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In 2014, Martin Motors has a gross profit of $400000, operating expenses of $180,000 (not including depreciation), and a tax rate of 40%. On January 10, 2014, Martin Motors purchased a machine that will help diagnose problems with engines. The machine cost $210,000, residual value of $20,000, and useful life of 5 years. Prepare two income statements to show the board of directors the depreciation method (straight-line or double declining), that would be best for financial statement purposes and the depreciation method that would be best suited to improve cash flow in 2014. Also, explain to the board, the impact on cash flows and expense over the entire life of the asset. Show depreciation calculations.
Expert Answer
Cost of machine=$210,000
Residual value=$20,000
Useful life=5 years
Straight-line method of depreciation:
Annual depreciation=(210000-20000)/5=$38,000
Double Declining method:
The depreciation rate is double the Straight line rate.
Straight line rate=(1/5)=20%
In double declining balance method it will be 2*20=40% on the beginning book value of the year.
Depreciation will end when the book value will be equal to salvage value.
The calculation is shown below:
Depreciation in year 5 is lower to match the year end book value=salvage value=$20,000
| A | B=0.4*A | C=A-B | ||||
| Net book value | Double declining | Net book value | ||||
| Year | Beginning of year | balance depreciation | End of year | |||
| 1 | $210,000 | $84,000 | $126,000 | |||
| 2 | $126,000 | $50,400 | $75,600 | |||
| 3 | $75,600 | $30,240 | $45,360 | |||
| 4 | $45,360 | $18,144 | $27,216 | |||
| 5 | $27,316 | $7,316 | $20,000 | (Salvage Value=$20,000) | ||
Income Statement with Straight-line depreciation:
| INCOME STATEMENT WITH STRAIGHT-LINE DEPRECIATION | ||||
| A | Gross Profit | $400,000 | ||
| B | Operating expenses(Excluding depreciation | $180,000 | ||
| C | Depreciation | $38,000 | ||
| D=B+C | Operating expenses(including depreciation | $218,000 | ||
| E=A-D | Income before taxes | $182,000 | ||
| F=0.4*E | Tax expenses | $72,800 | (0.4*182000) | |
| G=E-F | Income after taxes | $109,200 | ||
Income Statement with Double declining balance method:
| INCOME STATEMENT WITH DOUBLE DECLINING DEPRECIATION | ||||
| A | Gross Profit | $400,000 | ||
| B | Operating expenses(Excluding depreciation | $180,000 | ||
| C | Depreciation | $84,000 | ||
| D=B+C | Operating expenses(including depreciation | $264,000 | ||
| E=A-D | Income before taxes | $136,000 | ||
| F=0.4*E | Tax expenses | $54,400 | (0.4*136000) | |
| G=E-F | Income after taxes | $81,600 | ||
Cash flow in 2014 as per Straight line method=$109,200+Non cash expense of depreciation=$109,200+$38,000=$147,200
Cash flow in 2014 as per Double declining balance method=$81,600+Non cash expense of depreciation=$81,600+$84,000=$165,600
Income will be higher in Straight line method.
Cash flow will be higher in Double declining method
After year2 , under double declining method , the depreciation will be lower and cash flow will adversely affected.
But in Straight line method cash flow will be uniform.
