EFFECTS OF DEPRECIATION ACCOUNTING
ON TAXES AND EARNINGSThe QRS Corp. purchased capital equipment for use in a 5-year venture. The equipment
cost $240,000 and had zero salvage value. If the income tax rate was 52 percent and the
annual income from the investment was $83,000 before taxes and depreciation, what was
the average rate of earnings if the profits after taxes were invested in tax-free bonds yield-
ing 3 percent? Compare the results obtained when depreciation is computed by the
straight-line and sum-of-the-digits methods.
Calculation Procedure:- Compute the taxable income
With straight-line depreciation, the depreciation charge is $240,000/5 = $48,000 per year.
Then the taxable income = $83,000 - $48,000 = $35,000, because depreciation is fully
deductible from gross income. - Compute the annual tax payment
With a tax rate of 52 percent, the annual tax payment, excluding other deductions, is
0.52($35,000) = $18,200. - Compute the net income
The net cash income = gross income - tax payment, if there are no other expenses. Or, net
income = $83,000 - $18,200 = $64,800. - Determine the capital accumulated by investing the
net income in bonds
Use the USCA factor for j = 3 percent, n = 5 years. Or, S = tf (USCA) = $64,800(5.309) =
$344,000. - Compute the average earnings rate on the venture
Use the relation SPCA = (1 + /)", where SPCA = $344,000/$240,000 = (1+ O^5 i = 7.47
percent. - Compute the sum-of-the-digits annual depreciation
Using the previously developed procedure for sum-of-the-digits depreciation charges
gives D 1 = $80,000; D 2 = $64,000; Z) 3 = $48,000; D 4 = $32,000; D 5 = $16,000. - Compute the annual tax and net Income
Using the same method as in steps 2 and 3, we find the annual net income R is RI =
$81,440; ^ 2 - $73,120; ^ 3 = $64,800; ^ 4 = $56,480; R 5 = $48,160. - Determine the capital accumulated
Use the respective SPCA values for i = 3 percent and years 1 through 5 for the income
earned in each year. Or, S = $81,440(1.126) + $73,120(1.093) + $64,800(1.061) +
$56,480(1.030) + $48,160 = $346,700.
B. Compare the average earnings rate on the venture
By the method of step 5, $346,700/$240,000 = (1 + O^5 ; i = 7-63 percent.
The computed interest rates apply to a composite investment-the purchase and opera-
tion of the capital equipment and the purchase of bonds. The total income accruing from
the first element is $324,000, regardless of the depreciation method used. However, the
timing as well as the amount of this income is important.
The straight-line method produces a uniform annual depreciation charge, tax payment,
and net income. Under the sum-of-digits method, these amounts are nonuniform; the net