophet Manufacturing Company was organized January 1, 2008. During 2008 it has used in its reports to management the straight-line method of depreciating its plant assets.

On November 8 you are having a conference with Prophet’s officers to discuss the depreciation method to be used for income tax and stockholder reporting. Frank Peretti, president of Prophet, has suggested the use of a new method, which he feels is more suitable than the straight-line method for the needs of the company during the period of rapid expansion of production and capacity that he foresees. Following is an example in which the proposed method is applied to a fixed asset with an original cost of $248,000, an estimated useful life of 5 years, and a scrap value of approximately $8,000.

The president favors the new method because he has heard that:

1. It will increase the funds recovered during the years near the end of the assets’ useful lives when maintenance and replacement disbursements are high.

2. It will result in increased write-offs in later years and thereby will reduce taxes.

Instructions

(a) What is the purpose of accounting for depreciation?

(b) Is the president’s proposal within the scope of generally accepted accounting principles? In making your decision discuss the circumstances, if any, under which use of the method would be reasonable and those, if any, under which it would not be reasonable.

(1) Do depreciation charges recover or create funds? Explain.

(2) Assume that the Internal Revenue Service accepts the proposed depreciation method in this case. If the proposed method were used for stockholder and tax reporting purposes, how would it affect the availability of funds generated by operations?