True fund flow from depreciation is the opportunity saving of cash outflow through taxation. Describe with numerical examples
The true fund flow from depreciation is the opportunity saving of cash outflow
through taxation. Illustrate with numerical examples.
Depreciation does not generate cash flow. If a million dollar piece of equipment is purchased, an accountant would reflect that the company now owns a million dollar asset. Without depreciation, the
company would still show a million dollar asset on the books even though we all know the equipment's value is decreasing. As such, the company's value would be overstated in the books.
- "Depreciation recognized for tax purposes will, however, affect the cash flow of the company, as tax depreciation will
reduce taxable profits; there is generally no requirement that treatment of depreciation for tax and accounting purposes be identical. Where depreciation is shown on accounting statements, the figure usually does not relate to depreciation for tax purposes."Answer-The above answer is correct. This is an additional cash). Think about this - When you deduct depreciation from your profits, your net income figure gets reduced and if there is any distribution of cash which is based on net income, the amount of cash that is going out of cash within the business that could have gone out, had the depreciation not been done. Additional comment -And even more to add regarding the taxes thing (at least in Canada). Depreciation is not an allowable expense for calculating taxable income. What happens is that you add the depreciation that you expensed back, but then you are allowed to take a deduction for capital cost allowance (at specified rates for the particular class of is a a legit expense and is typical
done with straight line or MACRS.Additional comment -Regarding the first post: depreciation in accounting terms (amortization) is not meant to reflect the value of the asset. Rather, it is the gradual allocation of its cost to expense over its useful life.The fair market value of an asset may increase significantly over its original purchase price while at the same time its book value will decrease yearly due to depreciation.Strictly speaking, depreciation is a non-cash expense (no physical outflow of cash is involved). However, as mentioned above by others, it serves to reduce taxable income,
which, in turn, reduces the income tax paid
Business ownership costs
There are five ownership costs that every company incurs, namely: depreciation costs, interest costs, repair costs taxes, and insurance costs. They are commonly referred to as the "DIRTI 5".
This is a procedure for allocating the used up value of durable assets over the period they are owned by the business or until they are salvaged. By depreciating an asset, an allowance is made for the deterioration in the asset's value as a result of use (wear and tear), age and obsolescence. Generally, property is depreciable if it is used in business or to earn income;, wears out, decays, gets used up or becomes obsolete, and has a determinable useful life of more than one year. The proportion of the original cost to be depreciated in any one year is largely a matter of judgement and financial management. Normally, the depreciation allowance taken in any given year should reflect the actual decline in value of the asset - whether it is designed to influence income taxes or the undepreciated value of an asset reflecting the resale value of the asset.
There are four main and acceptable methods of calculating depreciation, namely:
• the accelerated cost recovery system (ACRS) method
• the straight line method
• the declining balance method
• the sum of the years-digits method.
The accelerated cost recovery system method is a relatively new method of calculating depreciation for tangible property. It came into use effectively in 1981. As a method ACRS generally gives much faster write off than other methods because it has tax savings as its primary objective. It usually gives little consideration to actual year-to-year change in value. Thus, for accounting purposes, other methods are more appropriate.
For tax purposes, property is classified as follows:-
i) 3 year property - automobiles and light-duty trucks used for business purposes and certain special tools, and depreciable property with a midpoint life of 4 years or less.
ii) 5 year property - most farm equipment, grain bins, single purpose structures and fences, breeding beef and dairy cattle, office equipment and office furniture.
iii) 10 year property- includes depreciable property with an expected life between 10 and 12.4 years.
iv) 15 year property - buildings.
The straight line method computes depreciation, Ds, as follows:
OC = Original cost or basis
SV = Salvage value
L = expected useful life of the asset in the business.
Declining balance method calculates depreciation as:-
Dd = RV x R
RV = undepreciated value of the asset at the start of the accounting period such that, in year 1, RV = OC, and in succeeding years,
RVi = [RVi-1 - Dd,i-1] x R (with salvage value not being deducted from original value before computing depreciation),
R = the depreciation rate, which may be up to twice the rate of decline, 1/L, allowed under straight line method.
Sum of the year-digits method estimates the depreciation of an asset as follows:-
RY = estimated years of useful life remaining
S = sum of the numbers representing years of useful life (i.e. for an asset with 5 years useful life, S would be 1+2+3+4+5 = 15).
5 Computation of depreciation
Using the straight line, declining balance, and sum of the year-digits methods, compute and tabulate the depreciation of a $1,000 asset with an estimated 10 years' life and projected salvage value of 10% of the original cost. (Assume for the declining balance method a depreciation rate calculated as 20% of the value at the beginning of the year. Usually the rate may not be greater than twice the rate which would be used under the straight line method).