Question

The Northwood Clinic purchased a new surgical laser for $ 75,000 on January 1st. The estimated residual value is $ 7,500. The laser has a useful life of four years and the clinic expects to use it 10,000 hours. It was used 1,600 hours in year 1; 2,100 hours in year 2; 3,400 hours in year 3; 2,900 hours in year 4. 

Instructions 

a) Calculate the annual depreciation for each of the four years under each of the following methods: 

i) straight-line 

ii) units-of-production 

b) If you were the administrator of the clinic, which method would you deem as most appropriate? Justify your answer. 

c) Which method would result in the lowest reported profit in the first year? Which method would result in the lowest total reported profit over the four-year period? 

d) Which method would result in the lowest cash flow in Year 1? Over the life of the asset?

Answer 1

1. a) Under the straight-line method, depreciation is calculated by dividing the difference between asset cost and its expected residual value by the number of years it is expected to be used.

The cost of the asset is $ 75,000 and its residual value is $ 7,500
The useful life of the asset is 4 years
So depreciation under the straight-line method for each year will be
	$ 75,000 - $ 7,500		=	$ 16,875
	4 years

b) Units of the production method of depreciation - In this method depreciation is calculated by dividing the difference between asset cost and its expected residual value by the total expected number of units and multiplied by units produced during the year.

The cost of the asset is $ 75,000 and its residual value is $ 7,500

So the amount on which depreciation should be charged is $ 75,000 - $ 7,500 = $ 67,500

As the clinic expects to use it for 10,000 hours, so per hour depreciation cost will be $ 67,500 / 10000 hours = $ 6.75 per hour

	Year 1	Year 2	Year 3	Year 4
Utilised hours	1600	2100	3400	2900
per hour depreciation	$ 6.75	$ 6.75	$ 6.75	$ 6.75
Depreciation to be charged	$ 10,800	$ 14,175	$ 22,950	$ 19,575

2. If I was the administrator of the clinic, I would have suggested depreciation charged on the basis of hours used. Value of the asset is more closely related to number of hours used. Also number of hours used is varied from year to year. So depreciation charged on the basis of number of hours used is more appropriate.

3. In the first method, depreciation in year 1 will be $ 16,875 and in the second method depreciation will be $ 10,800. So depreciation on the basis of SLM will report lowest profit.

Over the period of 4 years, SLM depreciation will be $ 16,875 *4 = $ 67,500 and depreciation as per unit hour will be $ $ 67,500. So overall profitability will be same in both methods.

4. Cash flow will not be impacted in both the methods as depreciation is non cash expense. So cash flow will not be impacted on the basis of depreciation method used.