Chapter 7, Problem 8AP

1.

To determine

Calculate annual depreciation using the company’s standard practice (straight line depreciation)

Explanation of Solution

Straight-line Depreciation: Under the straight-line method of depreciation, the same amount of depreciation is allocated every year over the estimated useful life of an asset. The formula to calculate the depreciation cost of the asset using the residual value is shown as below:

$\text{Depreciation = }\frac{\left(\text{Cost of the asset}-\text{Residual value}\right)}{\text{Estimated useful life of the asset}}$

Given, cost of the equipment is $4,200,000, expected life time is 12 years and residual value is $600,000.

Calculate annual depreciation using the company’s standard practice (straight line depreciation):

$\begin{array}{c}\text{Depreciation}\text{expense = }\frac{\left(\text{Cost of the asset}-\text{Residual value}\right)}{\text{Estimated useful life of the asset}}\\ =\frac{\left(\$4,200,000-\$600,000\right)}{12\text{year}}\\ =\frac{\$3,600,000}{12\text{years}}\\ =\$300,000\end{array}$

Therefore, the annual depreciation is $300,000.

2.

To determine

Calculate annual depreciation for each of the three options and state whether the option would increase or decrease net income.

Explanation of Solution

Option 1: adjust the estimated service life of the equipment from 12 years to 6 years.

Given, cost of the equipment is $4,200,000, expected life time is 6 years and residual value is $600,000.

Calculate annual depreciation using the option 1 (straight line depreciation):

$\begin{array}{c}\text{Depreciation}\text{expense = }\frac{\left(\text{Cost of the asset}-\text{Residual value}\right)}{\text{Estimated useful life of the asset}}\\ =\frac{\left(\$4,200,000-\$600,000\right)}{6\text{year}}\\ =\frac{\$3,600,000}{\text{6 years}}\\ =\$600,000\end{array}$

Option 1’s annual depreciation is $600,000 and in standard practice, the annual depreciation amount is $300,000. Therefore, the annual depreciation is $600,000.

The higher amount of depreciation results in lower net income.

Option 2: Adjust estimated residual values on the equipment from $600,000 to $0:

Given, cost of the equipment is $4,200,000, expected life time is 12 years and residual value is $0.

Calculate annual depreciation using the option 2 (straight line depreciation):

$\begin{array}{c}\text{Depreciation}\text{expense = }\frac{\left(\text{Cost of the asset}-\text{Residual value}\right)}{\text{Estimated useful life of the asset}}\\ =\frac{\left(\$4,200,000-\$0\right)}{12\text{year}}\\ =\frac{\$4,200,000}{\text{12 years}}\\ =\$350,000\end{array}$

Therefore, the annual depreciation is $350,000.

Option 2’s annual depreciation is $350,000 and in standard practice, the annual depreciation amount is $300,000. The higher amount of depreciation results in lower net income.

Option 3: Make the both the adjustments:

Given, cost of the equipment is $4,200,000, expected life time is 6 years and residual value is $0.

Calculate annual depreciation using the option 3 (straight line depreciation):

$\begin{array}{c}\text{Depreciation}\text{expense = }\frac{\left(\text{Cost of the asset}-\text{Residual value}\right)}{\text{Estimated useful life of the asset}}\\ =\frac{\left(\$4,200,000-\$0\right)}{6\text{year}}\\ =\frac{\$4,200,000}{\text{6 years}}\\ =\$700,000\end{array}$

Therefore, the annual depreciation is $700,000.

Option 3’s annual depreciation is $700,000 and in standard practice, the annual depreciation amount is $300,000. The higher amount of depreciation results in lower net income.

3.

To determine

State the option that has the biggest effect on net income.

Explanation of Solution

Annual depreciation under each option:

Options	Annual depreciation
Option 1	$600,000
Option 2	$350,000
Option 3	$700,000

Table (1)

Option 3 is having higher amount of annual depreciation. Hence, option 3 has the biggest effect on the net income.

Therefore, option 3 results in a greater decrease in the net income.