Question

14. accounting versus economic history Ralph forms a firm by investing 1,000 dollars. This cash is i ately paid for a machine with a useful life of 3 years. The net cash inflow from this machie wll be 110 at the end of the first year, 0 at the end of the second year, and 1,197.90 at the end of the third year. Net cash inflow is paid as a dividend immediately upon receipt Also the third year net cash flow of 1,197.90 consists of 1,000 from customers and 197.90 salvage value received when the machine is re- tired at that time. (The firm ceases to exist after the year 3 dividend is paid.) (a) Assume Ralph's accountant uses sum of the years' digits depre- ciation. Tell Ralph's history with end-of-year balance sheets, periodic income statements, and periodic cash fow statements. The initial balance sheet should show an asset (call it P&E) of 1,000 and capital stock of 1,000. (b) Assume the interest rate is r-10%. Tell Ralph's history, again with balance sheets, income statements, and cash flow state- ments, but in terms of economic income (c) Construct a 3-year income statement for Ralph. Does the total of the income numbers in your answer to (a) agree with this answer? What about the total of the economic income numbers? (d) Closely examine your accounting and economic income numbers What numbers in the overall history deter- mine the economic income in the second period? (Hint: think in terms of change in present vale plus dividends.) What num- bers in the overall history determine the accounting income in for the second year. the second period? (e) To what extent is it correct to say accounting income is a back ward looking calculation, based on actual transactions, and eco- nomic income is a forward looking calculation, based on antici- pated transactions?

Answer 1

Statement showing Calculation of Depreciation (Using sum of Digits Method):

Year	Depreciation Base	Remaining Life of the Asset	Depreciation Fraction	Depreciation Expense	Book Value
1	802.10	3	3/6	401.05	598.95
2	802.10	2	2/6	267.37	331.58
3	802.10	1	1/6	133.68	197.90

In Year 0, Balance Sheet will show $ 1000 in P& E on asset side and $ 1000 as common stock. In Year 1,2,and 3 the Balance sheet will show $ 598.95, $ 331.58 and $ 197.90 respectively as P&E.