CFA Practice Question

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CFA Practice Question

Taylor Corporation purchased a new asset for $80,000. The asset had an estimated life of 5 years and an estimated salvage value of $20,000. Now suppose that instead of using a life of five years, the company used an estimated life of ten years and a salvage value of $20,000. What is the effect on income in the second year, assuming straight-line method and a tax rate of 30%?

A. $12,000
B. $6,000
C. $4,200
Correct Answer: C

If the life is extended to 10 years, the depreciation expense for each of the ten years would be $6,000 [($80,000-$20,000)/10]. The effect on the first five years' income before taxes would be $6,000 ($12,000 - $6,000). The after-tax effect on income would be $4,200 ($6,000 x .7). For the first five years, income would be greater by $4,200. For the next five years, income would be less by that amount (assuming no changes in the tax rate). The advantage to the company would be that more income could be recognized earlier by using a longer period, and the company could probably replace the asset during the last five years and not have to recognize the depreciation expense.

User Contributed Comments 14

User Comment
mabrickley Can anyone explain how they came up with income before taxes would 6k, where is the 12K-6K coming from
yusu (a) Depreceiation cost (Useful life 5yrs) = (80,000-20,000)/5 = 12,000

(b) Dept Cost (useful life 10yrs) = (80000-20000)/10 = 6,000

(c) diff between a and b is 6K.
AusPhD Can anyone explain why tax is included here? Wouldn't they use the MACRS method for tax?
thud The question is asking for the effect on Net Income.
bahodir AusPhD, pay attention to "assuming straight-line method".
Just an example, I guess.
uberstyle MACRS applies to actual tax filings and payment of tax (cashflows), but not to calculation of net income
jainrajeshv This is change in accounting estimate and must have prospective effect only. So in the second year depriciation (Net of tax) should be $4200 i.e ((80000-20000)/10)*.7
Am i wrong anywhere?
Querdenker How do we take into account that we have already written off 12K in the first year? The sum of all depreciation over time should be 60K, so writing off 12K + 9* 6K gives a total of 66K (rather than 60K).
in4maha Any body know how to do it the Calculator (TI BA II plus)
thomama Querdenker, the depreciation schedule didn't change, i.e., management decided to extend the life of the asset from the beginning. So, the 10 year life is for the entire period. It's SLD, so each year is simply 6K depreciation.
johntan1979 When it just says "income", always assume they are asking for (after tax) net income.
jonan203 HP12:
$80,000 <enter>
$20,000 <minus>
5 <divide><enter><enter>
$80,000 <enter>
$20,000 <minus>
10 <divide><minus>
.70 <times>
Yrazzaq88 On the TI Plus Calculator:

[2nd] DEPR
Make sure you set to SL
LIF = 10
CST = 80,000
SAL = 20,000
You will get 6,000
Account for the TAX
6000 x .7 (assuming 30% tax rate)
Inaganti6 @johntan, you the man.
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