[levhelm]

On January 2, 2005, to better reflect the variable use of its only machine, Holly, Inc. elects to change its method of depreciation from the straight-line method to the units-of-production method. The original cost of the machine on January 2, 2003, is $50,000, and its estimated life is ten years. Holly estimates that the machine’s total life is 50,000 machine hours.

Machine-hour usage was 8,500 during 2004 and 3,500 during 2003. Machine-hour usage for 2005 is 3,800.

Holly’s income tax rate is 30%. Holly should report the accounting change in its 2005 financial statements as a(an)

A. Estimate change recognizing $3,800 of depreciation in 2005.

B. Estimate change recognizing $4,000 of depreciation in 2005.

C. Cumulative effect of a change in accounting principle of $1,400 in its income statement.

D. Adjustment to beginning retained earnings of $1,400.

The correct answer is B.

My first thought was that the answer was A, but CPAexcel says it is B because the book value at the beginning of 2005 is allocated over the remaining useful hours. This isn’t explained well in the study text, and the MCQ explanation is minimal.

Can anybody help me with this? Thanks!

Passed

[JohnWayneIsGod]

Just remember that a change in depreciation is a change in estimate and thus all changes are prospective in nature. That is, that all changes are done going forward. None of the previous expense recognized is changed due to the change in estimate. With this rule in mind, the new depreciation method will use the existing book value of the asset.

FAR - 80

Courage is being scared to death, but saddling up anyway.

-John Wayne

[levhelm]

That makes sense conceptually, but I'm still having difficulty understanding the reason why a ratio is involved in the calculation (see below). The answer requires dividing 40,000/38,000 and then multiplying this ratio by 3,800 to get 4,000. Other than straight up memorizing this formula, I don't understand why it is done this way. If I memorize the formula I won't truly understand the concept. Am I the only one who finds this confusing?

Any help is much appreciated here. Thanks!

SL

50,000

(5,000)

(5,000)

= 40,000

UOP

50,000

(8,500)

(3,500)

= 38,000

3,800 x (40,000/38,000) = 4,000

Passed

[Bnots]

Under the straight-line method you've recorded $10,000 in depreciation for 2003 and 2004 leaving you a book value of $40,000. With the change in depreciation method, that $40,000 has to be depreciated over the remaining estimated machine hours.

The remaining estimated machine hours are 50,000 minus the 12,000 total used in 2003 and 2004, or 38,000 machine hours.

Therefore, each machine hour used since the change to the units-of-production method requires you to record $40,000/38,000 or about $1.05 of depreciation. In the general case, then, you multiply the machine hours used by ~$1.05 to get the depreciation. In this case, since the 3,800 machine hours used in 2005 is exactly one tenth of the remaining estimated machine hours, you're recording one tenth of the remaining amount to be depreciated, or $4,000.

EDIT: The concept is the same going the other way. Using the units-of-production method you would have recorded $12,000 in depreciation over 2003 and 2004, and the remaining amount to be depreciated would be $38,000. Upon switching to the straight-line method with an estimated *total* useful life of 10 years, that $38,000 has to be depreciated over the remaining useful life, or 8 years. Therefore, each year going forward you would record $38,000/8 = $4,750 of depreciation expense.

[levhelm]

This was a huge help. You explained it so clearly. Thanks!

Passed

[Author]

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