Question

Lucy's Music Emporium opened its doors on January 1, 2015, and it was granted permission to use the same depreciation calculations for shareholder reporting and income tax purposes. The company planned to depreciate its fixed assets over 20 years, but in December 2015 management realized that the assets would last for only 15 years. The firm's accountants plan to report the 2015 financial statements based on this new information. How would the new depreciation assumption affect the company's financial statements

Answer 1

Answer: d. The firm's cash position in 2015 and 2016 would increase.

Explanation:

The financila statements had been calculated with the view that fixed assets would be depreciated over a 20 year period. However, it was discovered that the assest should be depreciated over 15 years instead. This reduction in the period would have the effect for increasing the depreciation payment.

For example, say the asset cost $20,000 and was originally to be depreciated over 20 years using Straight Line Depreciation. This means that the depreciation per year would be,

= $\frac{20,000}{20}$

= $1,000 a year.

If it was however discovered that it was supposed to be 15 years that figure would go to,

= $\frac{20,000}{15}$

= $1,333.33 a year

Notice how depreciation increased. Lucy's Music emporium will therefore see their depreciation cost rise. Depreciation is subtracted from revenue as it is tax deductible. When Lucy's Emporium deduct this new depreciation, they will have less profit. They will be taxed on this less profit and so pay a lower tax. This will thus increase their cash holdings because Depreciation is a non cash expense and does not actually require a cash payment.