Economics

The firm employed MACRS as depreciation method, for 5 years. In this respect, the MARCS basically depreciate asset value. This is the depreciation method used for the purpose of federal income tax, which involves a depreciation schedule that starts with declining balance method and then switched to straight line approach to complete the schedule.  The MACRS was modified from Accelerated Cost Recovery System or ACRS. A major goal of MACRS is to eliminate uncertainties in the present processes especially in relation to asset lifetimes and scrap values.  In this method, scrap valued assigned to the asset is normally zero, and if the asset is sold at a later time, such a sale counts as an income.  The various assets are put into different classes and every class assigned a certain lifetime.

 In the calculation of depreciation for the year, the procedure involves the following: assuming that the discount rate is 10 percent

 Years:

Year		Depreciation
1	350,000 x 20 %	70000
2	350000 x 32 %	112000
3	350000 x 19.2%	67000
4	350000 x 11.52%	40320
5	350000 x 5.76 %	20160

 

Therefore, the depreciation for the first year is $ 70,000

 If Jim’s location was within a Qualified Enterprise Zone, the depreciation would have depended on the outlined in section 179 that provides that deduction should be subjected to the limit of the business income. The depreciation for the item in this case would have been:

$315,000 x 20 %

Accumulated depreciation = 35,000 + 63,000 = $ 98,000

 

The depreciation method used in this case is Accelerated Depreciation that allows a firm to write off their assets faster during the earlier years that other methods such as straight-line method of depreciation, and in writing off a lesser amount in future. This method is advantageous because in that it provides tax shield. Firms that have large tax burden may be interested in using accelerated depreciation approach even if it means a reduction in the income reported in the financial statement (Stickney, 2010).  The method is also popularly used in writing off equipment whose replacement at the end of its replaceable year is not possible.  Firms that utilize this approach will declare lesser earnings at the start of the year and will appear more profitable in future.  Firms that will be intending to raise financing are more likely to apply accelerated depreciation at the beginning years but raise financing in the following years so that they can appears as having improved their profitability (Stickney, 2010).  A major advantage of the method is that it allows a business to have a higher deduction quickly. When a business has received a higher deduction presently, a business will minimize its current payable tax burden. Such a deduction is mostly helpful when businesses are new, that may be experiencing problems related to short-term cash flow.  Such funds that have been saved on deductions may be reinvested in the business to expand further its growth. Hence, the accelerated depreciation allows such business to maximize current deductions and thus, avoid deferring deductions to future days when the firm may have closed down.

Tax benefits and NPV for the 5 years

Year			depreciation	Tax savings	NPV factor	Net PV
1	315,000	0.2	98,000	34,000	0.909	31,178.70
2	315,000	0.32	100,800	35,000	0.826	29,141.28
3	315,000	0.192	60480	21,168	0.751	15,897.17
4	315,000	0.1152	36288 (SL)	12,700.80	0.683	8,674.65
5	315,000	0.1152	38288 (SL)	12,700.80	0.621	7,8887

 

Moving from one method of depreciation to another aims at accelerating book value depreciation of an asset so as to obtain some income benefits. However, shifting from accelerated depreciation method to the straight line method of depreciation would to lead to lesser benefits since the higher tax benefits provide in earlier years through the accelerated depreciation method will not be obtained (Pratt & Kulsrud, 2012). In this case, the Present Value will be lower which indicates the lower tax benefits for the asset or item. Once the switch is made to straight line, there are no more computations for the amounts of depreciation are needed. Given that the basic characteristic of straight line method is that equal depreciation amounts will occur annually, once the amount is known , it does not have to be recalculated every time.

Depreciation allows a business to spread costs of an asset’s useful life, but accelerated depreciation is important in claiming the expenses much earlier and in so doing saving funds.  The faster that the asset can be written off with as much depreciation as possible, the sooner and the higher these deductions can be claimed. However, the acceleration of depreciation may work against Jim in the coming years. This is because a rapid depreciation means that the deduction will run out more rapidly, and the business may not have any remaining taxable income in future if the depreciation allowances are finished (Pratt & Kulsrud, 2012). If he is just starting and he does not expect big profits for some years, the deductions from depreciation might be worth longer periods than their current worth.  Using the accelerated depreciation method only quickens the depreciation deductions recognition, but does not allow the creation of more tax deduction.  Therefore, having more upfront deduction from the method can affect a lower deduction in the coming years. If Jim’s business is growing, such can be a problem. A growth in business incomes means that the firm will move into a higher rate of tax. Accumulation of business deductions today means that the options available for Jim in future to minimize their taxes will be few when his business may have shifted to a higher tax bracket. The approach can also bring about a higher risk of recaptured depreciation (Pratt & Kulsrud, 2012). Jim may decide to sell his long-term asset before it become worthless as per the schedule and the resulting profit will be counted as recaptured depreciation.

Reference

Stickney, C. P. (2010). Financial accounting: An introduction to concepts, methods, and uses. Mason, OH: South-Western/Cengage Learning.

Pratt, J., & Kulsrud, W. (2012). Federal Taxation 2013. Cengage Learning. 9-42