Ron’s Manufacturing Company was organized January 1, 1992. During 1992 it has used in its reports to management the straight-line method of depreciating its plant assets.

On November 8 you meet with Ron’s officers to discuss the depreciation method to be used for income tax and stockholder reporting. Ron’s president has suggested a new method, which he feels is more suitable than the straight-line method for the period of rapid expansion of production and capacity that he foresees. Below, the proposed method is applied to a fixed asset with an original cost of $32,000, and estimated useful life of five years, and an estimated salvage value of $2,000.

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 will be high.

[2] It will result in increased write-offs in later years and thereby 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? Discuss the circumstances under which the method would be reasonable and those under which it would not be reasonable.

[c] The president asks your advice:

[1] Do depreciation charges recover or create funds? Explain.

[2] Assume that the IRS will accept the proposed depreciation method in this particular case. If the method were used for stockholder and tax reporting purposes, how would it affect the availability of funds generated by operations?

Years of Life Used Fraction Rate Depreciation Expense $ 2,000 Accumulated Depreciation at Year-End Book Value at Year-End Year 1. $ 2,000 $30,000 26,000 20,000 12,000 2,000 1/15 2 4,000 6,000 8,000 10,000 6,000 12,000 20,000 30,000 215 3 3/15 4 4 4/15 5 S/15 123