CASE 4–5 Toro Manufacturing is organized on January 1, Year 5. During Year 5, financial reports to man-

agement use the straight-line method of depreciating plant assets. On November 8, you (as consultant) hold a conference with Toro’s officers to discuss the depreciation method for both tax and financial reporting. Toro’s president suggests the use of a new method he feels is more suitable than straight line during this period of predicted rapid expansion of production and capacity. He shows an example of his proposed method as applied to a fixed asset with an original cost of $32,000, estimated useful life of five years, and a salvage value of $2,000, as follows:

Accumulated End of Years of Fraction Depreciation Depreciation Book Value Year Life Used Rate Expense at Year-End at Year-End 1.................. 1 1⁄15 $ 2,000 $ 2,000 $30,000 2.................. 2 2⁄15 4,000 6,000 26,000 3.................. 3 3⁄15 6,000 12,000 20,000 4.................. 4 4⁄15 8,000 20,000 12,000 5.................. 5 5⁄15 10,000 30,000 2,000 Toro’s president favors this new method because he asserts it:

1. Increases funds recovered in years near the end of the assets’ useful lives when maintenance and replacement costs are high.

2. Increases write-offs in later years and thereby reduce taxes.

Required:

a. What are the purpose of and the principle behind accounting for depreciation?

b. Is the president’s proposal within the scope of GAAP? Discuss the circumstances, if any, where this method is reasonable and those, if any, where it is not.

c. The president requests your advice on the following additional questions:

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

(2) Assuming the IRS accepts the proposed depreciation method, and it is used for both financial reporting and tax purposes, how does it affect availability of cash generated by operations?