Company A uses an accelerated depreciation method while Company B uses the strai

Question

Company A uses an accelerated depreciation method while Company B uses the straight-line method. All other things being equal, during the first few years of the asset's use, Company B will show which of the following compared to Company A?

When originally purchased, a vehicle had an estimated useful life of 8 years. The vehicle cost $25,000 and its estimated residual value is $3,000. After 3 years of straight-line depreciation, the asset's total estimated useful life was revised from 8 years to 5 years and there was no change in the estimated residual value. The depreciation expense in year 4 is:

a. A smaller fixed asset turnover ratio and a larger gain on asset disposal.

Explanation / Answer

Suppose both A and B have $1,000 worth of assets having useful life of 5 years. Further assume that A uses double declining depreciation.

Depreciation for company B = 100%/5 = 20% per year. For company A = 2*20*book value at the beginning

Deprecitaion schedules for A and B for first 3 years:

As we can see from the table above, company B has a higher closing book value of asset than company A. So, it will record a smaller gain than A. Suppose at the end of year 3, the asset is sold for $500. Gain for A = 284 (500-216) and gain for B = 100 (500-400).

In terms of fixed asset turnover ratio, the ratio = sales/fixed assets

As, the fixed assets is higher for B, its turnover ratio will be lower than A. Suppose both A and B have sales of 1,000 in 3rd year. The ratio for A = 1,000/216 = 4.6 and for B = 1000/400 = 2.5.

So the answer is option "c" - A smaller fixed asset turnover ratio and a smaller gain on asset disposal.

Depreciation per year using straight line = (25,000 - 3,000)/8 years = $2,750 per year.

Now, when revision is done, depreciation per year = (25000-3000)/5 = $4,400 per year.

This is the amount that will be recorded in the 4th year. Hence the answer is option "c".

The company will pass an adjustment entry when the life is revised from 8 years to 5 years to record revised depreciation for the years 1,2 and 3.

Year Beginning book value for A Depreciation Closing book value Beginning book value for B Depreciation Closing book value 1 1000 400 600 1000 200 800 2 600 240 360 800 200 600 3 360 144 216 600 200 400

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