Question

I.

Hakodat Manufacturing Group was organized January 1, 2019. During 2019, 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 Hakodat's officers to discuss the depreciation method to be used for income tax and shareholder reporting. Tao Chen, president of Hakodat, 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 residual value of approximately ¥8,000 (amounts in thousands).

Year	Years of Life Used	Fraction Rate	Depreciation Expense	Accumulated Depreciation at End of Year	Book Value at End of Year
1	1	1/15	¥16,000	¥  16,000	¥232,000
2	2	2/15	32,000	48,000	200,000
3	3	3/15	48,000	96,000	152,000
4	4	4/15	64,000	160,000	88,000
5	5	5/15	80,000	240,000	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 international financial reporting standards? 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.

c. The president wants your advice on the following issues.

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

2. Assume that the taxing authorities accept the proposed depreciation method in this case. If the proposed method were used for shareholder and tax reporting purposes, how would it affect the availability of cash flows generated by operations?

Answer 1

(a)    The purpose of depreciation is to distribute the cost (or other book value) of tangible plant assets, less residual value, over their useful lives in a systematic and rational manner. Under IFRS, depreciation accounting is a process of allocation, not of valuation, through which the productive effort (cost) is to be matched with productive accomplishment (revenue) for the period. Depreciation accounting, therefore, is concerned with the timing of the expiration of the cost of tangible plant assets.

(b)    The proposed depreciation method is, of course, systematic. Whether it is rational in terms of cost allocation depends on the facts of the case. It produces an increasing depreciation charge, which is usually not justifiable in terms of the benefit from the use of the asset because manufacturers typically prefer to use their new equipment as much as possible and their old equipment only as needed to meet production quotas during periods of peak demand. As a general rule, then, the benefit declines with age. Assuming that the actual operations (including equipment usage) of each year are identical, maintenance and repair costs are likely to be higher in the later years of usage than in the earlier years. Hence the proposed method would couple light depreciation and repair charges in the early years. Reported net income in the early years would be much higher than reported net income in the later years of asset life, an unreasonable and undesirable variation during periods of identical operation.

        On the other hand, if the expected level of operations (including equipment usage) in the early years of asset life is expected to be low as compared to that of later years because of slack demand or production policies, the pattern of the depreciation charges of the proposed method approximately parallels expected benefits (and revenues) and hence is reasonable. Although the units-of-production depreciation method is the usual selection to fit this case, the proposed method also conforms to IFRS in this case provided that proper justification is given.

(c)    (1)    Depreciation charges neither recover nor create funds. Revenue-producing activities are the sources of funds from operations: if revenues exceed out-of-pocket costs during a fiscal period, funds are available to cover other than out-of-pocket costs; if revenues do not exceed out-of-pocket costs, no funds are made available no matter how much, or little, depreciation is charged.

        (2)    Depreciation may affect funds in two ways. First, depreciation charges affect reported income and hence may affect managerial decisions such as those regarding pricing, product selection, and dividends. For example, the proposed method would result initially in higher reported income than would the straight-line method, consequently shareholders might demand higher dividends in the earlier years than they would otherwise expect.

                 The straight-line method, by causing a lower reported income during the early years of asset life and thereby reducing the amount of possible dividends in early years as compared with the proposed method, could encourage earlier reinvestments in other profit-earning assets in order to meet increasing demand.

Second, depreciation charges affect reported taxable income and hence affect directly the amount of income taxes payable in the year of deduction.

Using the proposed method for tax purposes would reduce the total tax bill over the life of the assets (1) if the tax rates were increased in future years or (2) if the business were doing poorly now but were to do significantly better in the future. The first condition is political and speculative but the second condition may be applicable to Hakodat Manufacturing Company in view of its recent origin and its rapid expansion program. Consequently, more funds might be available for reinvestment in plant assets in years of large deductions if one of the above assumptions were true.

If Hakodat is not profitable now, it would not benefit from higher deductions now and should consider an increasing charge method for tax purposes, such as the one proposed. If Hakodat is quite profitable now, the president should reconsider his proposal because it will delay the availability of the tax shield provided by depreciation. However, this decision should not affect the decision to use a depreciation method for shareholders’ reporting that is systematic and rational in terms of cost allocation under IFRS as presently understood.