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Chapter 7: Problem 15

When accumulated depreciation is shown on a balance sheet, how do changes in accumulated depreciation affect cash flows? What events result in changes to accumulated depreciation? Which have an effect on cash flows?

Short Answer

Expert verified
Accumulated depreciation doesn't directly affect cash flows but it does so indirectly via a depreciation expense which decreases business' taxes and thus increases cash flows. Changes in accumulated depreciation primarily occur due to depreciation expense of each period. Other factors include asset sale or disposal, value adjustments and depreciation method conversions. These events, other than the depreciation expense, do not directly implicate cash flows but may have an indirect impact through changes in depreciation expense.

Step by step solution

01

Understanding Accumulated Depreciation

Accumulated depreciation is the total depreciation of an asset that has been charged since the asset was put into use. It is a contra-asset account 鈥� an asset account with a credit balance. It always appears next to the asset's cost on a balance sheet and is subtracted from the asset鈥檚 cost to find the carrying value of the asset.
02

Effect on Cash Flows

Accumulated depreciation itself does not directly affect cash flows, but the depreciation expense, which increases accumulated depreciation, can impact cash flow indirectly. Since Depreciation is a non-cash charge that reduces the company鈥檚 earnings, by reducing taxable income, it reduces the amount of cash a company must set aside for tax payments, in turn increasing cash flows.
03

Events Resulting in Changes to Accumulated Depreciation

The primary event that results in changes to accumulated depreciation is the depreciation expense recorded for an accounting period. Other events could include the sale or disposal of an asset, adjustment for revaluation, correcting accounting errors from past years, or due to conversion from one depreciation method to another.
04

Event Effects on Cash Flows

While the depreciation expense indirectly increases cash flows, the other events do not have a direct impact on cash flows. If an asset is sold above its carrying value, it results in a gain and therefore increases cash flow. If sold below, it results in a loss and hence decrease in cash flow. Revaluations, corrections of past errors, conversions of depreciation methods do not affect cash flow directly. However, if they result in a change to depreciation expense, it might result in indirect impact.

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Key Concepts

These are the key concepts you need to understand to accurately answer the question.

Cash Flow Impact
Accumulated depreciation is key for understanding cash flow impacts because it helps manage tax expenses related to asset depreciation.
While accumulated depreciation doesn鈥檛 directly alter cash flows, the process of depreciating assets indirectly influences cash reserves. This is because depreciation expense, a major component, is non-cash and reduces taxable income.
Therefore, businesses get the benefit of decreasing their tax obligations without an actual outflow of cash. This means businesses have more cash on hand for operations and investments, improving liquidity.
Depreciation Expense
The depreciation expense reflects how much value an asset loses over a specific period. It is a systematic allocation meant to spread the cost of the asset over its useful life.
Each time a depreciation expense is recorded, it increases accumulated depreciation, which is then reflected on the balance sheet. This recorded non-cash charge lowers a company's taxable income, which can be advantageous for cash flow.
Companies can choose various methods to calculate depreciation like straight-line or reducing-balance, all impacting how much depreciation expense is recorded each period.
Balance Sheet Effects
On a balance sheet, accumulated depreciation appears as a deduction from the total asset value, specifically from the related specific asset category.
This reduction forms what is known as the book value or carrying value of an asset. A high balance in accumulated depreciation signifies that an asset is closer to the end of its useful life, which is critical for investors and management analyzing company assets.
When accumulated depreciation increases, it doesn鈥檛 affect cash flow directly, but it affects the net asset value significantly shown on the balance sheet.
Asset Sale and Disposal
When a company sells or disposes of an asset, it may impact accumulated depreciation.
- If sold at a value higher than the asset's current book value, a gain occurs, increasing cash flow. - Conversely, selling at a lower price results in a loss, reducing cash flow. - During disposal, the accumulated depreciation is removed from the books, as well as the asset itself.
These actions result in updated balances in financial accounts, ensuring the financial statements reflect the current state of the company鈥檚 assets.
Non-Cash Charges
Non-cash charges, like depreciation, play a crucial role in accounting as they affect the income statement without impacting cash flow directly.
These include various expenses recorded for accounting purposes, such as amortization along with depreciation. They allow businesses to lower reported earnings while maintaining the same operating cash levels.
The understanding of non-cash items is essential for getting a real sense of the financial health and operational cash position of a company, as these charges are essential for tax planning and cash flow management.

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Most popular questions from this chapter

A firm purchased a computer-controlled drill press for \(\$ 480,000\) at the beginning of \(2000 .\) The drill press has an expected useful life of 10 years and zero residual value. Assume that the firm begins the year with the following balance sheet accounts, ignoring depreciation on the existing plant and equipment: a. Show the effects of the drill press purchase on the firm's balance sheet equation. Assume that the firm borrowed money to purchase the drill press. b. Show the effects of straight-line depreciation on the balance sheet equation for the first two years of the drill press's life. c. Show the effects of double-declining-balance depreciation on the balance sheet equation for the first two years of the drill press's life. d. Comment on these differences. Is the firm's balance sheet stronger under ei ther method? Why?

Refute the assertion that "depreciation is a source of cash."

A firm purchased computer-aided drafting and machining equipment at the beginning of the year for \(\$ 420,000\). The machine has an expected useful life of six years and a \(\$ 38,000\) residual value. a. Calculate the annual depreciation expense for the first four years of the equipment's life using the straight-line method. b. Calculate the annual depreciation expense for the first four years of the equipment's life using the double-declining-balance method. c. Calculate the annual depreciation expense for the first four years of the equipment's life, using the sum-of-the-years'-digits method. d. Comment on the differences in your results. Which method would managers prefer if they are trying to maximize their net income? Which method is preferred if the objective is to minimize income taxes? Why? e. Using double-declining-balance depreciation, calculate depreciation expense through the sixth year. What adjustment to depreciation should be made in the sixth year?

Discuss the following proposition: GAAP should only include one depreciation method: options give managers too much flexibility and too many opportunities to manipulate net income.

Discuss the following proposition: GAAP should permit managers the flexibility to choose from among several depreciation methods; each firm is unique and may require the flexibility to match its depreciation method to its own unique circumstances
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